In the current business environment, many companies are finding it difficult — or prohibitively expensive — to secure the insurance coverage they need. One solution that may be worth exploring is to form or join a captive insurance company.

Simply put, a captive is a licensed insurance company that’s owned and operated by the business or businesses it insures. Although a captive can be a subsidiary owned by a single parent company, a group captive is usually the most attractive option for small and midsize businesses. It allows multiple organizations to share the risks, costs and liabilities. For example, a trade association might form a captive insurance company for its members.

Under the right circumstances, a captive can provide its members with a cost-effective alternative to purchasing insurance in the commercial markets. It may also offer some significant tax benefits.

Potential risk management benefits

Although it’s possible for a captive to replace traditional commercial policies, it’s more common for members to use captive insurance to supplement existing commercial coverage, such as general liability, workers’ compensation, or automobile coverage. For example, a captive might cover losses within a specified deductible or retention amount.

Benefits of captive insurance for members include:

• Access to coverage that may be unavailable from traditional insurers or, if available, may come at a high cost,
• The ability to tailor coverage to meet members’ specific needs and avoid paying for coverage they don’t need,
• Direct access to the wholesale reinsurance market, and
• Greater control over the claims review process.

In addition, members participate in underwriting profits that otherwise would go to a traditional insurance company. And they share in any investment income earned on the captive’s premium reserves.

Tax benefits

Although captive insurance shares many similarities with self-insurance, a captive that qualifies as an “insurance arrangement” for federal tax purposes enjoys some significant tax advantages. Unlike reserves set aside under a self-insurance program, premiums paid to a captive are deductible by its members. And the captive, as an insurance company, can deduct its reasonable loss reserves. So-called “microcaptives” offer additional tax benefits, although they can expect to be scrutinized by the IRS. (See “Microcaptives: Handle with care” below.)

To be considered an insurance arrangement, a captive must meet several requirements. Most important, the arrangement must achieve risk shifting and risk distribution.

Generally speaking, risk shifting means that members transfer certain risks to the captive in exchange for a reasonable premium. Risk distribution means that risks are pooled with enough other independently insured risks to minimize the possibility that actual losses will exceed expected losses. In addition, the captive must set premiums properly based on actuarial and underwriting considerations, be adequately capitalized, and be created for legitimate nontax reasons (among other requirements).

A captive can also be an effective estate planning tool. By providing family members with ownership interests in a captive, business owners can potentially transfer wealth to their heirs free of gift and estate taxes.

A formidable undertaking

Before taking action, know that forming and operating a captive isn’t a simple task. It requires owners to invest start-up capital, assume risk, comply with applicable regulations, and file state and federal tax returns. Owners must also manage the captive’s insurance business, which includes issuing policies, calculating and collecting premiums, setting aside reserves, and processing and paying claims. Many captives outsource day-to-day management activities to a captive consulting firm.

It’s also important to remember that forming a captive requires a long-term commitment. Shutting down a captive can be an expensive, time-consuming process. Despite the challenges, a captive can be an effective solution to a company’s risk management needs, under the right circumstances.

Microcaptives: Handle with care

A microcaptive is a captive insurance company that’s eligible for tax benefits available to “small” insurance companies. To qualify, a captive’s annual premiums can’t exceed a specified threshold ($2.8 million in 2024). In addition, it must meet the Internal Revenue Code’s diversification requirements. Among other things, this means that no single policyholder can contribute more than 20% of the captive’s annual premiums.

Small insurance companies, including eligible microcaptives, may elect to be taxed on only their net investment income. In other words, their underwriting profits escape taxation at the federal level.

The tax advantages of a microcaptive are significant. That’s because the business or businesses that own the captive may deduct their premium payments to the captive, but the captive isn’t taxed on its premium income.

However, be aware that in recent years the IRS has been scrutinizing microcaptive arrangements and challenging those it views as mere tax avoidance schemes. According to the IRS, abusive microcaptives “involve schemes that lack many of the attributes of legitimate insurance. These structures often include implausible risks, failure to match genuine business needs, and in many cases, unnecessary duplication of the taxpayer’s commercial coverages. In addition, the ‘premiums’ paid under these arrangements are often excessive, reflecting non-arm’s-length pricing.”

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