Captive Insurance
For several decades the form of risk transfer used by most Fortune 500 corporations was commonly referred to as “Captive Insurance.” This “captive” name was used in order to best describe the manner in which corporate insurance coverage was transferred to a wholly-owned subsidiary in the insurance business (captive insurance.)
Over the years this form of risk transfer has changed to include many small and medium-sized businesses. Further, the types of captive insurance companies also changed to include not only parent-owned captive insurers, but also included captives that could be owned by associations, professional groups, independent producers, reinsurance captives and a host of other types of businesses. Hence, the word “captive” no longer means what it once did in 1970.
Captive insurance has also attracted attention from tax authorities since insurance companies typically reserve premiums today for future claim losses. That form of special taxation for insurance companies has resulted in captive insurance tax cases, private letter rulings and IRS Revenue Rulings over the past years. Today, it is widely recognized that captive insurers must truly be run like any other small insurance company and not some form of investment club. That means the captive must reflect risk transfer in its manner of accepting risk and provide for minimal risk distribution by spreading risk (at least 30% of net written premium from unrelated risks.)
Onshore and offshore captive insurance companies owned by US citizens must file a US corporate tax return each year. Further, if a captive is offshore it must make a 953(d) election to avoid excise and other foreign tax issues. This election means that the captive, even if domiciled offshore, will be taxed and treated like a regular small onshore US insurance company. Further, onshore and offshore 953(d) captives may elect to be taxed under a special IRS Code section called 831(b.) This allows favorable tax benefits for non-life insurance captive insurers that write less than $1.2 million in premiums (net of reinsurance.) Other tax benefits of captive insurance may relate to the manner in which long-term capital gains and qualified dividends are taxed (currently at 15%.)
The process of forming a captive insurance company involves several important items. For example, people interested in owning a captive insurance company should consult with business consultants who specialize in this form of alternative risk transfer planning. Those consultants would likely meet with prospective clients to review reasons why they are considering a captive insurance company. Next the consultants would be engaged to develop a five-year financial pro forma to review the income and expenses involved with captive ownership. If all goes well, the process would be expanded to include a business plan and selection of possible captive domiciles. When the client decides on a domicile, the domicile application process would begin. This would include the completion of domicile applications and other Financial Services Commission (FSC) compliance forms. After FSC approval of the proposed captive, incorporation would be completed as it related to form of ownership, etc. This process must include an insurance manager who is licensed within the captive domicile and a registered agent firm.
After approval, the owners and consultants should prepare the manner in which insurance business would be added to the captive insurance company and duly recorded. This process would also include the manner in which monthly accounting would be completed in order to enable a year-end audit or compilation report. At this point the captive insurer has a bank account, claims committee, investment committee and corporate protocol fully established and operational. At year-end the captive corporate tax return would be completed and all necessary tax elections. Further, the year-end annual statement would be completed as well as any audit, etc.
The time-line for formation of a captive insurance company varies domicile-to-domicile and type of captive. The FSC has control of this process and in most cases requires at least 4-6 weeks for review. The initial application paperwork may take several weeks to complete depending upon the client’s ability to complete necessary forms and other FSC requirements. One never knows the speed in which any government might review a captive insurance application file.
Other captive insurance concerns are such things as reinsurance, fronting, types of approved investments, underwriting risks, claims handling and banking. Each topic has many unending sub-topics and are beyond the scope of this memorandum.
- To insure risks that can’t obtain traditional insurance cover.
- To insure risks where local insurance markets are too expensive.
- To obtain greater insurance claims control.
- To obtain favorable tax benefits.
- To have greater insurance underwriting input.
- To have greater control of cash flow and investment income.
- To provide for greater asset protection and wealth management planning.
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