Does Captive Insurance Have Anything to do with Somali Pirates? – Wealth Legacy Group, Inc.

A captive insurance company is a self-insurance option that has become increasingly popular in smaller to medium-sized US businesses that are very profitable.  These “captives” historically insured workers compensation, medical malpractice and various warranties.  Recently, they have become more popular for both health insurance and enterprise risk.  In the enterprise risk captives, policies are designed to insure against risks with a very low probability of occurrence.

Generally, there is common ownership of the captive and the business it insures.  It can be owned by the business owner, their spouse or relatives, a trust, or any of the companies that are owned by the business owner.

Most businesses that utilize captives continue to work with commercial insurance companies.  They insure the gaps in their commercial coverages (deductibles, coinsurance, excess limits, and excluded risks) through their captives.

History of Captive Insurance Companies

The term “captive” was coined in the US in the 1950s by Fred Reiss, who is known as the father of captive insurance.  At the time, regulations made it prohibitively expensive to form and operate captives in the US.  Reiss established the first modern-day captive in 1962 in Bermuda.  There are now approximately 5,000 captives located worldwide, responsible for more than $9 billion in annual premiums.  Bermuda leads the way with the most captives, followed by the Cayman Islands and then the State of Vermont.  California does not have any captive insurance laws, at least – not yet.

Types of Captives

The most common types of captives are as follows:

  • “Single-parent” captive (or “Pure” captive)—a captive that only insures its parent company.
  • “Group” captive—a captive established by a group of companies with similar business or exposure risks.
  • “Association” captive—a captive owned by a trade, industry or service group, such as medical doctors.
  • “Industry” captive—a captive established by a group of companies with similar types of businesses.
  • “Rent-a-captive”—a captive that is owned by an outside organization who charges participants a fee to “rent” licenses and capital from them.  This can be a very attractive option for those that do not want to form their own dedicated captive, or want to keep initial costs lower.

How it Works…Broadly Speaking  

The parent company first identifies potential areas of risk to the business.  Perhaps as much as two-thirds of business risks are typically not insured against.  Examples include the loss of a key supplier, loss of a key customer, loss of a key employee and so forth.  These risks present a measureable loss with a low probability of occurrence but they could have significant financial consequences.

Once the risks have been identified, and the costs for setting up and administrative services determined, the business can decide how much it wishes to deduct from gross income in that year … up to $1.2 million if filing under the Section 831(b) election under the Internal Revenue Code.  New legislation passed in 2015 will expand the annual premium limitation to $2.2 million, starting in 2017.

At the end of the tax year, whatever “reserves” remain (after paying for operating expenses and any claims which might have occurred) can be invested into a diversified portfolio of stocks, bonds, mutual funds, etc.

Benefits of a Captive

  • Lower insurance costs—by cutting out or reducing the share of the “middle man,” you avoid paying for some of the typical fees and costs that are built into insurance premiums.  
  • Create a new profit center—the captive’s ability to generate investment income from funds not paid out in claims creates a new profit center independent of the parent company.
  • Insure risks that would otherwise be uninsured—when the commercial market is unable or unwilling to provide insurance coverage for certain risks, or where the price for coverage is prohibitively expensive, a captive may provide the insurance coverage that the business needs.  For example, you could insure against the risk of Somali pirates if you owned a boatful of cargo that was travelling through the Indian Ocean in Northeast Africa.
  • Asset protection—asset protection is created for the parent company because at least some of the profits have been moved into the captive and are beyond the reach of creditors.
  • Improved cash flow—since premiums may be deductible expenses for the corporation (and underwriting profit may not be taxable to the captive), funds that might otherwise have been spent on taxes could be used to build reserves to protect the business in the future.  This may help reduce lending and bonding costs for the company.
  • Access to the reinsurance market—a captive can obtain advantageous rates by accessing the reinsurance market, which operates on a lower cost structure than direct insurers.

Where Should the Captive be Domiciled?

Captives are regulated by the location in which it is headquartered.  Off-shore locations, such as Bermuda, are no longer as attractive to US business after the passage of the Stop Tax Haven Abuse Act of 2009.  As a result of this law, the IRS now closely scrutinizes any captives that are located in these “off-shore secrecy locations.”  Based on this Act, it may now be prudent to only consider US jurisdictions as the domicile of the captive (assuming you own a US business).

Nothing’s Perfect … Drawbacks of a Captive

Although captives have many benefits, they also have possible drawbacks that need to be considered:

  • Increased administrative burden—additional time, money and personnel will be required for insurance claim administration, loss control and underwriting (this is usually outsourced).
  • The need for additional expertise—the business and the captive will need to acquire expertise for handling the insurance related issues that will be involved in self-insuring the business.
  • Capital commitment—at least in the initial stages of forming the captive, there will be a cost to the parent company to fund the initial set-up costs and meet the capitalization requirements ($50,000 – $250,000) of the jurisdiction where the captive is domiciled in.
  • Captives have greater IRS scrutiny—the IRS placed captives on its 2015 annual “dirty dozen” list of tax scams.  The IRS is on the lookout for exorbitant insurance premiums that are used to cover ordinary business risks, or for esoteric, implausible risks, as well as when loans are immediately made back to the business owner who had just set up the captive. Bottom-line … don’t be a hog … be sensible and you should be fine.

What’s the next step?

Determining whether a captive may be right for your business can be done in stages.  There is no charge for an initial conversation and cursory examination of potential application for your company.  Additional issues concerning captives were covered in my November 2015 radio show with two experts in the field: Keith Langlands and Chris Jarvis.  

What is your situation?  We can provide answers to the most challenging of situations and tailored to your unique situation – whether or not Somali pirates may be a risk.

Imagine That™”!

 Written by R. J. Kelly – January 2018

 

Image by Cindy Tang on Unsplash

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