Businesses with predictable insurance needs may find captive insurance a compelling proposition.
Captive or self-insurance — a financial risk-management tool large companies have used in the U.S. for more than 60 years — is making headway among small and midsize organizations looking to pare business insurance costs.
Due in part to the growing awareness of captive insurance, the number of captive insurers worldwide has increased about 35 percent from 2007 to 2015, according to industry publication Business Insurance.
Jim Hill, Vice President of Institutional Services for Regions Bank, has seen corporations spanning a broad spectrum of industries jump into the insurance business to handle their own workers’ compensation, general liability, warranty, and other risk needs. Captives have long been popular with health care organizations such as hospitals, nursing facilities, and physician groups. Captive insurers are also popular with trucking companies, product distributors, and agricultural groups.
According to Hill, some small businesses may also be eligible to exclude premiums up to $2.2 million a year from taxable income under section 831(b) of the federal tax code. However, in November 2016 the IRS issued a directive that identified 831(b) elections as 'transactions of interest,' due to the 'potential for tax avoidance or evasion.' As a result of the directive, industry observers have urged businesses to treat their captive insurers as an insurance vehicle, not as a means to dodge taxes or transfer wealth. “These can be pretty useful for companies that incur certain claims year after year and want to manage those as effectively as possible,” says Hill, who helps client companies manage surplus accounts," he says.
Generally, a captive entity can potentially ease financial pressures if insurance issues are an ongoing concern for your business operations. For example, a transportation company with frequent claims tied to its fleet of vehicles or an industrial company that deals with hazardous materials may find captives a compelling alternative to traditional carriers, as premiums for such companies could be prohibitive.
How Do Captive Insurers Add Value?
Companies establish captives as third-party entities to handle business insurance needs. “By forming a captive insurer, a company takes on its own insurance risk, as opposed to placing it with a commercial insurance organization,” Hill says.
Ideally, Hill says that such a setup offers benefits including:
- Tighter control of insurance costs
- Improved claims management
- Better operating practices
- Improved risk management
- The opportunity to steer the commercial insurers’ profit margin to a reserve account or the bottom line
Furthermore, captive companies can offset a portion of their risk, if not all of it. Hill says that when a company covers a certain level of potential liabilities — for example, the first $250,000 — through a captive entity, covering additional risk tends to be priced much more reasonably from a commercial insurer or reinsurer.
Typically, it may makes sense for a company to consider a captive insurer when its annual insurance premium exceeds $500,000, according to Hill. Companies often start with workers’ compensation and general liability coverage in the captive entity, as well as property-casualty for companies that own vehicle fleets. Later, a company may move directors and officers’ liability coverage, warranty insurance, and cyber risk protection into the captive.
Captives Are Not a Wealth Transfer Tool
Some small businesses may also be eligible to exclude premiums up to $2.2 million a year from taxable income under section 831(b) of the federal tax code.
However, in November 2016 the IRS issued a directive that identified 831(b) elections as “transactions of interest,” due to the “potential for tax avoidance or evasion.” As a result of the directive, industry observers have urged businesses to treat their captive insurers as an insurance vehicle, not as a means to dodge taxes or transfer wealth.
Capitalizing on the Captive Opportunity
To pursue captive insurer possibilities, Hill suggests taking the following steps:
- Engage a captive manager from a reputable insurance group to conduct an initial feasibility study.
- Hire an actuary to conduct a full feasibility study that scrutinizes your company’s risk profile, financials, and cash flow, and to work with the captive manager to develop a business case for creating a captive insurer.
- Concurrently, research possible locales for the entity, as captives can be housed in 28 states or certain nations offshore. Based on your due diligence, apply to the appropriate regulators and set up shop following approval.
“Generally, a captive insurer covers a portion of your business’s overall insurance needs, so it must be coordinated properly with your commercial broker and your other insurance brokers,” Hill says. “But it’s a legitimate vehicle for financing risk within your company.”
