For small-business owners, captive insurance is a legal tax arrangement. Premiums paid to a captive insurer can be deducted from your taxes if the arrangement meets specific risk-distribution criteria. As a result, even though losses may never arise, the company receives a current-year write-off. The Internal Revenue Service (IRS) has established the rules under which captive insurance qualifies as insurance for federal income tax purposes and premiums are deductible in Rev. Rul. 2002-89 and Rev. Rul. 2002-90. Captive insurance is considered as legitimate insurance (i.e., premiums are deductible) under two safe harbors:
Are captive insurance companies taxable?
A captive insurance business (also known as a captive) is a licensed insurer designed to fulfill the risk management needs of a single firm or group of companies. Captive entities are typically created to complement current insurance coverages, fund risk exposure blocks, or offer coverage for unusual risks. Captive programs allow corporations to control these risks while also benefiting from tax advantages. For premiums to be deductible as insurance for federal tax purposes, a captive must be licensed as an insurance firm by a state or foreign authority and meet certain standards. Assuming the captive satisfies the requirements, its taxable income is normally based on underwriting income, with some tax adjustments. Certain qualifying insurance businesses, on the other hand, may choose to be taxed exclusively on taxable investment income.
The Four Pillars of Captive Insurance
Though captive structures have existed for many years, we have been able to ascertain what the IRS considers to be a well-functioning captive program because to activity in the tax court since 2016. To qualify as an insurance company for federal tax purposes, a captive must meet the following criteria:
- Risk Transfer In order for a captive program to stand up to examination, the risk that has to be insured must be moved outside of the at-risk organization. As a result, the capital structure and ownership of a potential captive must be considered to enable successful risk transfer.
- Risk Distribution While the tax courts have not provided any clear-cut guidelines for defining an adequate risk distribution, business-minded captive owners must ensure that premiums paid cover a significant number of unrelated risks. In other words, the captive’s premiums must cover a sufficient number of separately identified risks.
- Insurance Risk – The captive’s risks must be loss risks originating from insurance coverages. A captive program can’t be used to control investment losses or transfer business risks. The captive’s premiums must be for real risks, as determined by an insurance process.
- Common Insurance Concepts In order to fulfill its mission, the captive must operate in the traditional manner of an insurance company. To put it another way, the captive should issue premiums based on risk, set up reserves for unpaid losses, and fund those losses to ensure the captive’s liquidity.
Captive Insurance Taxation Nuances
After making necessary tax changes, captive insurance companies are normally taxed on their underwriting income. In contrast to traditional insurance arrangements or traditional self-insurers, captive owners may deduct losses on outstanding losses as they occur. This allows for a faster deduction timeframe. Captives can give a residual advantage of large reductions in effective tax rates on insurance activities if they are used to shift risk.
In addition, smaller captives might decide to be taxed only on their taxable investment income (under IRC 831(b)). For tax year 2022, organizations having net or direct written premiums of no more than $2.45 million can make the 831(b) election. Taxable non-insurance income less qualified investment expenses equals net investment income.
This decision can be especially favorable to captive owners because it allows them to take a full tax deduction for premiums paid by insureds while only paying taxes on net investment income.
What are the disadvantages of captive insurance?
Because the company is effectively self-insured, it will need to raise a large sum of money to maintain in reserve in case of a claim. If the entity undervalues its need for protection or suffers a catastrophic loss, it may not have enough cash on hand to provide effective protection. If the corporation is forced to use other assets, this could have a significant negative impact on its bottom line.
Are captive insurance dividends taxable?
A captive insurance company (or “Captive”) is a domestic or foreign insurance firm set up by a business owner to insure the risks of the company’s operations. For the aim of insuring his connected firms, the owner of a business or a group of enterprises can incorporate a totally owned Captive. In exchange for insurance, the insured enterprises pay premiums to the Captive. The insurance premium paid is a tax deductible for the operating business, and the premium revenue received by the captive insurance company is frequently tax-free.
The business owner, his spouse, his relatives, a Trust, or any other entity can own a captive. The running business pays the Captive premiums, and the Captive insures the operating business’s risks. A captive insurance company not only helps a company to control its insurance costs and ensures prompt payment in the event of a claim, but it also gives a very tax-efficient way to create wealth. Captives can also be used by businesses to lower their insurance costs or improve their coverage for little or no cost.
Many of Captive’s non-insurance perks are summarized in this article. Estate planning and wealth creation, retirement planning, and asset protection are just a few of the advantages. This post is meant to be broad in scope and to just call your attention to this complex and versatile tool.
History of Captives
Captives were first established in Bermuda in the early 1960s, and were formalized in the late 1970s with a medical malpractice Captive for Harvard University. Captive insurance and similar risk transfer techniques have exploded in popularity. The number of pure Captives in the United States presently exceeds 1,500. There are around 5,000 pure Captives in the world. Captives aren’t nocturnal creatures. Instead, they are sophisticated instruments that have been thoroughly examined and authorized by the Internal Revenue Service.
(b) Captives
Captives are often taxed on all of their earnings as if they were C corporations. However, the Code grants property and casualty insurance firms certain taxable income deductions that are not accessible to regular corporations, such as premium income and investment income. As a result, premiums received by a well-managed property and casualty Captive may generate little or no taxable income.
For eligible small Captives, Code Sec. 831(b) gives a significant tax benefit. If the Captive’s annual premiums are less than $1.2 million, it can decide to be taxed simply on its investment income. As a result, premiums are not taxed. The 831(b) election cannot be rescinded once it has been made without the IRS’s prior written authorization. Fortunately, the deductibility of premiums paid by operational corporations is unaffected by a Code Sec. 831(b) election. The main benefit of forming a Code Sec. 831(b) is that the Captive can build surplus from underwriting earnings without paying taxes on it. If the Captive chooses its risks well, it can amass considerable assets in a relatively short period of time.
Estate Planning
Consider a Captive that goes five years without a substantial claim and little appreciation. In that time, the Captive can easily amass $6.0 million in assets. If the Captive was designed to be controlled by a trust or limited liability corporation for the benefit of your children and grandchildren, you would have effectively moved $6.0 million to your children tax-free. Furthermore, you would have the extra benefit of moving the $6.0 million to the children and grandkids while producing an income tax credit for you without income. To summarize, a Captive can generate a considerable income tax credit while also moving assets out of your estate free of gift taxes if it is correctly designed.
Retirement Planning
A Captive that elects to make a Code Sec. 831(b) choice may also be able to give significant retirement benefits to its owners. Profits earned on an insurance premium by a Code Sec. 831(b) Captive are taxed when they are delivered to shareholders as qualifying dividends or long-term capital gains, both of which are currently taxed at 15%. While Congress alters tax rates on a regular basis, this tax deferral tool gives you a lot of freedom. Because shareholders have control over the timing and amount of distributions they get from their Captive, they may choose the method and period that affords them with the most tax benefits.
Asset Protection
A Captive can provide extensive creditor protection depending on the arrangement. In addition to the corporate shield’s protection, some laws protect premiums paid to a Captive from being pursued by the insured’s creditors. Anguilla, for example, has law that states that premiums paid to the captive are protected from the insured’s creditors unless they were paid with the intent to mislead the creditor. Furthermore, the statute shields the insurer from proceedings brought against insurance premiums paid to it, as long as the premiums are kept separate from all other accounts.
Conclusion
Captives are highly adaptable yet complicated tools with enormous non-insurance benefits. Despite their non-insurance advantages, Captives are not for everyone. There is no one-size-fits-all solution. Let us assist you in determining whether a Captive is right for you.
Is captive insurance a good idea?
. Despite the fact that their execution and legal framework are frequently misunderstood, the financial benefits might be highly appealing. Captive insurance, according to some experts, is the best thing since sliced bread. Others are hesitant to involve their clients in the creation of a prisoner, knowing that the IRS closely monitors them. This article explains what captive insurance is and why the Internal Revenue Service frequently disputes it, as well as why, when done right, captive insurance can be a valuable instrument. The post also explains how to set up and run a captive to avoid IRS penalties.
What is the difference between captive insurance and self-insurance?
The most important distinction to make between self-insurance and captive insurance is the way they are set up. Self-insurance entails the establishment of a form of savings account in which the owner saves money to be used in the event of a claim. Captive insurance, on the other hand, is more formal due to the fact that it is a small insurer.
Captives are safer than self-insureds because they have guarantees against losses. Self-insureds, on the other hand, only have a limited amount of money set aside. An employer who self-insures their health plan, for example, has no means of knowing if they will have enough money to cover claims. Because captives insure themselves against potential claims, they have additional incentives and risk management options than self-insurance schemes.
Understanding captive and self-insurance is critical because a company considering these choices must know how much risk it can take on and how equipped it is to handle claims. A solid risk management plan is the foundation of every successful self- or captive insurance program.
What is the point of captive insurance?
To be clear, the aim of an insurance firm, and hence a captive, is to cover losses (your own losses) and provide you (the owner) greater control over your risk and any losses that do arise. Captives, to put it another way, are a risk transfer mechanism that is used to fund risk.
How does a captive insurance company make money?
Because of the numerous economic and noneconomic benefits that can be obtained via its use, captive insurance is the most common form1of alternative risk financing. The following are some of the advantages of captive insurance over commercial insurance:
- Costs are stabilized because captives aren’t subjected to the underwriting cycle. As a result, possible premium changes from year to year will be unaffected by commercial rate changes in an insurance company’s book of business. Rather, premium adjustments will be based on the captive’s loss history. Premiums paid into the captive will be consistent assuming stable loss experience.
- Earn investment income: Captives can profit from their loss and unearned premium reserves by investing them. A commercial insurer’s guaranteed cost insurance would not give the policyholder with this additional money.
- Capture underwriting profits: If the premium paid into the captive is larger than the loss and expense expenses that the captive will eventually incur, the captive will be allowed to keep the underwriting profits. These underwriting earnings might be returned to the parent as a dividend or used to assist increase capital and surplus. On this excess capital and surplus, a captive can make investment income. If the parent had purchased a guaranteed cost policy, these profits would not have been realized.
- Provide coverage that isn’t available on the market: Some coverages have exorbitant prices, making them virtually unaffordable on the open market. When possible, a captive can provide these coverages at a premium based on the insured’s loss experience. A captive can also provide coverage for unusual risks that aren’t covered by standard insurers.
- Improved claims handling and risk management: A captive gives for more control over the claims handling process in some scenarios. Potentially big claims can be detected and managed early on to save money, as claims losses tend to rise the longer they remain open and unresolved. 2
- Potential federal tax benefit: For federal tax purposes, a captive may be able to deduct both loss payments and reserve estimates, whereas self-insurance only allows for deductions as losses are paid. Because of the faster timing of deductions, investment income can be gained on the taxes that were previously avoided. These savings can be significant for large captives and captives that write long-tailed coverages, especially in a high-interest rate environment.
- Capturing the complete cost of risk: While self-insurance can provide many of the benefits listed above, a captive is an effective risk management tool for measuring the total cost of risk. The primary reason why parent firms employ a captive, according to a survey of parent companies in the Marsh 2020 Captive Landscape Report, is to operate as a formal funding vehicle to insure risks that the parent has elected to self-insure. 3 The costs of self-insuring with a captive can be easily traced through the captive’s financial accounts.
Captive insurance is used by nearly all Fortune 500 corporations and many midsized businesses for these reasons, among others. 4 Single parent captives, which insure the risks of a single company (the parent), are the most common type of captive. In 2019, single parent captives accounted for over 80% of the captive market’s gross written premium. 5
Despite the fact that captives are set up for different reasons than other types of insurance, we were curious if single parent captive insurers make more money than other types of insurance. To see if single parent captive insurers are more profitable than other types of insurance, we looked at financial statement data from over 60 single parent captives over the last five years (2016-2020), as well as annual statement data from S&P Global Market Intelligence for traditional commercial insurance companies and risk retention groups (RRGs), a more regulated form of captive insurance. Any reference to “captives” in the rest of this article refers to single parent captives. RRGs are a type of group captive that insures the risks of many enterprises. Group captives have various aims, objectives, and rewards.
We looked at a variety of financial measures that can be simply calculated from insurers’ balance sheets and income statements. We didn’t make any adjustments for accounting biases and merely used the numbers as is. The data for traditional insurers and RRGs is obtained from the aggregate of the top 100 for each firm type (using calendar year 2020 net earned premium).
The combined ratio is likely the greatest indicator to use when assessing profitability. Using the income statement, we estimated combined ratios as the ratio of experienced losses, incurred loss adjustment costs (LAE), and underwriting expenses to earned premium. Figure 1 depicts the historical combined ratios for each insurance business over the previous five years.
Figure 1: Combined Ratios 2016 to 2020 by Company Type
Traditional insurers and RRGs both have higher combined ratios than captives. The combined ratios of traditional insurers and RRGs are hovering around the breakeven point of 100 percent. The RRG combined ratios are somewhat higher than 100% in 2019 and 2020. Captives, on the other hand, have a five-year average of 83 percent. Because the total ratio is 100 percent less than the percentage of premium gained as underwriting profit (ignoring investment income), captives are profiting roughly 20% of premium! These gains can be utilized to boost surplus, which can serve as a safety net in the event of a loss. They can also be utilized to pay the parent a dividend.
While looking at previous combined ratios can provide insight into a captive insurer’s profitability, we went deeper into these profit disparities. An insurer’s premium is the sum of three items in a simplified world: expected future expenses, projected future losses, and a profit and contingency provision. Expenses are the first component of premium that we analyzed amongst company kinds. The ratio of current year underwriting expenses to current earned premium was used to construct historical expense ratios. The graph in Figure 2 shows the historical expense ratios for each type of firm over the last five calendar years.
Figure 2: Underwriting Expense Ratios 2016 to 2020 by Company Type
Over the last five years, captive underwriting expenditure ratios have averaged roughly 9%, compared to around 31% for traditional insurers and 21% for RRGs. The overhead costs of captives are minimal to non-existent. They usually lack specialized personnel and office space. A third-party administrator (TPA) often handles claims, whereas an actuarial business handles actuarial services. Some captives may also route a portion of their expenses through their parent business rather than the captive, which could explain the lower ratios. Traditional insurers have additional costs, such as agency commissions, in addition to paying for staff and corporate office space.
When comparing traditional insurers to RRGs, RRGs often have a smaller staff, resulting in lower overhead costs. The disparity in expense ratios between traditional insurers and RRGs is also due to commission and brokerage expenses. The average ratio of net commission and brokerage fees to earned premium for traditional insurers from 2016 to 2020 is 13 percent, compared to 0.5 percent for RRGs. The difference in commissions is fairly significant because many RRGs had zero net commission and brokerage fees.
Premium taxes are another cost consideration. Captive insurance companies pay lower premium tax rates than typical insurance companies. Furthermore, compared to the percentage of premium charged in most other states, other states, such as Arizona and Utah, simply charge a minimal yearly cost. There is no benefit to RRGs because they are subject to the same premium taxes as traditional insurers6.
Not all captives, however, have lower expense ratios. Our 60 captives were divided into three categories based on premium volume. Small captives, defined as those with annual premium volume of less than $1 million, have a five-year annual average expenditure ratio of 42 percent. Medium-sized captives, with annual premium volumes ranging from $1 million to $10 million, have expenditure ratios that are closer to RRGs, with a five-year average of 17%. Large captives, defined as those with an annual premium volume of more than $10 million, benefit from economies of scale, with an average expense ratio of 8%. These huge captives, which account for the bulk of the captives surveyed, are the principal driver of the low expense ratios seen in Figure 2. Some of the world’s largest captives have expense ratios of less than half a percent. Figure 3 shows the expense ratios and percentages of captives surveyed by year and size in a table.
Figure 3: Captive Expense Ratios 2016 to 2020 by Captive Size Band
Because captives’ historical expense ratios are much lower than those of other firm kinds, the variations in combined ratios in Figure 1 must be due to decreased expenses, right? Not so quickly! Let’s take a closer look at captive spending. Returning to our simple premium example, expenses are relatively predictable when compared to loss and LAE projections. Captives have expenses for captive management, actuarial, audit, legal, and board meetings, among other things. These costs are mostly set and may be forecasted easily in the future. Premium taxes are the only variable cost that captives have, and they are highly predictable because they are simply added to the overall premium. Captives will generally know what their expenses will be when predicting premiums, and will price these expenses into their policies accordingly. Commercial insurers and RRGs, on the other hand, can usually forecast the expense component of their premiums with a high degree of precision.
As a result, the greater premium base must be the driving force behind the reduced expenditure ratios, rather than the expenses themselves. To gain a better understanding of the premium’s components, let’s continue our investigation.
The loss and LAE were the following aspects of premium that we looked into. The loss and LAE ratios were derived using the income statement’s current year incurred losses and LAE to earned premium ratios. These historical loss and LAE ratios for each type of company are shown in Figure 4 as a graph per year.
What is an 831 b captive?
831(b) Captive a captive that may be taxed under Internal Revenue Code 831(b), which states that a captive qualifying to be taxed as a U.S. insurance company may pay tax on investment income only in years when its written premium is at or below the applicable tax year’s threshold, which was set at $500,000 in 2017.
Are dividends from a captive insurance company qualified?
A captive insurance firm functions similarly to a regular property and casualty insurance company.
company of insurance A captive is responsible for issuing insurance, processing claims, and adhering to all applicable regulations.
regulations, files an income tax return for a property and casualty insurance company, and makes a profit,
If lucrative, insurance firm owners will have access to it. The distinction is that with an
The captive owner(s) chooses whether to retain or not to retain an insured-owned captive insurance firm.
Profits from the company should be distributed. In a traditional insurance company, the insurer and its agents work together.
The profits are retained by stockholders rather than the insureds.
We’ll go through how a captive is structured and set up in this article, as well as
how premiums are transferred from the captive owner’s company to the captive insurance company We
The captive owner’s ability to invest and maintain profits in the captive will also be discussed.
Profits from the captive are paid out in dividends.
While the terms of each arrangement may differ, captive insurance is commonly used.
premiums are paid to a ceding or fronting firm by the captive owner’s operating company.
which is a phrase used to denote the captive insurance business that underwrites the policy.
policy, or “writes the paper,” as the case may be. The insurance is issued by the company that wrote the document.
policy to the insured, the company that is obtaining coverage. After that, the captive is usually
through a typical type of arrangement known as a reinsures the fronting or ceding corporation “the quota
agreement to share
“A quota share agreement is a pro rata reinsurance contract in which the insurer bears a portion of the risk.
and the reinsurer’s share of premiums and losses is based on a defined percentage.
For instance, if the fronting and ceding companies each bear 50% of the risk,
The fronting or ceding company keeps half of the premiums. An example of a common quota sharing
risk-shifting agreement that complies with the Internal Revenue Service’s safe harbor regulations
A risk distribution is one in which at least half of the risk is shared.
For example, if an insured pays a fronting or ceding company $1 million in premium,
The fronting or ceding corporation would first keep or hold back $500,000 for claims.
The remaining $500,000 would be transferred to the reinsuring captive insurance provider.
The fronting or ceding corporation bears 50% of the risk. After the initial holdback or
After a claims history and an actuarial review, the fronting or ceding business keeps the policy.
When all of the factors are taken into account, the fronting or ceding corporation may be able to release half of the money.
Premium that was once held back is still available.
In this case, the original amount held aside is $500,000, and half of it is released.
An additional $250,000 has been released. Prior to release, the holdback is usually invested as a security deposit.
Interest earned or investment income on the insurance company’s reserve is usually included.
The cost of any claims is deducted from the remaining money. The remaining $250,000 (from the original $500,000)
The fronting or ceding company usually releases the $500,000 holdback after all policies have been completed.
issued by the fronting and ceding company have run out of time and have been given an extension.
time limit for filing claims
The extra claims period typically lasts 45 to 60 days after the policy expires.
The fronting or ceding business will typically transfer such assets after this 45-to-60-day timeframe.
remaining funds to the hostage, plus any investment income earned during the time the funds were held captive
retained, less a ceding fee and the amount of paid and pending claims. The use of a fronting or
The cost charged by a fronting or ceding company to the captive for issuing tickets is known as the ceding fee.
Insurance risk is pooled and policies are pooled.
What happens after the prisoner receives its food? This is a subject that captive owners frequently ask.
premiums from the ceding or fronting firm?
The profits of the prisoner are included in the surplus. Surplus funds (assets minus obligations) may be used for a variety of purposes.
be invested in accordance with the captive’s jurisdiction’s approved investment policy
licensed and regulated Surplus is also used to determine an insurance company’s profitability.
It is used in various financial ratios to analyze an insurance company’s economic strength or viability.
the viability of the business
Remember that, like any other business, a captive can pay dividends to its owner.
shareholders. Because captive dividends are normally eligible dividends, the distribution of captive dividends is not taxed.
A captive owner’s profits may be tax favorable. Remember that the procedure for
Receiving a dividend from a captive is more difficult than receiving one from a nonregulated company.
company. As a regulated and licensed insurance company, the permission of the regulator is usually required.
the department of insurance in the state where the captive is registered. To get started,
The captive owner (or owners) wants the captive insurance management to pay a dividend.
Obtain approval from the insurance department. The insurance is then examined by the department.
company financials to see how receiving a dividend affects the insurance company’s bottom line.
ratios, as well as the company’s ability to pay claims. Additional financial testing is also done by the department.
under the regulatory structure of the jurisdiction, as it thinks appropriate and expedient. In the event that the
When the captive manager’s request is approved by the department of insurance, the captive insurance company is formed.
A dividend payment from the captive may be issued by the firm.
A captive is a regulated, licensed business that must meet certain requirements in order to operate in a specific jurisdiction.
Insurance companies are required to follow all applicable rules and regulations. A company, like any other, has to make money.
The goal of a transaction between a captive investor and a shareholder is to make a profit while keeping the ownership.
critical capacity to control the hazards of the operational company Dividends are paid out once a business is profitable.
usually available within the regulatory framework of the Department of Insurance
for the benefit of the shareholders A captive insurance firm will need to be licensed and regulated like a business.
Many businesses require extra care and attention, but a captive’s unique capacity to manage
Insurance for a business can be transformed from an expense to a source of profit for its owners.
to a risk-management system that is lucrative