Captive insurance companies are a great option for business owners who pay taxes in the United States. In many ways, a captive insurance company (CIC), is the same as any other insurance company. Because it provides insurance to one or several related businesses, it is called “captive”. Captive insurance is where premiums paid by businesses are kept within the same “economic group”, and not paid to an outsider.
Two key tax benefits enable a structure containing a CIC to build wealth efficiently: (1) insurance premiums paid by a business to the CIC are tax deductible; and (2) under IRC § 831(b), the CIC receives up to $1.2 million of premium payments annually income-tax-free. The business owner can also shift taxable income from the operating business to the captive low-tax insurer. An 831 (b) CIC pays tax only on its income from investments. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.
Large corporations formed the first captive insurance companies 60 years ago to offer insurance that was too costly or not available in the traditional insurance market.
The steps and procedures for establishing and operating a CIC have been clearly established over the years by a combination US tax laws, IRS rulings, and court cases.
Captive insurance companies must fulfill “risk shifting”, and “risk distribution”, requirements to qualify for tax purposes as insurance companies. This can be done easily through routine CIC planning. CIC insurance must be considered insurance. This means that the CIC insures the loss and the premium-paying business must shift the risk.
CICs offer tax advantages, but also increased control and flexibility. These benefits increase insurance protection, and decrease cost. Conventional insurance is dictated by an outside carrier. Many risks cannot be covered conventionally or are too expensive to be insured. Conventional insurance rates are often unpredictable and volatile. Additionally, conventional insurers can deny valid claims by overstating technicalities. Even though business insurance premiums are usually deductible, once paid to an external insurer they are gone forever.
Captive insurance companies insure risk efficiently in many ways. This includes customized insurance policies, favorable rates from reinsurers and pooled risk. Captive insurance companies are well-suited to insuring risks that would otherwise not be insured. Many businesses have traditional “retail”, insurance policies to cover obvious risks. However, they remain exposed and vulnerable to loss and damages from many other risks (i.e. they “self-insure” those risks). A captive company is able to create custom policies for each business and negotiate directly between reinsurers. CICs are particularly qualified to issue business casualty insurance policies. These policies cover business losses that are claimed by the business, and not third-party claimants. One example is that a business might be insured against loss due to business interruptions due to weather, labor issues, or computer problems.
An 831(b), CIC is exempted from tax on premium income up to $1.2million annually, as noted above. A CIC is considered economically sensible if it receives premiums in excess of $300,000. The business should not pay more than 10 percent of its annual income in insurance premiums. To pool resources and risk, a group of professionals or businesses with similar risks may form a multi-parent captive (or group captive), insurance company.
A captive insurance business is an independent entity with its own management, finances, and capitalization requirements. It is organized as an insurer and has the procedures and personnel necessary to handle insurance claims and policies. A feasibility study is done to determine if a CIC would be appropriate for a specific economic family. An actuarial study determines the best insurance policies and their premium amounts. Capitalization requirements are also identified. The application for an insurance licence may be submitted once the jurisdiction is chosen. There are many competent service providers that can provide “turnkey solutions” for licensing, initial evaluation, and ongoing management. These turnkey services typically cost between $50,000 and $150,000 annually, which is high but easily offset by lower taxes and higher investment growth.
A captive insurance company could be set up under one of many offshore jurisdictions, or in a country (e.g., one of the 39 US States). Some captives such as the risk retention group (RRG) must be licensed domestically. Offshore jurisdictions tend to be more accommodating than the domestic insurance regulators. As a practical matter, most offshore CICs owned by a US taxpayer elect to be treated under IRC § 953(d) as a domestic company for federal taxation. However, an offshore CIC does not pay state income taxes. It costs less to license and manage an offshore CIC than it does domestically. A offshore company has better asset protection options than a domestic one. An example is an offshore irrevocable trust that owns an offshore captive insurance business. This provides asset protection for creditors and grantors, as well as allowing the grantor to reap the benefits of the trust.
Captive insurance companies can help US business owners save money on their insurance premiums. They also build wealth, reduce taxes, and make it easier to integrate into estate and asset planning. A captive insurance company can shift up to $1.2million of taxable income as deductible premiums from an operational business to a CIC with low taxes.
