What is captive insurance?
Captive insurance is when an individual business, or group of businesses, gets together to start their own insurance company. In other words, captive insurance is where the insurers own the insurance company.
What are the benefits of creating and using a captive insurance company?
There are a number of very good reasons for creating a captive insurance company.
Control Many of the reasons to create a captive insurance company come down to the ability of the owner of the Captive to gain additional control over key aspects of their lives or businesses. This control extends to the type of risks to insure, how much premium to charge and how to respond to claims when they occur.
Premiums Overtime some individuals or business pay substantially more to commercial insurance companies in premiums than they receive back by way of payment on claims or other benefits. Creating a captive allows the owner to pay lower premiums or receive the profit created by low claims.
Specialized Risk Some businesses have peculiar risks for which commercial insurance companies do not offer insurance coverage. In other cases, the coverage offered by commercial insurance companies has so many limitation that is does not provide effective insurance. Owners of captive insurance companies can write their own insurance policies to provide coverage tailored to their needs.
Access to Reinsurance Insurance companies rarely insure 100% of the policies they write. They purchase insurance to cover, or reinsure, portions of the risk they undertake. Reinsurance is like buying wholesale insurance. Consumers cannot purchase wholesale insurance, but captive insurance companies can.
Tax Deferral A business that purchases insurance is able to deduct the amount of the insurance premium from the taxes it pays. Under many circumstances, businesses who are insured by captives have the same deduction.
Profit Commercial insurance companies stay in business because they make a profit for their owners. Captive insurance companies can do the same. Imagine the benefit of deducting premiums paid to a Captive in the current tax period and, sometime later, receiving profit from the captive insurance company, which profit is taxed as a capital gain.
What kind of insurance can be insured in a captive insurance company?
Almost any kind of risk can be insured by a captive insurance company.
The most common kind of insurance provided by captive insurance companies covers losses due to mistakes and accidents. The cause of the accident and the property protected varies widely. Captive insurance can be used to protect its owners against simple slip and fall accidents, more complex professional liability and highly specialized risks unique to the owners of the captive insurance company. This is known as casualty insurance.
Captive insurance companies are being increasingly used for other types of insurance, including workers compensation and healthcare.
Captive insurance companies are also well suited to insure risks considered uninsurable by commercial insurers.
What are the risks associated with a captive insurance company?
Running any business (including captive insurance companies) takes money, time, effort and reliance on skilled professionals knowledgeable in the industry. And even with these elements in place, there is no guarantee of success. However, with proper planning and management, each of these risks can be overcome. After all, most insurance companies are in business year after year.
Business Risks A captive insurance company is a real business with real business risks. Like any business, a captive insurance company can fail. If this happens, policyholders who purchased insurance from the captive insurance company no longer have insurance.
Regulatory Risk There are also regulatory risks involved in using a captive insurance company. These risks arise at both the state and federal levels:
State Regulatory Risks
An insurance company must be licensed by any state in which it does business. Since most captive insurance companies are not licensed by any state, they must, therefore, be very careful to avoid doing business in any state. What exactly constitutes "doing business" in a state is a technical legal question that requires careful planning and review to avoid running afoul of state regulators.
Federal Regulatory Risk A second regulatory risk arises when deducting the cost of insurance premiums from federal (and state) tax. For many years, the IRS took the position that such premiums were not deductible. After a number of embarrassing defeats in court, the IRS has recently changed its approach to dealing with premiums paid to captive insurance companies. The IRS has now issued a series of revenue rulings which provide guidance regarding when premiums paid to captive insurance companies can be deducted. With careful planning and tax advice, most captive insurance companies can be structured so that the premiums paid to it are deductible.
What does it take to start a captive insurance company?
Creating a captive insurance company is a relatively straight forward process. However, it does take both time and money.
Time This depends entirely on the scale and complexity of the project. Setting up a simple captive insurance company can take as little as one month. Four to six months (or longer) is more common.
Documents Prepare necessary documents including those involved with corporate creation, governance and the actual insurance policies.
Capital Nearly all jurisdictions that license captive insurance companies require that the company be started with a minimum amount of capital. Minimum capital requirements range from $100,000 to $500,000.
Feasibility Study A feasibility study is really a business plan. It should answer basic questions such as:
Fees Again depending on the complexity, the expertise of a number of professionals will be needed during the process of creating a captive insurance company. These include lawyers, tax experts, actuaries, and managers. There will also be fees charged by the jurisdiction in which the Captive is created. Expect to pay between $75,000 and $100,000 in professional and other fees.
- Is the Captive economically viable?
- Where is the most advantageous place to license the Captive?
- Which service providers should be involved in managing the Captive?
- What is the best corporate structure to use for the Captive?
What if there is claim against your Captive?
Not to worry. This is why the Captive was created. Responding to claims adds legitimacy to Captives and provides support for the premiums the Captive has been charging.
Handling claims is where the control offered by Captives becomes a great advantage. Is your biggest fear frivolous lawsuits? Your Captive can provide both the money and vehicle to go after the dirty so-and-so's who threaten your busines with frivolous lawsuits. Are you more interested in avoiding conflict and resolving disputes? Again, your Captive can provide the means and the funds to resolve troublesome lawsuits. As with any business, handling the Captive's claims requires skill and experience.
In general, the more parties the Captive insures, the larger the number of pitfalls that can arise in handling claims. Like all insurance companies, Captives must deal in good faith with those they insure. Responding intelligently to a claim or to litigation requires the services of attorneys experienced in defending the specific type of claim. But a litigation attorney hired to represent the insured owes his or her best efforts to the insured. The Captive may also need advice separate and apart from the party it insures. The issues are reasonably easy to handle upfront, but can be very difficult to resolve after the fact.
What's the catch? Why doesn't everyone just set up their own captive insurance company?
Captive insurance is an amazing opportunity for medium to large sized companies. However, for smaller businesses, it may not make financial sense to set up your own captive insurance company. The rule of thumb is that if you're currently paying over $500,000 a year in insurance premiums, then captive insurance can save you a lot of money.