Not many people are aware or fully understand captive insurance plans. Most often industry experts, even some CPAs, incorrectly assess the risks and benefits of a captive: the truth is that they are hazy on the details of this effective, yet complicated, risk planning strategy.
While providing consultation to the C-level executives, I’ve learned that most don’t implement captive insurance planning because their tax team does not understand how a captive actually works.
However, when used properly, it can result in significant tax savings. So, let’s understand what is meant by captive insurance, in plain English. A captive insurance company is generally defined as an insurance company that is wholly owned and controlled by the insured; its primary purpose is to insure the risks of its owners, and its insured’s benefit from the captive insurer’s underwriting profits. As a business owner, you get the tax deductibility of premiums along with any profits realized by the captive.
In a captive, a business owner forms his or her own insurance company to cover certain business risks. Premiums will be paid to the captive just as they are paid to any other insurance company.
However, the captive insurance policy may cover a broad range of risks that are not normally covered by traditional insurance companies. The best part about captive insurance companies is that a business owner will have total control over the claim process. The chances of getting the claim denied are negligible. Captive owners also don’t have to worry about any claim fraud as they are in total control of
operations. The use of a captive insurance strategy benefits businesses in many ways, including:
If the premiums paid to the captives exceed the loss amount in a given year, the earnings are considered as “earned surplus.” This extra income can be used to invest in business growth, retire loans, or pay dividends to the shareholders.
A captive should be located in a domicile with an accessible and efficient regulatory environment. This is necessary for a captive to be economically feasible. Also, the legislation should consider captives as distinct and not impose restrictions like those of standard insurance companies. The domicile where the captives operate will determine the regulatory claims, risk levels, and taxes. So, it’s important that the captive is located in a jurisdiction that allows cost effective operation.
Delaware, for example, has created captive-friendly legislation, No other state combines corporate and business laws with alternative risk transfer plans quite like Delaware. The state passed House Bill 218 in 2005 to update laws relating to the formation of captive insurance companies. Captives located in Delaware reap the benefit of reduced costs and effective administration of insurance coverage.
The best thing about captive insurance is that policies can be custom designed to cover the risks that are pertinent to your company. An added incentive is that captives with premiums less than $2 million are exempt from federal income tax. So, you may be able to reduce the risk of loss and greatly reduce tax liability by forming a captive insurance company. Another interesting feature of captive insurance is the transfer of risk for a premium. Certain risks can be transferred
from the insurance company to another firm known as the reinsurer.
Genesis Metals was paying $400,000 per year in premiums to a third-party insurer. Actual claims were about $125,000 per year, so the insurer was profiting by nearly $275,000 per year. After implementing a captive, Genesis set premiums at $300,000. Claims in the first year amounted to $150,000. Genesis was able to pocket $150,000 in untaxed earnings; and let’s not forget the $100,000 they saved with the difference in premiums paid by the third-party insurer. These amounts do not even include any investment income that may be realized from the unused premiums.