CAPTIVE INSURANCE
COMPANIES
FOR
CLOSELY HELD BUSINESS
AND THEIR OWNERS
By Richard M.
Colombik, JD, CPA
Richard M. Colombik
& Associates, PC
Published at http://blog.inc.com/law-and-taxation/
August 13, 2008
Captive insurance
companies have been growing by leaps and bounds. A captive is
an insurance company that insures the risks of its parent
company. It is owned by a parent or at times by the shareholders
of the parent company. The operating entity insures all or part
of its risks with its captive company. The captive may reinsure
some or all of such risks, or may retain such risks. The benefits
of a captive may be many, but the primary goal is to retain the profit
that would have been made by an outside third party insurance company
or to provide coverage where coverage would not be available.
There are many
differing types of captives, based upon what the needs of the parent
company or its owners are. The most commonly encountered types
of captives according to Wikipedia
are as follows:
- Single Parent
Captive - is an insurance or reinsurance company formed primarily
to insure the risks of its non-insurance parent or affiliates.
- Association Captive
- is a company owned by a trade, industry or service group for the benefit
of its members.
- Group Captive
- is a company, jointly owned by a number of companies, created to provide
a vehicle to meet a common insurance need.
- Agency Captive
- is a company owned by an insurance agency or brokerage firm so they
may reinsure a portion of their client?s risks through that company.
- Rent-a-Captive
- is a company that provides 'captive' facilities to others for a fee,
while protecting itself from losses under individual programs, which
are also isolated from losses under other programs within the same company.
This facility is often used for programs that are too small to justify
establishing their own captive.
- SPV ? special
purpose vehicles. Although used extensively in the past for various
financing arrangements, recently they have been used for catastrophe
bonds and reinsurance sidecars.
- SPC ? segregated
portfolio companies. SPCs can be formed as a rent-a-captive facility
to enable those companies who lack sufficient insurance premium volume,
or who are averse to establishing their own insurance subsidiary, access
to many of the benefits associated with an offshore captive.
Captives, like
all Insurance Companies, have specific tax rules that allow them special
benefits that non-insurance companies do not have. An insurance
company receives premiums, pays it expenses and then invests the monies
it has retained, reserves, to pay future claims. The insurance
company receives an income tax deduction for almost all of its funds
deemed reserves, and then can invest and accumulate these funds.
A regular corporation pays income tax on the funds it retains and calls
such retentions profits. Yet as the business of insurance requires
the payment of future claims, the accumulation of funds is a necessity
for being able to pay such claims.
The amount
of reserves that a company can accumulate is determined by an actuarial
calculation of the nature and amount of risks it covers, combined with
the insurance rules as to the types of allowable investments for company
reserves. There are restrictions upon what types of investments
and what percentage of assets per investment may be made.
The jurisdiction or state of the insurance company?s license will
also have an effect on its operations and retentions.
A company owning
a captive normally receives an income tax deduction for the payments
it makes to such captive as an ordinary and necessary business expense
within IRC §162. The captive receives such
funds, pays its operating expenses and then deducts the allowable amounts
of reserves it invests. If a claim is made the reserves are used
to pay such claims.
A captive insurance
company may provide an opportunity for a company that either self insures
certain risks to have a current income tax deduction for payments to
another entity it owns, or its shareholders own, that will provide the
future funds for what would otherwise have been a non-deductible current
assumption of risk. Instead, the income tax deduction is accelerated
for the operating company and funds are provided for it by the captive
company should the risks transpire. If the risk is true third party
risk, then the requirements of risk shifting and risk distribution would
normally be present and such coverage would be deemed ?insurance?.
Not generally
known to most business owners is an opportunity in the Internal Revenue
Code to not only deduct payments made to a captive but to also not require
the captive to pay any income tax!
The two IRC
sections at issue are IRC §501(c)(15) and IRC §831(b).
IRC §501(c)(15)
allows a very small property and casualty insurance company to not pay
any income tax on the receipt of premium income and from its investment
income if the total amount of funds received during a year are $600,000
or less and greater than 50% of the income received was from premium
income.
IRC §831(b)
provides an expansion of the amount of annual premiums received which
are non taxable to $1,200,000 but provides that the company would pay
an income tax on its taxable investment income.
For the closely
held business owner, these sections provide an opportunity to expand
the closely held company?s ability to save funds and retain profitability
by owning a captive or a portion of a group captive.
An example
of this is with a recent client who self funded catastrophic medical
as well as disability coverage for their employees. The client
was attempting to accumulate cash within the company to pay out in the
event of an employee?s disability or medical expense exceeding their
policy limits. As the company was self-funding for these risks,
it was in essence self insuring such risks. Self-insurance is
unfortunately non-deductible.
The problem
the company had was that all income was taxed at the maximum federal
corporate income tax rate of 39%. All accumulations of income
were taxed at the maximum federal corporate income tax rate of 39%.
As such, they had a difficult time accumulating sufficient funds.
The solution was to set up a captive insurance company, owned by the
corporate shareholders. The insurance company provided the insurance
coverage, versus self-assumption of risk. This also provided the
operating company with a tax deduction for the premiums paid to shareholder?s
company. The captive insurance company by virtue of receiving
less than $1,200,000 of annual premiums did not have to pay any federal
income tax. The insurance company then invested its reserves in
tax-free investments, so that no income tax would be due on the insurance
company?s investment income.
The net effect
of the $1,000,000 annual premium payment per year is as follows:
Premium paid $1,000,000 $1,000,000
Less: Income
tax $
0 $ 390,000
Sub total $1,000,000 $
710,000
Investment
Earnings $ 50,000 $ 35,500
(5% )
Less: Income
tax $
0 $ 19,845
Annual Available
Funds $1,050,000 $
731,655
It is apparent
that the operating company when self-insuring does not have the ability
to accumulate as much money, as quickly, as it could through the operation
of a captive. The captive, however, provides the opportunity to
have a company or its owners retain the profits that might otherwise
be earned by a third party insurance company. Not all risks would
be appropriate for a captive to assume, but an actuary familiar with
the operation of a captive would be able to assist with a feasibility
study to determine if the captive was appropriate for the circumstances
at issue. In many cases the captive provides the opportunity for
a current deduction and, if such captive is profitable, a way to also
increase the shareholders net worth by the insurance company increasing
in value. The shareholders? net worth is further increased by
the annual income tax reduction by virtue of the premium payments being
deductible, versus self-insurance.
It is recommended
that you work with a tax lawyer and a team that is familiar with the
structure and operation of captives as this a technically complex area
that combines not only income tax, but insurance law, as well and contains
many landmines for the unwary.
Captives can
be used for malpractice coverage and almost any property and casualty
risk even if commercial coverage is not available to protect against
such risk. Captives properly thought out and funded can be a big
win for the business owner!
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