The following is Part V of a six-part series of blog postings regarding whether a captive insurance subsidiary or one owned by the owners or affiliates of a company may represent an effective risk management tool that also provides economic benefits. Although there are various types of captive insurance, this posting and the one to follow will focus primarily on single parent/pure captives and how they might provide economic benefits for you or your agribusiness company. Part I, Part II, Part III and Part IV of the blog series are here.
This posting provides an overview of the benefits to a company and its shareholders or members of forming a single parent or pure captive.
PART V – CERTAIN BENEFITS OF FORMING A SINGLE PARENT OR PURE CAPTIVE
Customizing Insurance Not Provided by a Third Party Insurer
After identifying the most salient risks facing a company (which should be a part of any company’s risk management function) it must determine whether:
- commercial insurance coverage is available for that risk;
- the available commercial coverage has such a high deductible and so many exclusions that the company is effectively self-insuring the loss;
- the cost charged by the commercial provider is not only affordable but is alsoless than the company could provide itself through forming a captive subsidiary for that risk and other risks facing the company, given the probability of the occurrence of the event and the magnitude of the loss if the event were to occur; and
- the commercial insurance for that risk is likely to remain available at such affordable costs for the foreseeable future.
If the answer to any of these questions is “no,” the company should consider further whether it should form a captive insurance company to insure against such risks. The value of the single parent captive is the parent’s ability to customize policies that insure against business and operational risks that are not available from third party insurers or at costs that are unreasonably high given the risk and the potential harm to the company. Captive insurance rarely replaces third party insurance. Rather, it serves as a gap filler to provide coverage that commercial carriers do not provide at a reasonable cost.
Use of Captives to Pay Deductibles Lowers Premium Costs Paid for Commercial Coverage
Even where insurance is available and affordable, a captive insurance subsidiary can be used to pay the deductibles on claims made by the other subsidiaries of its parent rather than relying on those subsidiaries’ self-insurance (i.e., paying the deductible from their respective operating incomes or retained earnings). Where a captive subsidiary is organized and operated because management has determined it makes economic sense for the parent for other business reasons, the deductibles are usually paid by the captive. When a company has the ability to pay higher deductibles, the premiums charged by the commercial insurer are generally lower.
Additional Opportunities to Lower Premium Costs and Negotiate More Favorable Terms for Commercial Insurance
That the parent company has a captive subsidiary effectively competing with commercial insurance carriers gives it an enhanced bargaining position to negotiate lower premiums and better terms and conditions on the policies for coverages not provided by the captive. Further, commissions are no longer being paid on insurance coverage formerly provided by the commercial insurance provider.
- Investment Opportunities with Respect to the Premiums
Premiums not used to pay claims can be invested by the captive insurer in instruments approved by the applicable insurance regulatory authorities to earn additional income.
If and to the extent the captive grows and offers policies to its brother-sister affiliates and to other third parties, it may ultimately grow into its own profit center for the direct or indirect parent company that formed it. For those captives that incorporate in a tax-free domicile, the premiums paid may continue to grow tax-free, such that more money is available to be reinvested as capital and to pay claims and, to the extent of regulatory approval, dividends.
The parent, through its captive insurance subsidiary, will have access to the less expensive reinsurance market from which it can purchase its own insurance to provide the full extent of the coverage it has agreed to provide to its brother-sister affiliates. Reinsurance is available only to insurance companies.
- Improved Claims Handling Efficiencies and Control
A good captive manager can devise and implement claims handling policies and procedures that may be more efficient and tailored to the needs of the brother-sister affiliates than the third party insurer may provide.
- Improved Risk Management
Implementation of a single parent captive insurer often forces management to more closely examine the risks of operating the business to determine the appropriate risks of the brother-sister entity to insure and the amount of the insurance the captive should provide to insure those risks. Through this process, management may identify and quantify its risks leading it to develop ways to substantially reduce those risks. Identifying, quantifying and taking steps to reduce risks will demonstrate to the company’s board of directors, audit committee, safety committee and outside entities such as the company’s lenders and investors that the company is committed to risk management and cost reduction throughout the company. It should also result in reduced claims to be paid by the captive insurer and the cost of reinsurance thereby reducing the company’s costs.
- Tax Advantages
- Tax Deduction by Brother-Sister Affiliate Paying the Premium to the Captive. The single parent captive insurance subsidiary is a separately formed subsidiary to which its brother-sister affiliates pay premiums for the insurance coverage the captive subsidiary provides to them. The amounts paid by the brother-sister affiliates to the single parent captive are deductible for federal income tax purposes to the extent the captive is a bona fide insurance company.
- Section 831(b) Election for Smaller Companies. Premium payments of $1.2 million or less received by the single parent captive from its brother-sister affiliates is excluded from taxable income if the captive qualifies for the election it can make under Section 831(b). This is referred to as the “831(b) Election”. It is essential to note that treatment of up to the $1.2 million of premium payments as non-taxable is predicated on compliance with certain clearly defined rules of the IRS and is subject to Internal Revenue Service audit. It is also important to note that single parent captives that receive premiums from their brother-sister affiliates inexcess of $1.2 million are not permitted under Section 831(b) to treat the $1.2 million as non-taxable income and the remainder as taxable. No amount of the premium may be treated as non-taxable.
Clearly there are insurance and economic benefits in forming single member and pure captive insurance companies. However, no management analysis would be complete without examining all considerations. Our sixth and final blog posting in this series will discuss those factors and concludes the series with a brief summary of the analysis we suggest management conduct in considering whether captive insurance is the right enterprise risk management tool for it.