What is a captive insurance company?

A captive insurance company is a subsidiary or affiliate of a closely-held business entity formed to insure or reinsure certain risks of those entities. The captive is formed either in a U.S. or foreign jurisdiction for the purpose of writing property and casualty insurance. It goes through a regulatory licensing process that has become simpler as more states have created modern captive statutes. Once licensed, the captive is capitalized (amount varies by jurisdiction), and then issues insurance policies to the insured affiliates and collects premiums. Premiums are determined by independent actuaries based on existing market comparables, when available. Policies contain all of the normal terms of commercial insurance contracts, but can also contain special coverage and terms not available in the commercial market

What kind of insurance does a captive insurance company provide?

Businesses don’t insure all of their risk. Many risks are “self insured,” meaning the business doesn’t have any insurance coverage. A captive can solve this problem. The business can transfer its “self insured” risk to the captive. This could include deductibles and exclusions on existing commercial policies. A captive is an excellent method of providing certain types of insurance coverage that are unavailable or difficult to obtain, often due to historic loss experience or conditions such as environmental, earthquake, wind, and weather. Recently in the news we have read about the deaths and financial loss of food-borne illness, such as the recent episode of listeria-caused deaths from cantaloupes or romaine lettuce. We regularly see stories about E. coli losses. Hail, heavy rain, wind or other weather hazards have a greater impact on agribusiness than other businesses. Environmental issues related to pesticides, and state and federal regulatory issues can also pose significant risks. Just the costs of litigation of many of these claims could be enormous, apart from the liability itself. Finally, remember the catastrophic impact of a "black swan" event such as terrorism on the agricultural industry. These are only a few examples of the risks that could be insured through a captive insurance company.

The captive could insure these risks through policies such as: agricultural income protection, political risk (import/export), pollution liability, product recall/withdrawal, administrative actions, loss of key supplier/customer. The insurance policies issued by the captive can be tailored to the specific needs of the business.

Risk and control of asset investment.

Captives aid a business in enterprise risk management by helping management understand and price risk. A captive can also provide incentives to improve risk management throughout an organization, since surplus not used to pay claims can be distributed to shareholders as dividends. Control of the captive also means that the client has investment control of the captive's assets, subject to certain restrictions and regulations depending on the jurisdiction in which the captive is formed.

Special tax treatment for captive insurance companies.

Captive insurance companies have been recognized by and received special tax treatment under the Internal Revenue Code, similar to that afforded major property and casualty carriers such as AIG, Travelers and ACE, for over 50 years. Another special provision available to "small" property and casualty companies ($1.2 million or less of annual premium) allows all premiums to be fully non-taxable to the captive, even though they are deductible by the insured company. Reserves are invested by the captive and retained in anticipation of future losses and/or a growing net equity.

Captive insurance company benefits enjoyed by thousands of companies.

Today, the owners of thousands of businesses have accumulated substantial pre-tax wealth through their captive insurance companies. In order to receive these special benefits, the captive and the policies written must have the attributes of insurance, including (1) risk shifting and (2) risk distribution. Risk shifting is easily accomplished by a valid insurance contract shifting the risk to a validly formed and licensed insurance company. Risk distribution involves the "law of large numbers" and has been an area closely scrutinized by the IRS. Fortunately, the IRS has published several rulings that provide guidance on the risk distribution requirement. Therefore, formation, qualification and operation of a closely-held captive insurance company require advice from professionals with significant experience in this area.

Benefits of ownership by or in trust for children and grandchildren.

If the captive is owned directly or indirectly by or in trust for the business owner's children or grandchildren, there will be a net wealth transfer without gift, estate, or generation-skipping transfer tax consequences if the captive's reserves are not used to pay claims. Insurance premiums are business expenses, if reasonable -- not gifts. Since the captive's assets would be outside the business owner's taxable estate it is an asset that is ideal for a generation-skipping dynasty trust.

Benefits of ownership by family limited partnerships or LLCs.

As with many estate planning structures, the captive insurance company could be owned by a family limited partnership (FLP) or limited liability company (LLC). The FLP or LLC could in turn be owned by various family members or trusts with differing classes of interests and rights. This could provide a continuing ability for the business owner to control and invest funds received as distributions from the captive insurance company.

Benefits of ownership by key management.

Another common ownership structure involves creating restricted shares for key management. Since the captive is taxed as a "C corporation" for income tax purposes, it can have multiple classes of stock. The classes could have vesting and transfer restrictions that would provide incentive and retention features for management. This also provides incentives for employees to manage business risk more effectively. Insurance premiums paid to the captive should not be deemed compensation to the employee-owners for income tax purposes.

Benefits for asset protection.

Generally, the assets of the captive insurance company should not be subject to claims by creditors of the main business. This assumes that the insurance premiums are reasonable and justified, the captive is not a sham, and that it was properly formed and operated.

Benefits for shareholders.

To the extent that claims against the captive's reserves are less than premiums plus investment income, reserves grow and the captive stock becomes more valuable. Dividends can be paid to the shareholders from excess reserves which are subject to capital gain tax rates today. When the captive is liquidated, the proceeds received by shareholders are also treated as capital gain.

Who sets up captives?

What kind of agribusiness companies set up captive insurance companies? Almost every large agribusiness has a captive, including ADM, Cargill, Dairylea Cooperative and Growmark. In recent years, private agricultural businesses have started using captives, for risk management and financial benefits. Captives are used in all major industries. For example, virtually all major private home builders have captives (dealing with construction defect claims and subsidence claims) as do most major owners of car dealerships and other companies that sell extended warranty insurance contracts (for example, Best Buy). Numerous firms in the construction and manufacturing businesses have also formed captive insurance companies. In fact, the vast majority of the Fortune 500 own captive insurance companies. A captive insurance company might be right for you too. But you don't have to be that big to benefit from a captive insurance company. Here are some ways to determine if it might make sense for you.

When should you think about setting up a captive?

While each business has unique factors that may impact the viability of a captive insurance company, here are three pretty good indicators of whether a captive insurance company makes sense for a business. If you meet any one of these tests, you should look further into this opportunity.

  • If your business has annual sales of at least $50 million, or
  • If your current commercial property and casualty (P&C) premiums are at least $500,000 annually, or
  • If you suffered a recent large casualty loss (e.g., wind and weather, flood, fire, crop loss)

When deciding whether to establish a captive, the business owner should be prepared to pay premiums of at least $500,000 on the policies that will cover risks insured by the captive, as determined by independent actuaries. The captive may issue policies that replace existing insurance, or write risks that are outside the scope of the existing commercial P&C coverage. It is not required that the same coverage be continued each year. The policies can be changed or eliminated or new policies written from year to year.

Many legal, insurance and financial considerations bear on the decision to form a captive insurance company, so always obtain the advice of experienced professionals early in the process.