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Captive Insurance: Why an increasing number of businesses own their own insurance companies

Many corporations, both public and closely held, have experienced problems with the commercial insurance markets and, as a solution to these issues, have set up their own “captive” insurance companies. Each corporation has done this for its own reasons – but are they reasons that may make sense for your business, too? The economics have developed so that even smaller companies with significant risks can profitably operate a captive.

Initially, most captives were formed offshore, such as in Bermuda or the Cayman Islands. Over 30 states now authorize captive insurance companies, including Kentucky, which is among those states that have licensed the most captives in the last four years.

Why more captive insurance companies are being formed

It may seem surprising that closely held businesses can profitably operate a captive, but the use of captive insurance has risen dramatically in recent years for several reasons:

  • Captive insurance has been accepted into the mainstream of insurance alternatives.
  • Captives are more affordable because of the growing infrastructure of service providers to assist in establishing and operating captives.
  • The IRS began accepting captive insurance 10 years ago and continues to do so.
  • Many U.S. jurisdictions are seeking captives.
  • Business owners have become concerned about the commercial insurance market particularly after 9/11, Hurricane Katrina and the AIG financial meltdown, among other high-profile events.

Reasons to consider owning your own insurance company

Companies with great risk exposure (both insured and self-insured risks) have established their own insurance companies. Doing so often allows a company to:

  • Capture the commercial insurance market’s profit.
  • Control claims handling.
  • Obtain insurance coverage not available in the commercial market.
  • Obtain insurance coverage only available in the market at an excessive price.
  • Avoid fluctuating premiums.
  • Access the reinsurance market.
  • Formalize the insurance program and funding of uninsured risks.

Types of captive insurance companies

There are several ways to form a captive insurance company. Sometimes one parent company or entrepreneur owns both the insurance company and the operating companies (a single parent captive); sometimes the members of the next generation or a trusted employee will own some or all of a single parent captive; and sometimes unrelated companies in the same industry form a “group captive” to cover hard-to-insure risks. Some businesses choose to own or “rent” a portion (cell) of another’s insurance company.

Good candidates for captive insurance

Businesses should only establish a captive insurance company if there is a valid, non-tax business reason, as well as comfort with assuming the risk of loss and absorbing the volatility of such losses.

Companies should view captive insurance as a long-term commitment. Experience indicates that prime candidates for captive insurance are companies with large uninsured risks, as well as those with high insurance premiums and good loss experience, including those in the trucking, manufacturing and construction industries.

It is easier to set up your own insurance company than you might think

The first step in exploring a captive is to commission a feasibility study to determine if the benefits of a captive insurance company outweigh the additional costs. Among other things, the study will identify potential domiciles, projected costs, potential coverages and premiums, volatility of the risks, potential benefits, necessary capitalization and the financial consequences of operation.

Many service providers have experience with the various aspects of operating a captive insurance company. You can either use these providers extensively, or supply some of the expertise internally and hire the expertise that you do not have within your business.

Captives with no more than $1.2 million of premium income do not pay tax on their underwriting income; only their investment income is taxed. A complete tax exemption is available (but very hard to obtain) for certain smaller captives. From a purely tax perspective, longer-tailed coverages (e.g., workers’ compensation and liability) are more valuable than shorter-tailed coverages (e.g., fire and wind storm). Some captives insure the deductibles under the operating companies’ policies.

Bingham Greenebaum Doll LLP has experience with forming and operating captive insurance companies, including the many tax issues involved. We represented the taxpayers in two of the five favorable captive insurance tax cases at the Federal Court of Appeals level (the level just below the U.S. Supreme Court) and won both cases. For the right situation, captive insurance companies can be a perfect solution. If you have any questions related to captive insurance companies, please contact Charles J. Lavelle at Bingham Greenebaum Doll LLP.

  • Senior Partner

    Chaz is a senior partner in the tax and employee benefits department with over 40 years of experience in tax controversy work, primarily before the Internal Revenue Service and U.S. Tax Court. He also has an emphasis on the taxation of ...

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