Setting up a captive Featured

7:41am EDT May 1, 2006

Because of trends in the insurance market, many domestic businesses — faced with exposure to risks such as mold, earthquake, construction defect and professional liability — have been left with a dilemma: pay outrageous premiums for limited coverage or find another way to buy insurance.

Captive insurance as an alternative risk management strategy is being used by many large corporations. Most small or medium size companies, unfortunately, don’t know enough about captives. Some smaller companies — as long as they’re profitable — can also benefit from establishing a captive.

The “single parent” captive is the most efficient and cost effective. It generally underwrites risks of companies related to the parent. There’s also “rent-a-captive,” which provides access to captive facilities without the user needing to fund its own captive. And pooling captives insures liability exposures of its group members, all of which must be engaged in similar business activities.

“Captives can provide a self-insurance portion of coverage, thereby lowering premiums but maintaining coverage,” says Glenn Gelman, managing director of Glenn M. Gelman & Associates. “Captives can also provide insurance where coverage does not exist at all.”

Smart Business asked Gelman more about captive insurance.

Define a captive insurance company.

A captive is a limited-purpose insurance company formed to insure risks, primarily of its owner. Like a traditional insurance company, a captive collects premiums, pays losses and earns investment income. But unlike a traditional company, principal beneficiaries are the original insured.

So you’re saying that a captive insurance company is the same as self-insurance?

No. Captives can be established so that they provide supplemental insurance, allowing you to have larger deductibles and exclusions but lower total premiums. You’re not giving up any coverage, but part of the risk may be self-insured.

The beauty is that, if there are not any claims, you keep the premiums. If you use the system really well, you benefit in two ways: you’ve got a tax deduction, and the money is yours.

What type of company should consider forming its own captive insurance company?

A captive is a business and economic solution to the problems inherent in purchasing insurance in certain markets and certain circumstances. It should only be formed when economics justify it. Generally, it should be utilized by exceptionally profitable businesses with significant risk-management needs.

What are the benefits?

You have total control — underwriting, rates, claims, forms — and you’re not paying commissions to any agents. You also have access to the reinsurance market.

What’s reinsurance?

Insurance companies spread out the risk, like banking institutions. For instance, if you borrow $10 million from your bank, the bank will spread out the loan and the risk associated with repayment to other participating banks. The same thing happens with insurance: individual companies don’t want all the risk, so they ‘participate’ it out. With a captive, you are an insurance company, so you have access to the reinsurance — or wholesale insurance — market, which operates on a lower cost structure than a direct insurer.

Specifically, what are the tax benefits of a captive?

The benefits include lower insurance premiums that more accurately reflect the insured loss history. Captives can help achieve premium stabilization, risk financing and the transfer of wealth.

The tax benefits stem from immediately deducting insurance reserves and taking advantage of Internal Revenue Code 831(B), which exempts net premiums of $1.2 million from tax.

A regular corporation could deduct $1.2 million in premium paid to a captive, but the captive would not pay tax on the receipt of the premiums.

Are there any drawbacks or risks?

First, start-up costs run in the neighborhood of $100,000.

Second, you have to become a real insurance company. A licensed and qualified insurance manager must be retained to set it up and manage its affairs. There are usually monthly and annual costs associated with being an insurance company.

Third, you can’t just insure yourself, unless you have 12 subsidiaries, as required by the Internal Revenue Service.

Finally, if you’re a small company, you may have to become part of a pool of captives in order to yield the best tax benefits.

What happens if you disband it?

If you liquidate the captive, its shareholders should be eligible for capital gain treatment, which is generally a much lower rate of tax than ordinary income tax rates. Today, the federal spread, or difference, is 20 percent. Thus, if a company pays premiums of $1.2 million to a captive and saves 35 percent federal tax, or $420,000, the captive’s shareholders could pay a tax of $180,000 upon liquidation. There would be a tax savings of $240,000 for that one year. If the captive existed for 10 years and the tax law stays the same, the savings would be $2.4 million.

GLENN M. GELMAN, CPA-MST, is the managing director of Glenn M. Gelman & Associates. Reach him at (714) 667-2600 or www.aten-usa.com.