Captive Insurance – Beginners Guide For Small or Medium Size Business Owners (You Can Save Money!)

Captive insurance companies used to only be for large, multi-billion corporations. Times have changed, and as business owners’ risk management needs have become more complex, more and more mid-size companies are taking the captive plunge. Read more to see if a captive insurance company is right for you.

Why Use a Captive Insurance Company?
You may be considering setting up a captive insurance company and it’s very likely you may be saying to yourself, “why should I be doing this?” There are lots of good reasons – and you have probably heard most of them – but the main reason for setting up a captive is… To make money.

How can a captive make me money?
A captive gives you the ability to share in underwriting profit and investment income which can lower your company’s insurance cost. A captive can provide income tax benefits because premium ceded to a captive is tax-deductible, while underwriting profits and investment income are tax-deferred. Assets placed into a captive are shielded from creditors other than claimants if set up properly. A captive can be an invaluable estate planning tool. Assets put into a trust can be excluded from your taxable estate.

A captive is not for everyone.

Who is a captive for?

  • You need to take a long term view toward risk management.
  • You strongly believe in loss prevention.
  • You have a willingness to share risk.
  • You need at least $1,000,000 of annual insurance premiums.
  • You should have $500,000 or more of pre-tax corporate profits.

Who is a captive not for?

  • You buy insurance to “win” against your insurer.
  • You are not interested in loss control or prevention.
  • You are risk averse.
  • Your insurance premiums are not big enough.
  • Your assets are not sufficient to provide the necessary collateral.

How do I set one up?

First you need to choose a jurisdiction where your captive will be domiciled. It can be onshore in one of the many states that have favorable regulations, or it can offshore in such places as Bermuda, Cayman Islands or Barbados. These are the components of a captive start-up:

  • Feasibility study
  • Business plan
  • Actuarial study
  • Application fees
  • Capital investment
  • Collateral
  • Captive manager

The Rent-a-Captive Option

If you want an easier, less expensive way to get into the captive business, you might want to consider using a rent-a-captive. A rent-a-captive is a specific type of captive set up to provide all of the benefits of an owned captive insurance company, without the upfront costs, capital investment and annual maintenance costs. You “rent” a protected/segregated cell, working capital, and licenses from an insurance company set up for this purpose. There is no pooling of risk between cells – each cell, and its assets, are legally separated from the others.

What is the 831(b) Election?

The Internal Revenue Codes section 831 applies to the taxation of insurance companies other than life insurance companies. Subsection (b) applies to the tax treatment of small insurance companies, which are defined as writing $1,200,000 or less in annual written premium. This tax election exempts underwriting profits from tax, and the captive pays tax only on investment income. This tax election can be used for an offshore captive as long as you elect to pay U.S. Tax. You should consult your tax advisor if you think this could work for you.

What is Collateral?

Collateral is needed if the captive insurance company is used as a reinsurer of an admitted insurance company, and is needed so the insurance company can take credit for the reinsurance in their financial statements. The collateral protects the insurance company from any credit risk of the captive’s performance. Five types of collateral are acceptable: Letters of Credit; parental guarantee; pledged assets; performance bond and insurance trust.

Is There an Exit Strategy?

Risk management strategies evolve over time and at some stage, the owners of a captive insurance company may look for an exit strategy. Here are three options for exiting from a captive insurance arrangement:

  • Commutation. The fronting insurance company agrees to assume all outstanding liabilities of the captive. This may allow the release of collateral.
  • Novation. A reinsurer agrees to step in the place of the captive and assume the remaining outstanding liabilities of the captive.
  • Reinsurance. The captive enters into a contract with a new reinsurer to assume the remaining outstanding liabilities of the captive. This option works for insurance that was fronted by an admitted insurer as well as for insurance policies issued directly by the captive.