For those unfamiliar, a captive is a closely-held insurance company established by one or more business entities to insure and manage the risks of these same entities. Captives are licensed insurance companies that can be located onshore or offshore.
There are several different types of captives available for use, with the two most common being the single-parent captive and group/association captive. A single-parent captive insures only the risks of its parent or affiliate(s), while a group or association captive is owned by multiple, non-related entities, usually operating in a similar trade or industry.
A captive requires the 1) insuring of some risk of economic loss, and 2) risk shifting and risk distribution. The risk of economic loss must be transferred from the insured to the insurer (captive), and the premiums must be pooled so that an insured is not, in effect, paying for its own risk.
There are several reasons to consider the use of a captive, among them premium reduction, protection from market volatility, increased cash flows from underwriting and investment income, risk management, wealth preservation and transfer, and tax advantages, including reduced gift and estate taxes.
Captives are taxed as C corporations on the accrual basis of accounting and file IRS Form 1120-PC. The insured entity will continue to claim income tax deductions for insurance premiums paid to the captive. The captive can be structured to be taxed currently only on net investment income, with the insurance premiums accumulating (net of all claims paid) tax-free over time, and available to be invested in a variety of ways. These net premiums are not taxed until ultimately distributed to the captive’s owners.
Captives generally purchase reinsurance (stop-loss policy) to limit the captive’s annual claims exposure and protect the assets accumulating within the captive. Additionally, unlike traditional self-insurance policies, captives provide the benefit of asset protection against creditors, since the premiums have been transferred to a regulated, licensed insurance company.
While captives are widely used, they aren’t practical for all business entities. There can be significant costs incurred to establish a captive, including analysis and feasibility study (if necessary), legal fees to structure the captive, costs of regulatory filings, drafting the insurance policy(ies), etc. As a guideline, captives can be beneficial for companies with health, workers’ compensation, business and occupation, warranty or other premiums (individually or collectively) of at least $500k-$1.0 million annually.
Please contact your Schneider Downs tax advisor if you have questions or would like additional information.
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