Ever since the 1930s, large companies in the United States have been forming their own property and casualty insurance companies in order to reduce the premium costs charged by commercial companies and insure risks otherwise not covered by commercial companies. During the past 20 years, the costs of establishing one’s own small captive business liability insurance company have come down so that middle market companies have been able to afford to use captive insurance companies to reduce their premium costs and insure risks not otherwise obtainable in the commercial markets. For example, owners of real estate use captive insurance companies to insure gaps in their existing coverage. Real estate owners have insured their deductibles, casualties that are too expensive in the commercial markets, risks where no commercial coverage is available, such as toxic mold, and non-traditional risks such as a change in zoning.
Captives can be used to insulate working capital that would otherwise be exposed in the event of a bankruptcy or a creditor claim filed against the property owner. Given that any risk is eligible to be covered by a property and casualty policy, one should consider the use of a captive insurance company to hold funds needed for future operating expenses or replacement reserves. Furthermore, the property owner need not form their own captive insurance company, which has the potential for being ignored by a court in a creditor proceeding. Instead, there are third-party group captives and captive pools which are respected as independent insurance companies.
Think about a property owner with a large deductible that would otherwise be self-insured. Typically, the property owner can predict a certain amount that will be paid each year under its deductibles. In addition, a property owner frequently establishes reserves, not only to cover anticipated expenses, but also for the replacement of major components, such as a furnace or air conditioning system. Think about the need to replace a roof with the passage of time. Any anticipated future cash need can be the subject of a property and casualty insurance policy. When prepaying anticipated costs in the form of property and casualty insurance premiums, these funds are then held by an independent insurance pool. If a commercial insurance company cannot be required to refund premiums to a property owner’s creditors, the same restriction should apply to a captive insurance company. In addition to risks that are anticipated, it is not unusual for a company or a property owner to insure risks they never expect to incur. These are the 100-year storm risks that in all likelihood will never occur. But in the event that they occur, it could mean the end of the business. It is not unusual to insure risks unlikely to occur even though there is a minute possibility they will occur.
In addition, companies have risks that they do not think about insuring. Take an operating business where the future of the business is incumbent upon a key employee or a key owner. If anything happens to a key employee before retirement, it would have a negative impact on the revenues of the business. This type of risk can be insured. Typically, if nothing happened to the key employee, the insured receives a refund of the unused premiums in the pool. However, while the policy coverage is in effect, these funds remain the property of the insurance company and cannot be attached by the creditors of the insured.
Of course, the funds set aside for premiums must be reasonable in relation to the risks to be insured.
There are different kinds of captive arrangements, and the tax considerations of a captive insurance company vary. The most important factor for a captive insurance company is whether there is a viable business purpose for the use of a captive. Business reasons include reducing the amounts you would otherwise pay in premiums to commercial insurance companies, covering risks you currently self-insure, covering risks for which no commercial coverage is generally available and providing for risks that are unlikely to occur but if they do occur it would be a financial disaster for the company. Once it is decided there is a viable business purpose, and the premium and coverage are actuarially supported, the next question is how to structure the captive insurance company. These considerations include forming an offshore company or a domestic company. In addition, there are income tax and estate planning factors that need to be considered. In other words, once it is decided that a captive insurance company has a viable business purpose, you then consult with your tax advisor to decide upon the most appropriate structure for your captive insurance company in order to maximize the income tax and estate tax savings.
Under IRC Section 831(b), the first $1.2M of premiums paid to a qualifying small captive insurance company is received 100% income tax free, and to the insured the premium payments are deductible to the extent they are ordinary, necessary, and reasonable. When future dividends are distributed from the captive to its shareholders, the dividends are taxed at more favorable qualified dividend rates, and when you wind up the business of the captive, the liquidation proceeds are taxed at long-term capital gains rates.
The most important consideration when considering captives for creditor protection is to be satisfied that there are other non-tax reasons to establish the captive insurance company to hold funds that will become sheltered from creditors. In this regard, the substantial cost premium savings that can be achieved by captives and the tax savings generally available can give rise to the non-creditor protection motive.
Beware, as captives are marketed as tax shelters and a way to own your boats and planes. Run away from these promoters. While captives enjoy certain tax advantages, they should be employed primarily for risk management and asset protection structures.