What You Should Know About Captive Insurance

Long considered an alternative market, Captive insurance programs are steadily moving to the forefront of business insurance choices. In this blog, I’ll explain exactly what a captive is, how a captive works with business taxes, and the benefits of captives. I’m indebted to an article published online by the International Risk Management Institute for research on this topic.

What is a Captive?

Business owners have been trained to see insurance as a contract with an insurance company to cover your risk. A captive is different; you can call it business self-insurance. In general, captives cover the most common business needs: Workers’ Compensation and General Liability. Captives are fully or partially funded to cover expected losses – an actuary determines expected losses based on a historical loss amounts and payout characteristics of a business.

Strictly speaking, a captive is an insurance vehicle entirely owned by the business policyholder. Captives usually cover losses within a specific deductible or retention amount. $250,000 per occurrence is common — this means that the actuary’s expected losses include losses falling at $250,000 and under.

Finally, captives are formed in a special U.S. state or foreign country, known as a Captive Domicile, that has special legislation enabling captives. Bermuda is an offshore domicile, and Vermont is the preeminent onshore domicile. At least 28 U.S. states have captive enabling legislation.

Taxes and Captives

You want premiums paid to the captive to be deductible from your taxes, like you deduct premiums paid to an insurance company. Two IRS tests (on risk shifting and risk distribution) determine whether you can do this.

Since 1990 a series of IRS rulings have defined the IRS position on captive premium deductibility. The “economic family doctrine” says that since a captive is a subsidiary of its parent company, it falls within the company’s economic family, making premiums paid a transfer of assets – basically a no risk transfer, and no risk distribution. There are a variety of requirements needed to satisfy the IRS insurance company tests, but these two are the most important. I can fill you in on the details.

Is a Captive For You?

If you’ve made it this far, clearly you’re interested in investigating a captive. Your major consideration should be this: is your business amenable to creating an on-balance sheet asset – the captive – to manage risk capital? If not, your premiums will continue to transfer insurable risk to the commercial insurance markets.

It all comes down to how you want to manage your money. A captive enables you to keep a portion of your event risk on-balance sheet, allocating the necessary capital, or allocate your risk capital through insurance premiums and retain whatever amount of passive (unfunded) risk is demanded by the insurance providers. If the concept of building an asset devoted to managing risk is attractive to you, then we should definitely talk.

Please email or call me anytime to get the conversation started.