Captive insurance companies can serve a number of objectives, including reduction of insurance costs through self-insurance, maintenance of insurance at predicted costs, control of the claims process, and direct access to reinsurance markets. A Captive can provide insurance coverage not otherwise available. There are many types of Captives, but this Letter discusses the Statutory 831(b) Captive.
A Captive formed under 831(b) of the tax code is particularly attractive to the closely held business. This Captive is typically owned by the principals or shareholders of a company; however, for estate and asset protection purposes, the Captive can be owned totally or in part by children or by a trust for children, by a spouse perhaps as separate property or by other persons. Key employees can own minority percentages of the Captive as a form of employee incentive.
Regardless of ownership, the Captive will be licensed to issue insurance policies to the Principals' own business or company, for various forms of liability coverage. The scope and type of policies will depend on the specific business, and might, for example, include excess liability over existing policies, for punitive damages, loss of income, loss of reputation, employee claims etc. Actuarial support for the premiums and policies is always recommended.
The Captive can issue "reimbursement" policies against which only the insured company can claim, thereby eliminating the risk of third party claims against the policies. This is not always the objective.
Premiums for business casualty and/or liability policies are normally deductable as an ordinary and necessary business expense, but the deductibility of premiums paid to an 831(b) Captive is limited to $1,200,000 per year. Because the policies will usually run for a 12 month period, the premium should be deductable in the year paid, and coverage and premiums can if necessary be adjusted each year.
The Captive files a U.S. tax return but direct premium income is tax deferred; earnings on the premiums are currently taxed. Upon dissolution of the Captive, whenever the shareholders elect, the assets are distributed to the Captive shareholders (not back to the company), and capital gains rates should apply to most if not all assets distributed. The Captive may therefore offer an attractive form of "pension" or retirement planning, since employees will not participate unless they own some of the Captive.
There are several Sates that promote the formation of Captives, including Vermont, New York, Delaware, Utah, and Arizona. Offshore jurisdictions include Anguilla, the Bahamas and Ireland, among others. Neither the tax code nor case law distinguishes between domestic and offshore insurance companies. Offshore jurisdictions might require lower capital and administrative costs, but such companies must elect to be taxed as U.S. companies. Several States are certainly competitive. Offshore Captives, like other U.S controlled foreign corporations, are subject to U.S. reporting requirements.
Regardless of whether the Captive is formed onshore or offshore, Captive assets are usually kept onshore, but in any case at least 10% of the assets must remain onshore.
For a premium in excess of $600,000 per year (not an absolute number), a "stand alone" Captive may be economical and offer other advantages. However, for smaller premium levels, the principals might consider using, for example, a "series business unit" (SBU) owned by a Delaware Limited Liability Company which is authorized to maintain separate cells or "series"; this arrangement can enable a company to economically pay a much lower level of premium. The annual maintenance costs are similarly reduced. The SBU, owned by the principals or any other person or entity as discussed above, obtains its own tax id number, and files its separate tax return, and is in fact the statutory Captive.
TAX DEDUCTIBILITY OF CASUALTY INSURANCE PREMIUMS
Premiums paid for casualty (liability) insurance are tax deductable, provided the required parameters for "insurance" are met: the premiums should be deductable as a business expense under IRC section 162, as long as the premium is reasonable for the coverage provided, and that there is a legitimate business purpose for the insurance issued by the Captive. The tax code does not specifically define what is "insurance", but Regulations define "business expenses" to include premiums for insurance against fire, storms, theft, accident or "other similar losses". In general, a Captive can insure any reasonable risk of a particular business.
A Captive must meet the regulatory requirements of 'risk shifting' and 'risk distribution', technical terms which are not discussed in detail here. The single purpose 831b Captive, discussed below, will normally meet this requirement by contracting with an established insurance "Pool", which insures a limited number of unrelated companies with Captives at a similar level as the subject Captive. The end result (oversimplified here) is that the Captive shifts a percentage of risk to the Pool, so that, in the event of a claim, the Captive might recover any excess over the contributed premium from the Pool, at least up to a contractual maximum; the Captive has therefore "distributed"' some of its risk. The Captive might allocate up to 50% of its annual premium to the Pool, for a limited time, and may or may not actually pay the funds into the Pool, but if paid, that amount is in any case refunded if no claims are made.
Captive insurance companies, and especially the "831(b)" or statutory captive, with tax deductable premiums, can serve many purposes, but they must be carefully and conservatively planned to meet regulatory requirements and a business purpose.
The important role of professional advisors is to help determine whether a Captive should be considered, to review insurable risks which are appropriate for the Captive, to obtain actuarial support for the premiums and policies, and to advise on pooling arrangements with a view to minimizing the Captive's exposure.