A properly utilized captive insurance company can not only create significant benefits for its owners, but can also serve as an integral component of a financial institution’s overall insurance and risk-management program. Captives have historically been used by larger institutions and were predominantly formed in offshore domiciles. Now, because of favorable rulings and clarification by the Internal Revenue Service, competitive state legislation and efficient economic development by vendors and others, more financial institutions, particularly those in the middle market, are able to realize the benefits associated with this alternative risk-planning tool.
A captive is a special type of insurance company formed to insure or reinsure risks of its parent company, affiliates or even unrelated entities. A captive does not have to replace a current insurance program; rather, a captive affords its owner and insureds with an additional tool to address their insurance and risk management needs.
The type of insurance coverage a captive may offer is regulated by the laws in the captive’s state of domicile. Generally, a captive may cover most standard property and casualty risks, such as directors and officers liability, professional liability, employment practices liability and workers compensation.
While there is no rigid profile of a typical captive owner, a few common features include:
A captive can provide a number of business and tax benefits, such as stabilized insurance costs, increased focus on risk management and loss control, enhanced control over cash flows, the ability to generate investment income, and serving as an effective way to protect against risks for which insurance is either prohibitively expensive or generally unavailable in the conventional market. In addition, the following are a number of other benefits of a captive:
Recapture of the underwriting profit. A captive will allow the financial institution to recapture the underwriting profit that would have been made by the conventional insurance company. For example, the price of insurance coverage purchased in the conventional market typically reflects a significant markup to pay for the insurer’s acquisition costs (sales commissions), administration and overhead, while building in a profit margin for the insurer.
Premiums paid to the captive are deductible. A properly structured captive will qualify as an insurance company for federal tax purposes. Premiums paid to the captive are deductible for the financial institution as an ordinary and necessary business expense under Internal Revenue Code § 162.
At the same time, under the provisions of IRC § 831(b), a captive will generally not pay federal income tax if it makes a proper election and its annual gross premium income for property and casualty lines does not exceed $1.2 million for the taxable year. As a result, the captive will only pay tax on its investment income. The premium income is not taxed until it is distributed to the captive’s owner. For smaller financial institutions that own a captive, this IRC section potentially provides additional cost-saving benefits over purchasing insurance from a conventional insurance company.
It is important to note that, among other factors, the IRS will examine any captive arrangement to ensure that it is not an economic sham and that it operates in a traditional insurance business manner. This includes consideration of whether a valid non-tax purpose motivates the formation of a captive and the associated insurance transactions.
Wealth transfer. The ownership structure of the captive can be used to achieve wealth-transfer objectives or to incentivize and reward key employees. For example, a captive can be owned by a trust set up for the benefit of the family members of the owner of the financial institution. Successful operation of the captive will result in the accumulation of wealth, which can then be distributed to the captive’s owners. Because the captive insurance arrangement is a transaction in the ordinary course of business, no gift or estate tax should attach to the wealth transfer.
Most successful captive insurance arrangements require a long-term commitment, so the decision to utilize a captive should not be made lightly. A critical component of deciding whether to utilize a captive involves a diligent feasibility study, including an audit of the current insurance program. It also includes detailed actuarial and financial projections to assess the viability of implementing a captive insurance arrangement.
Properly structured and managed captives provide flexibility and numerous benefits to owners and insureds. While captives are not right for every organization, financial institutions should at least consider a captive as part of their overall insurance and risk-management programs.
Zachary A. Abeles and Zachary R. Dyer are attorneys with Polsinelli PC based in St. Louis and Kansas City, respectively. Contact the authors at 314-889-8000; or by email at zabeles(at)polsinelli.com or zdyer(at)polsinelli.com.
Copyright (c) November 2013 by BankNews Media