Captive insurance companies are becoming more widespread in business today.  We see captives being used to save businesses money by reducing premiums, they have been used in asset protection plans, and they have been used as tax shelters.  Just what is a captive insurance company?

In its essence and simplest form, a captive insurance company is a wholly owned subsidiary of a parent company.  The parent company pays premium to the captive that would otherwise have been paid to an outside insurance company.  The captive then covers the claims made against the parent company.  This is the self-insured use of the captive that large companies have used for many years.  Most major companies and universities have formed their own captive.  Today, captives can be much more diverse and do not have to be owned by one parent company.

When used as insurance, the idea is that the parent company benefits from the good performance of the company rather than the outside insurance company.  If the premium is $10,000, for example, and there is $5,000 in claims in a given year, the company will have a $5,000 surplus.  If, on the other hand, there is $15,000 in claims paid on that same premium there would be a $5,000 loss.  For this reason, most captives will purchase reinsurance or excess insurance to cover claims in excess of a certain amount.  Alternatively, some captives have reserves that have grown large enough over the years that they can absorb such losses.

In 2002, the IRS issued guidance on how to establish a captive in compliance with the tax code.  This allowed many smaller companies to save money by establishing captives.  For instance many companies have formed captives to administer their health insurance.  This has also opened the door for other legitimate uses by smaller companies.  In addition, several companies and/or individuals can get together and form a captive of their own.

When marketed as an investment vehicle or asset protection device, the fact that a captive can potentially reduce income taxes and be transferred estate tax free to heirs are strong selling points.  However, the idea behind the captive is not to use it solely as an investment or asset protection vehicle.  My firm can assist you to form a captives for companies to insure against potential risks.  The IRS does look for abuses such as a captive that insures for a risk that the parent company does not have.

If you are considering a captive you will want to consider how it will be established and run.  You should have an attorney, CPA, and actuary who are familiar with the process during the formation.  There are companies that, for a fee, will administer the insurance program for you.  You must be prepared to handle claims and comply with insurance regulations, so having an experienced administrator is important.  There are also companies that will adjust your claims and handle the entire claims process.  No company should do this on their own.

Additionally, when considering a captive you need to determine which risks you wish to insure.  You may only want to cover health insurance or maybe worker’s compensation.  Also, a benefit of a captive is that you may be able to insure more than traditional insurance would insure if you choose to do so.  Many traditional insurance policies have exclusions that prevent a recovery and you do not have to write those into your own policy.  Waiting periods and caps can be changed to suit your preference and potentially cover your true business loss.

There is a strong potential for abuse through misuse of a captive.  They are subject to audit but the IRS does not audit a large percentage of the captives that currently exist. However, that may change as the IRS continues to look closer at captives.  Therefore, it is important that the company be set up and administered properly.

If you have any questions about captives please contact me at jmcguire@c-wlaw.com.