Captive Insurance

A tax law that may cut your cost of doing business.


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The Internal Revenue Code is designed to "taketh" your money. "Giveth" is not in its vocabulary. Yet, Section 831(b)dealing with captive insurance (a technique where a business forms its own insurance company subsidiary to finance retained losses), can be structured to offer tax-advantaged benefits.

For example: Joe owns Success Co, which has uninsured risks that his current property and casualty insurance (PCI) will not cover. Joe creates New Co., a corporation insurance company (or Captive) that will cover Success Co.'s uninsured risks. Joe's children own the New Co. stock.

Suppose the insurance premium for uninsured risks are determined (professionally by a consulting actuary) to be $500,000 per year. Success Co. pays the $500,000 premium to New Co. The entire premium is immediately deductible by Success Co. like any other PCI. Under the Captive rules, all of the $500,000 is income tax-free to New Co.

Say Success Co. is in a 40% tax bracket (state and federal combined). Success Co. is only out of pocket $300,000 ($500,000 less $200,000 in tax savings). New Co. has the entire $500,000 to invest. A good start. But remember, New Co. is a captive and must hold the $500,000, plus earnings as a fund to pay potential claims for the risks it insurers.

Next, let's explain "uninsured risks." Every business has risks: some insured, some uninsured. The most common risks—like workmen's comp, vehicle, property and general liability—are transferred to your traditional property and casualty insurance carriers and are insured risks.

Risks you can't always buy coverage for in the insurance market include litigation defense, loss of a key customer or supplier, change in a regulation, product warranty; and strikes/labor problems.

Your business is self-insured for all of the above risks, either by choice or because the risk just can't be insured commercially. Even though a Captive cannot reduce (actuarially determined) premiums, a financial windfall (unused reserve) results if the insured's actual losses are less than actuarially predicted. A portion of the unused reserve can a) be refunded to Success Co.; b) reduce future premiums; or c) be paid to the Captive's shareholders as a dividend.

Your Captive must be formed and operated for a business purpose, demonstrating that it is, in fact, acting as a proper insurance company. No attempt is made in this article to explore all the rules, traps and opportunities in forming your own Captive. An experienced advisor can easily tailor a Captive to fit you, your business and your circumstances.