The price of insurance coverage you need to protect your business can sometimes be very high, but is usually worth the cost because it protects your business against catastrophic loss. But what if your business’s insurance claims are always less than what you pay for coverage? What happens to all that money you paid in excess of your claims? Answer: It goes right in to the insurance company’s pocket. This frustrating reality is what often leads businesses to create their own insurance companies that they use to insure themselves, which are called “captive” insurance companies.
A captive operates just like any other insurance company would, except that it is owned by the businesses it insures. This means that if you own a captive and insure your business through the captive, you don’t lose any money if your insurance claims are less than the premium paid that year. This is because the captive keeps the difference, and you own the captive! Also, because you created a captive to insure your own company, you can often make a custom tailored policy that provides coverage for only what you need, instead of the more general coverage you would get from a commercial insurance carrier.
A captive can therefore be a great choice if you own a business and are unhappy with your current insurance coverage. But establishing a captive is a big decision, so you should also consider some of the possible downsides. Owning a captive is a big responsibility and there are risks involved with captive insurance. Most importantly, if you are thinking about establishing a captive, make sure that you are doing it for the right reasons. Captives can create some great tax benefits for your businesses. But if you abuse of those benefits the IRS will fine you heavily. Because captives have become very popular recently, the IRS has made it a point to closely watch how captives are operated to make sure that all the rules are followed.
One of the benefits of a captive insurance company is that any premiums your business pays to a captive are tax deductible. Also, if you own a business and you want to transfer wealth to future generations of your family, profits earned by a captive are not subject to gift or estate taxes as long as the captive is owned outside of your estate. These are significant tax benefits that are valid considerations when establishing a captive. But you should remember that the true purpose of a captive is risk coverage and insurance, and those must be your primary reasons for establishing one. If a captive does not truly function as an insurance company should – meaning that it shifts the risk away from the business and diversifies its risks– the IRS will take note.
The premiums you pay to a captive must also relate to the relative risks you face in your industry or in the location where your business operates. For example, high premiums for earthquake insurance for a business in Nebraska are likely to raise a few eyebrows at the IRS. If the IRS investigates and decides that your captive is not truly operating as an insurance company, your business could lose the benefit of tax deductible premiums paid to the captive, and it could also be fined of up to $200,000.
You should also consider the time and money that you will need just to establish a captive. Most states require an initial capitalization of $200,000 to $250,000 to establish a captive. Many states have additional licensing fees that are due each year. You will also need to hire several insurance industry professionals, including actuaries, attorneys, and captive managers. Between the required initial capital, licensing fees, and employee salaries, establishing and running a captive could easily end up costing hundreds of thousands of dollars.
Even though some states have high initial capitalization requirements, there is still a risk that when you establish a captive, it might not have enough money in its loss reserves to cover the risks it is insuring. Unlike commercial insurance companies, one or two catastrophic losses by a business could completely deplete the captive’s funds. This might mean a direct loss to your business. If your insurance company doesn’t have the money to pay claims, somebody has to pony up – and that somebody will end up being you.
Even if no catastrophe strikes or no claims are made at all, a captive with too little money in its reserves can make the IRS suspicious and cause them to open an investigation. If the IRS decides that an undercapitalized captive is a sham corporation being used as a tax shelter, they will assess additional fines against your business. Undercapitalization therefore could end up being a real one-two punch to your business’s checkbook – out of pocket expenses for claims not covered by the captive’s funds followed by hefty fines from the IRS. Ouch.
You are probably thinking that the solution here is obvious – don’t undercapitalize. But it is sometimes more complicated than that, especially if you are a small businesses. Under Section 831(b) of the IRS code, a captive that takes in $1.2 million or less per year is not taxed on the premiums it receives – another one of the tax benefits of a captive! But if the captive takes in more than $1.2 million, that tax benefit disappears. So the decision to increase premiums in order to increase the captive’s reserves is not such a simple decision. It may end up costing the captive a significant tax benefit, all in the name of protecting itself against catastrophe that might not even happen.
Establishing a captive insurance company can be a great way for your company to save money on its insurance premiums, receive personalized insurance coverage, and perhaps even profit in years that your claims are low. But a captive is not the right choice for every business. Before you decide to establish a captive, you should carefully consider all the risks and benefits of establishing a captive to see if a captive would be the best way to meet your insurance needs.
