Captive insurance companies are becoming more and more popular these days. This is largely thanks to lower administrative costs and recent IRS safe harbor rules.
Many business owners are turning to captive insurance programs for insurance and tax benefits. This guide will discuss how captive insurance companies work and review the internal revenue code (IRC) governing them.
We will also focus on some tax and business planning opportunities available to business owners using captives. Let’s dive in!
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What is a Captive Insurance Company?
A captive insurance company is an insurance company taxed under Internal Revenue Code (IRC) § 831(b). It is an affiliate of the business entity who needs insurance to cover specific business risks.
A captive insurance company is allowed special tax privileges under the internal revenue code. This IRS code section provides that a captive that qualifies to be taxed as a U.S. insurance company can exclude insurance premium income of $2.3 million annually (subject to future inflation adjustments).
Section 831(b) of the US Tax Code has special income tax rules applicable to any small insurance company, not just captives. The captive must meet the following qualifications and conditions:
- The captive insurance company must qualify as an insurance company for tax purposes. As such, it must have adequate risk shifting and sharing and operate under the regulation like a “real” insurance company (i.e., with sufficient capital to allow it to take the risk).
- The company is required to be a U.S. taxpayer. It must be domiciled in the US or domiciled offshore but having elected and qualified under tax Code § 953(d) to be taxed as a US insurance company.
- The gross premium for the tax year must be $2.3 million or less, with the premium cap adjusted for inflation. This premium cap is applicable to all insurers, including a single consolidated tax filing.
Captive insurance companies are popular because if a captive is taxed under § 831(b), it does not pay tax on its underwriting premium received income (assuming it is below the threshold). The insurer will pay tax only on its investment income.
Only investment income is taxable when the gross premium is below the established threshold. The profit on premiums and underwriting can either be returned as a shareholder dividend or remain in the captive as a surplus.
Thanks to IRS guidance that has been issued over the years, the IRS provided some clarification and safe harbors for specified captive insurance businesses. These new rulings and subsequent cost reductions open the door for small and midmarket privately-owned companies to take advantage of these opportunities.
Why would someone set up a Captive Insurance Company?
In most situations, conventional insurance is provided on a guaranteed cost basis. Minimal incentive exists to improve risk management practices since there is no participation in the profitability of the insurance program.
But with captive insurance, the related companies can benefit from favorable claims experience, and any surplus in the insurance captive company will accrue to its shareholders.
Because the client has ultimate control of the captive, any insurance policies can be custom designed. This added flexibility will allow a captive owner to structure or customize a policy to meet the company’s specific needs. This customization can include the scope of coverage, deductibles, levels of risk, and insurance premiums.
Because the company has control of the captive, it also allows for control of the insurance claims process. This is critical as litigation often involves third-party insurance companies over insurance coverage problems. The control of the captive means that the client also has control of the insurance company’s assets. This excellent benefit is not available for premiums and a reserve surplus paid to a traditional insurance company.
Lastly, there are significant captive insurance tax benefits for companies that are formed and administered consistent with the IRC and treasury regulations. We will discuss these in detail below, along with some planning opportunities.
What are the risk benefits of forming a Captive?
The goal of a pure captive is to cover the risk of currently self-insured economically. This could include higher deductibles on current or existing policies, assuming the risk of traditional insurance, or simply taking risks for existing exclusions and deductibles.
The insurance and tax benefits are compelling:
- Captives can cover certain types of insurance coverage are difficult to obtain or simply unavailable in the marketplace. This is typically due to historic high loss experiences for a given industry or sector. This could include medical malpractice, the situation concerning construction defects, or environmental issues.
- The business now can address certain insurances risks that would be difficult to insure in a financial and tax efficient manner.
Premiums paid to a captive should be tax deductible as ordinary and necessary business expenses. Premiums will be deemed “ordinary and necessary” only if they result from an arms-length transaction. This required that they be similar to those paid in the marketplace for comparable insurance coverage.
Captive insurance tax benefits
Captive insurance tax benefits are compelling. Take a look at a few of them:
- The ability of the operating entity to immediately deduct insurance premiums paid.
- The ability of the captive company to avoid paying tax on the first $2.3 million in premiums received in a given year.
- Investment income and capital gains generated by the reserves are taxed at the favorable C-Corp 21% rate. This is lower than the highest individual tax rate of 37%.
- The IRS allows 50% of the dividend income is excluded from taxation under the C-Corp.
- The captive may be owned by a Roth IRA, thereby enabling the investment profits of the captive to receive dividends tax-free. You can find out more about that here and here.
- The insurance company could be owned (at least in part) by the children or relatives of the operating company owner. This can allow for effective estate planning.
Premiums paid to a captive should be tax deductible as ordinary and necessary business expenses. Premiums will be deemed “ordinary and necessary” only if they result from an arms-length transaction. This required that they be similar to those paid in the marketplace for comparable insurance coverage.
How do you get Funds out of the Captive?
For an annual insurance policy, the premiums are typically tied up in the insurance company for one year. After the one year expiration, the reserves are held in the insurance company. Remember that the insurance company is taxed as a C-Corp.
The owners of the insurance company can take dividend distributions that are taxable to the shareholders at the qualified dividend rate. Dividends will be limited to surplus reserves.
It may make sense to leave the excess reserves in the C-Corp to invest in dividend paying stocks to take advantage of the 50% dividend exclusion.
The owner can also take money out of the insurance company by using a loan. It must be documented and pay fair interest.
What are the fees relating to the formation and ongoing administration of Captives?
It used to be common to see fees over $50,000 annually to administer a captive insurance company. These fees made sense for very large companies, but the economics often did not work for small and midsize business owners.
Thankfully, there has been streamlining of many captive insurance companies that have made the process easier to structure and administer. The improved streamlining has significantly lowered costs. As such, many captive companies are available for $5,000 a year to administer.
In addition, business owners will typically have to surrender a portion of the insurance fees paid to cover co-insurance related costs. This can vary from 3% to 20% of premiums. But around 10% of premiums paid is standard in the marketplace.
Captive insurance example
So let’s take a look at how this would work in practice. Let’s assume there is a dentist office with five employees and $2 million in gross revenues. The profit to the owner is $700,000 a year. The owner is in a combined federal and state tax bracket of 42%.
The owner is interested in setting up a captive insurance company to give him additional protection for general liability, business interruption, and other insurance risks.
The owner then engages a third-party administrator (TPA). This company will review the business operations and financials and inquire about specific risks pertaining to the dentist and his office. In addition, the TPA will review the owner’s operations and compare the designated risks and insurance requirements to other similar dental practices to determine appropriate coverages and premiums.
Upon finalizing the insurance assessment, the TPA identifies the following insurance requirements and proposed premiums:
| Insurance Type | Premium |
|---|---|
| Business interruption | $30,000 |
| General liability | $45,000 |
| Professional liability | $50,000 |
| Employee-related insurance | $40,000 |
| Specialty insurance | $35,000 |
| TOTAL PREMIUM | $200,000 |
The TPA has identified premiums of $200,000. This is 10% of the company’s revenues of $2 million.
The business owner then reviews the analysis and determines that he thinks this insurance is reasonable and consistent with his business risks. He decides to proceed.
The dentist pays the TPA $5,000 to set up the captive insurance company. This setup fee will cover the incorporation paperwork, insurance fees and applications, and other administrative tasks associated with the setup.
Once the TPA completes the entity setup, an insurance agency is identified to help manage the plan and related risks. For the $200,000 in premiums, the insurance group will charge $20,000, or 10% of the insurance premiums. This fee covers any retained risks.
The total year one fee to the dentist is as follows:
| Cost | Amount |
|---|---|
| Set up fee | $5,000 |
| Insurance premium | $20,000 |
| TOTAL COST | $25,000 |
The dentist now has gained insurance for his business risk. The insurance and setup costs are tax deductible by his dental office. In addition, the dentist’s children are owners of the insurance company providing him with additional estate planning protection.
The captive insurance tax benefits to the dentist in year one are as follows (assuming a 42% tax bracket):
| Type of Fee | Tax Savings |
|---|---|
| Setup fee | $2,100 |
| Insurance premiums | $84,000 |
| TOTAL SAVINGS | $86,100 |
What are the downsides of Captives?
The benefits of captives are available based on IRS Safe Harbor rulings, but some pitfalls and planning concerns can complicate these structures.
One significant issue with § 831(b) captives occurs when a company believes it has to simply meet the mathematical test of premiums less than $2.3 million. It’s not that easy.
If the company typically pays for example $10,000 annually for insurance, it is probably not reasonable for it to all of a sudden pay a $1 million insurance premium.
The company must be qualified as an insurance company. There must be a legitimate business purpose that is not simply driven by tax purposes. The insurance coverage should be the primary motivator for both the formation and operation of the captive insurance company.
Another concern with captives is that they have attracted attention through aggressive marketing as a tax strategy for income tax and estate planning. Many folks with limited captive knowledge have pushed the tax reasons for setting up a captive. But the overriding consideration must be the insurance aspect.
Insurance Compliance Concerns
The insurance company must be appropriately structured as an insurance company for federal tax purposes for the premiums to be deductible by the insured business. This requires qualified premium underwriting services to determine the market’s actual cost of comparable coverage.
The insurance manager must complete an underwriting evaluation if similar coverage is unavailable. When choosing a captive management company, the underwriter must have the experience required to design the insurance policies and accurately price the premiums.
Captive insurance companies are regulated financial institutions. The captive manager should professionally follow the formation, annual management, and operations.
Business owners should carefully review the experience of the captive management company’s history and expertise to ensure that a captive will stand up to IRS scrutiny. Any company that promotes it purely for captive insurance tax benefits should be avoided.
Here are a few other considerations:
- A captive will qualify to be taxed under the provisions of § 831(b) on an annual basis.
- The insurance premium threshold is calculated on a gross (not net) basis.
- A captive owner cannot split risks into two or more captives and claim that each qualifies under § 831(b). All captives controlled or owned by a single entity are treated as combined entities.
How is the Insurance Company Structured?
These companies are structured so that reasonable insurance premiums can be paid from the affiliated entity to the insurance company and be fully tax deductible by the insured. The code allows the first $2.3 million indexed by inflation to be tax exempt upon receipts into the captive insurance company. This results in an excellent opportunity for owners looking to reduce their current income tax liability and transfer wealth without excellent estate planning tools.
The captive company is required to be a C corporation and is subject to chapter C and chapter L of the Internal Revenue Code. There are a variety of different captive insurance companies. This includes pure captives, risk retention groups, group captives, and producer-owned reinsurance businesses. This post focuses on pure captives, which are designated and structured to ensure the risks of business entities related to or affiliated with the ownership of the captive.
When these structures were initially approved, they were typically used by Fortune 500 companies in an attempt to lower insurance costs. The fees involved were very high, and the plans covered a lot of complexities. But for large corporations, the captive insurance tax benefits and risk reduction far outweighed any of the costs.
What does the IRS say about Captives?
While these plans and structures are legal under the IRC, the IRS has taken issue with the design of many captives. Litigation often results when a captive insurance company is overly aggressive, and the insurance premiums paid have no economic substance or questionable relevance to the actual business.
The good news is that the IRS has subsequently issued safe Harbor rulings. This means that if the requirements of these rulings are satisfied, the IRS will generally not challenge the deductibility of premiums paid to the captive. Most captives today are structured to cover the Safe Harbor rules. If structured properly, the IRS will generally not take exception.
Final Thoughts
It should be no surprise that insurance costs are rising. In addition, there are higher self-insured risks for many businesses. Covid has exacerbated this.
Captive insurance has been around for over 60 years. A captive insurance company is a corporation that is formed either in the United States or a foreign jurisdiction with the intended purpose of writing casualty and property insurance for a small related group of businesses or insureds.