Companies are turning to captive insurance in greater numbers in an effort to better manage risk and take advantage of tax benefits.
What is a captive, and what does it do?
As a means of managing their insurance risks and even retaining underwriting profits, large companies have been using captive insurance for nearly 50 years. Created in the 1950s by Ohio insurance broker Frederic Reiss, the concept is simple: a parent company forms an insurance company subsidiary — the “captive” — that insures the parent.
The industry received tepid support until the 1980s, when it began to gain momentum. While there were roughly 1,000 captives in 1980, the number has swelled to more than 6,000 worldwide today.
“Captive insurance companies have taken on a sexy appeal over the past few years,” explained Michael Mead, president of M.R. Mead & Company, Inc., a captive consulting and management company. As such, companies are increasingly looking at forming a captive. But while the industry is certainly trending, there are significant consequences — tax and actuarial, for instance — that must be considered before moving forward. Indeed, “A captive is not for everybody and won’t solve everybody’s problems,” Mead said. It is in this context that Mead, along with actuarial consultant Kyrle Mrotek, of The Actuarial Advantage, and Doug Youngren, a Plante Moran insurance tax partner, addressed key captive insurance trends and considerations.
A captive was originally created for tax purposes – reserves converted to premiums were tax deductible — and they allowed companies to better control their claims and reserves. “It’s about control, control, control,” said Mead.
While captives can write any type of policy, about 70 percent focus on workers’ compensation (“they want their own claims people,” Mead explained), along with general liability, auto liability, crop, property, and loss of income. Emerging captive coverage includes cyberliability, which is becoming increasingly popular because of the proliferation of cyberliability lawsuits. “Actuaries can’t give you a rate, there is no standard cyberliability wording and all have exclusions,” Mead said.
There are several types of captives, though not every domicile licenses each type:
- Single parent or “pure”
The most popular type; these are when the captive writes the risks only of its parent or its affiliates.
Established by a group or association to write the risks only of its owners or affiliates.
A captive that is owned by a non-parent company and available for others to use for a fee. “These are very popular today,” Mead said, as they reduce the costs associated with a company forming its own captive.
- Risk retention group
A group or association captive whose purpose is to assume and spread the risk for commercial liability exposure.
Today, more than 50 percent of the commercial property/casualty market is in some form of self-insurance, and captives have gained popularity with estate planners and wealth management advisers, too.
Costs are a significant barrier to entry in the captive market. A company must have at least $250,000 in capital, and startup costs range from $50,000, with at least $75,000 in ongoing fees (actuary, manager, accountant, taxes).
Captive insurance tax planning
Over the years, the IRS has struggled to clarify tax consequences for parent companies and their captives, considering distinctions between risk shifting (the insurer assumes risk that was formerly with the insured) and risk distribution (the insurer pools a number of independent risks). In many instances, it has ruled that premiums paid to captives are a form of self-insurance and thus not deductible (unless the captive also wrote coverage to non-parent companies) under Section 162.
Its ruling was based on its determination that there was real risk shifting, as the same “economic family” was responsible for any loss. However, in a later ruling, it concluded that a captive owned by multiple unrelated shareholders could legitimately achieve risk shifting and distribution, as the captive retained a level of unrelated risk. Generally, to meet a risk-shifting requirement, the parent must demonstrate that it has transferred specific risks to the captive by paying a reasonable premium.
Smaller captives enjoy significant tax benefits under IRC 831(b): Those whose gross premiums fall under $1.2 million do not have to pay tax on premium income, paying taxes only on investment income. However, losses cannot be deducted.
Family attribution rules
As an estate planning vehicle, captive insurance is also gaining acceptance, as it helps shield family members from incurring substantial tax liabilities. For instance, if the shareholders of a captive are family members of the owner(s) of the parent, they are entitled to the income of the captive without having to pay gift or estate tax, as it is considered an intra-familial transfer of wealth.
Protected cell companies
Several states have established the creation of a Protected Cell Company (PCC), which allows companies to take advantage of the benefits of a captive without creating their own. A protected cell company includes a “master cell” that holds the capital for the entire entity, and individual “cell companies” whose assets and liabilities are shielded from the remainder of the PCC.
The IRS allows for individual cells to be treated as separate captive insurance companies as long as it would be considered as such within the jurisdiction where it operates. Such an arrangement essentially allows the cell to operate a captive insurance company at a lower cost and with a smaller level of risk.
With so many potential risk and tax-savings benefits, forming a captive would seem a logical pursuit, but Mrotek advises a more deliberate approach. “Actuaries are critical to the healthy function of insurance and captive insurance,” he said, adding rhetorically, “But the question remains, is a captive right for your company?”
Mrotek views the feasibility of captives from an actuarial lens, performing financial and operational evaluations as well as a thorough actuarial analysis.
The key elements he considers include:
- Risk management objectives
- Proposed coverages and policy provisions
- Historical losses (minimum five policy periods)
- Historical and prospective exposures (minimum five years)
A final analysis
After preparing a number of reports including loss and loss expense payout reports, pro forma financials, and a capitalization analysis, business owners/managers make a determination. And lately as to whether a captive makes sense for a company, business owner’s conclusions are leaning more often toward “yes.”
Citing recent comments from a risk management consultant, Mrotek stated “There are roughly 600,000 business in the U.S. that can justify the cost of a captive. At least one-sixth of those have a business reason to pursue this, which is 100,000 companies.
“That means you’re going to keep hearing about captives. They’re here to stay. They’re poised to continue growing. And they can be done with insurance companies.”
Michael Mead, CPCU, M.R. Mead & Co., Inc., is a veteran of the insurance industry having served as an underwriter, broker, manager, and consultant. He is currently the editor of Captive Insurance Company Reports and the president of M.R. Mead & Company, Inc., a captive consulting and management company.
Kyle Mrotek, with The Actuarial Advantage, Inc., is an actuarial consultant specializing in property/casualty insurance.
Doug Youngren, CPA, Plante Moran, is an insurance tax partner at Plante Moran who oversees all aspects of the firm’s insurance company tax services area.
Michael, Kyle and Doug presented at the fifth annual Plante Moran Insurance Conference, which brought together top executives from insurance organizations to explore a number of opportunities the insurance industry can leverage for continued growth and success.