Captive insurance may be a useful tool for business owners

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 10/09/19

Captive insurance has made headlines recently as the Internal Revenue Service announced a settlement program targeted to taxpayers who have participated in programs deemed as abusive. These arrangements have been under scrutiny by federal regulators challenging that certain taxpayers wrongfully claim tax benefits without properly establishing a bonafide captive insurance program. However, when established properly for valid insurance purposes, captive insurance arrangements can also provide valuable tax benefits.

What is captive insurance?

With captive insurance, a business goes through a formal process to establish its own insurance company to address certain known and established risks. For example, a physicians’ group in private practice may set up a captive insurance program to address the specific risks associated with their profession and within their group.

Micro-captives – also known as 831(b) captives – offer smaller businesses certain tax benefits as well. Insurance premiums paid by the business to an 831(b) captive arrangement are deductible as business expenses. They are not considered income to the captive insurance company if the premium does not exceed $2.3 million annually. It is important to note that any investment gains on funds held within the captive are subject to taxation.

Since the captive is a legally registered insurance entity at the state level, the arrangement must be designed to provide insurance. The business has to verify the existence of risk as well as demonstrate a process for risk sharing and distribution.

Customization is one of several advantages

Captive insurance allows businesses to customize insurance coverage to specific needs. The underwriting for the insurance is based on the business’s own risk profile.

Additional benefits include:

  • Provides insurance coverage for uninsured risk that is not currently available (or not cost-effective) on the commercial insurance marketplace
  • May provide access to the reinsurance market, which can be a more cost-effective means of securing coverage
  • Can serve as an asset protection strategy. Funds held within the (separate) captive insurance company are generally not exposed to claims from potential creditors of the business owner(s)
  • May be used for wealth accumulation and transfer. Funds inside the captive insurance program may accumulate over time and can be a financial asset to the practice or business, subject to claims history. Captive insurance may be able to provide cash flow to the owners through dividend payments. Also, ownership of a captive insurance company can be transitioned to heirs through the use of trusts or family limited partnerships (FLPs), for example.

How are captive insurance plans used?

  • Deductible reimbursement for businesses holding high-deductible insurance coverages
  • Risk shifting by raising deductible limits on existing coverage (such as malpractice insurance), and using associated cost savings to fund the captive
  • Product liability, which may be excluded from a commercial general liability policy
  • Employment-related claims and risks
  • Cyber risks such as a data breach
  • Environmental risks
  • Litigation expense risk
  • Business interruption

Common scenarios that may become issues

There are several common scenarios that can lead to IRS scrutiny or an audit. Some examples include:

  • When the risk being insured against is vague or not well-defined
  • If the premiums funding the captive are extremely high relative to the level of risk
  • If the claims history is very low. For example, if a captive plan was established years ago and no insurance claims were paid from it, or if there is a very low average loss history as a percentage of total premiums paid
  • Lack of up-front planning and analysis, such as no formal feasibility study completed during the process of establishing the captive

Captive insurance can present its own risk

Establishing a captive insurance company involves its own risks and can be very complex and costly. A qualified legal professional with experience in this area may be the best equipped to implement this strategy. For more information about asset protection strategies in general, see Putnam’s investor education piece, “Asset protection: basic principles and strategies for safeguarding your wealth.”