Captive Insurance Solutions for Rising Insurance Premiums

By Mark Heroux, J.D., Chicago

Editor: Alan Wong, CPA

Miscellaneous

Captive insurance is insurance or reinsurance provided by a company that is formed primarily to cover the assets and risks of its parent company or companies. It is essentially an in-house insurance company with a limited purpose and is not available to the general public. This is an alternative form of risk management that is becoming a more practical and popular means through which companies can protect themselves financially while having more control over how they are insured.

Companies large and small can have a difficult time finding and affording traditional insurance policies to cover their risks and assets. Premiums are increasing, making insurance coverage nearly cost-prohibitive for many companies, leaving them vulnerable to catastrophic loss. Some companies' risks are difficult or impossible to cover, such as cybercrime or gender discrimination. Increasingly, traditional insurance companies are setting up their credit rating structures without considering actual loss experience but, rather, considering trends in the market, making it difficult for many companies to qualify for coverage. In these instances, captive insurance can be a good alternative.

There are five basic types of captive insurance companies. The single-parent captive is the most prevalent, in which an insurance or reinsurance company is formed simply to insure the risks of a parent company or its affiliates that are not insurance companies. The association captive is an insurance company that is formed and owned by an industry, trade, or service group strictly for the benefit of its members. The group captive is owned by a group of companies and provides them with a captive insurance company for a shared insurance need. The group captive works best when a taxpayer cannot or does not want to be a single-parent captive. An agency captive is a reinsurance company owned by a separate insurance company to reinsure its clients' risks. The last type is the rent-a-captive, which provides the benefits of a captive company for a fee to small companies that may not have the resources to form their own.

The financial benefits of this type of arrangement can be significant. Commercial insurance premiums are padded to cover the insurance company's own profit margins and overhead costs. With captive insurance, premiums tend to be lower since companies are not attempting to make a profit but simply providing themselves with low-cost insurance coverage. It's also more flexible than traditional insurance. The company can adjust the proportion of assumption of risk or the amount of reinsurance depending on the market.

Another benefit is in claims management. With in-house insurance, a company cuts through the red tape and bureaucracy associated with traditional insurance companies, and the parent company can dictate the procedure by which claims are processed. Perhaps one of the biggest benefits is that excess net premiums can be recouped by the parent company when claims are low, and they can increase reinsurance in riskier areas.

Like traditional insurance, captive insurance can cover several types of risk. It can underwrite public and product liability, physical property damage, professional indemnity, employee benefits such as medical aid, and employer's liability.

Captives have been approved by the IRS for many years. Onshore captives are quickly gaining in popularity as state insurance commissioners work to stop the flow of this business to offshore jurisdictions. Vermont is now third out of all jurisdictions, domestic and foreign, in the number of captive insurance companies operating within its borders. The number of captive insurance companies operating in Arizona, Delaware, Hawaii, Nevada, South Carolina, and Utah has grown significantly in recent years.

According to Capstone Associated Services,a provider of captive insurance services,more than 90% of Fortune 1000 companies and many successful middle-market businesses have captives. More than half of all property and casualty premiums are written through captives.

The Sec. 831(b) captive or "small" captive (also known as a "micro captive") introduces middle-market companies to alternative risk transfer and its benefits, providing this class of insurance buyers a valuable cost-saving tool long used by Fortune 1000 companies. While the rules for captives are complex, the general requirement for a Sec. 831(b) captive is that net annual written premiums cannot exceed $1.2 million. With proper structuring, a micro captive can allow companies to build loss reserves on a pretax basis while maintaining a current deduction for the cost of premiums.

EditorNotes

Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.

For additional information about these items, contact Mr. Wong at 212-792-4986 or alan.wong@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP

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