The Financial and Tax Benefits of Captive Insurance Companies

A captive insurance company is a privately-controlled insurer that is set up to insure some of the risks of its parent company, a group of related companies, association members, or industry group. Captives are an alternative to traditional insurance arrangements, and offer tax-advantaged ways to handle selected risks.

Fortune 500 companies have benefited from captive insurance companies for decades. Now, small businesses and investors are realizing significant financial and tax benefits by establishing their own insurance companies.

Captives have traditionally been set up offshore. Recently, the South Carolina legislature and Department of Insurance have made that state one of the best places for captives to be domiciled. Other states are competing for those businesses as well.

Some businesses reduce their premiums by accepting large deductibles on traditional policies, and then obtaining coverage for those deductibles from their own captives.

Businesses may deduct premiums they pay to related insurance companies. Yet if an insurance company has premium income of less than $1.2 million annually, it can elect for the premium income to be free of federal income tax. This provision is in Internal Revenue Code Section 831(b), and is available only to bona fide insurance companies. Investment income earned on the funds held inside the insurance company is taxable at ordinary corporation rates.

Premiums between related parties must be properly structured in order for the premium payments to be deductible by the operating business. There must be risk shifting and risk distribution for the payments to qualify as insurance. The insurance company must also maintain sufficient third party insurance in order for premiums to be deductible.

To qualify for the tax benefits, a captive must comply with state regulations. A firm specializing in advising captive insurance companies should be engaged to help issue and account for insurance policies, manage risks, maintain proper books and records, and provide reports to the owner.

For example, Ed is a successful real estate investor and business owner. He sets up a bona fide captive insurance company to help control his insurance costs. His businesses raise the deductibles on their current insurance policies with traditional insurance companies. His businesses insure the deductibles through the captive. Once the deductibles are higher, the traditional insurance premiums are $100,000 lower. That amount is paid to the captive to insure the deductibles.

In addition, Ed’s businesses obtain new types of insurance coverage from his captive insurance company, which they had not previously purchased from the traditional insurance companies. These new coverages include business interruption, terrorism, and fire damage to tracts of timber. Premiums for these coverages are $100,000, which is paid to Ed’s captive.

Under Internal Revenue Code section 831(b), the $200,000 of premium income received by Ed’s insurance company is free of federal income tax. Additionally, if his captive insurance company is properly structured, his operating businesses will be allowed to deduct the $200,000 of insurance costs. At a 40% (federal and state) income tax rate, this saves Ed’s companies $80,000 of income tax.

Ed controls the operations of his insurance company. However, a captive advisory firm performs most operations. The advisory firm does not have direct access to the assets of the captive.

There are several ways for Ed to get cash out of the captive. Some options may be salaries, loans, dividends, redemption of stock, payment of claims, and management fees to related entities. Ed may also continue to hold the stock of his insurance company until his death, when the stock passes to his heirs with a basis step-up, and the company can then be liquidated without income tax.

Captive are not right for everyone. However, those who are interested in controlling business insurance costs and saving income taxes should evaluate the possibility of establishing a captive insurance company.

PrimeFortress Management, L.L.C. R. Thomas Savage, Jr., Managing Member 5154 Ravens View Road, Johns Island, SC 29455 Phone/Fax: 843.557.1782  1.866.704.5835 Email: tomsavage@primefortress.com