Construction is a highly competitive industry notorious for its razor-thin profit margins. That’s why it’s important for contractors to identify every possible way to reduce costs, generate income and minimize losses.
A group captive insurance arrangement may help with all three of those points by reducing your construction business’s insurance expenses, allowing you to share in the captive’s profits and enhancing your risk management efforts. Naturally, there are some administrative burdens and risks to consider.
What’s a group captive?
A captive is simply a licensed insurer owned and operated by the companies it insures. Captives can take several forms, but let’s focus on group captives, which are the most common arrangement for small to midsize construction companies to participate in.
True to their name, group captives are formed by groups of similar companies — such as businesses in a certain industry or members of a trade association — to serve the insurance needs of their members. Although participants may replace their existing commercial insurance with the captive’s coverage, members more commonly use captive insurance as supplemental coverage.
The members own and operate the captive, paying premiums to cover operating expenses and fund a cash reserve for losses. They also share in the captive’s profits and investment income.
How do taxes work?
Although a group captive is essentially a form of self-insurance, members may deduct their premiums as a business expense in the same way they would deduct premiums paid to a commercial carrier. Underwriting profits, if any, are free of tax until they’re distributed to members. So-called “microcaptives” may enjoy an additional tax benefit, though the IRS is highly suspicious of these arrangements. (See “IRS targeting microcaptives” below.)
To be eligible for these tax benefits, a captive must qualify as an “insurance arrangement” for federal tax purposes. That means:
- Members must shift risk to the captive, and
- Risk must be distributed among enough unrelated parties to minimize the chances that a single loss would deplete its cash reserves.
Whether risk is sufficiently distributed depends on each group captive’s distinctive facts and circumstances, and a full discussion of the factors considered is beyond the scope of this article. Generally, however, a captive that insures only its parent company probably wouldn’t be considered an insurance arrangement. On the other hand, a captive that receives 50% or more of its premiums from businesses unrelated to the parent would likely qualify as one.
How do members benefit?
Under the right circumstances, a properly created and managed captive can provide a number of benefits. These may include:
Cost savings. Coverage through a group captive typically offers lower, more stable premiums than comparable policies with commercial insurers. One reason for this is that commercial premiums include a significant markup to cover the insurer’s expenses and profit margin.
Another reason is that the best group captives require members to meet certain risk management standards. Thus, these captives tend to experience fewer losses than the overall insurance market, resulting in lower premiums. In addition, group captives have direct access to the wholesale reinsurance market for protection against catastrophic losses, allowing them to control their expenditures.
Tailored coverage. Because members control the captive, they can tailor coverage to meet their specific needs and avoid paying for unneeded insurance. They may also be able to obtain coverage for risks not typically insured by traditional carriers, often at higher limits and with fewer exclusions.
Potential income. Group members participate in the captive’s underwriting profits. This provides an additional incentive for members to implement risk management best practices to help minimize claims. In addition, captives typically invest their reserves and surpluses, generating investment income for members.
More control over claims. As owners of the captive, group members have a great deal of control over the claims review and approval process.
Stronger operations. Given the importance of minimizing losses, best-in-class group captives generally require members to demonstrate strong risk management practices and a firm commitment to worker safety and wellness as a condition of acceptance.
This provides an incentive for members to share best practices for reducing losses from accidents and illnesses. Such collaboration not only reduces costs and enhances profits, but also helps participants retain employees and improve their business reputations.
Like most business strategies, a group captive insurance arrangement has challenges and disadvantages to consider. Joining a captive may involve an upfront investment of capital. From there, group captives impose considerable administrative burdens on members, including compliance with insurance regulations.
They also require members to develop insurance industry expertise and share control of the captive with other members. And it’s worth noting that membership in a group captive could complicate a merger or acquisition.
A major decision
Make no mistake, the decision to join a group captive is a major one wrought with complexities and risk. If interested, be sure to discuss the concept at length with your leadership team and professional advisors.
IRS targeting microcaptives
A microcaptive is a particularly small captive insurer that may enjoy a particularly enticing tax benefit. That is, it can elect to be taxed only on its net investment income, not on its premium income. Generally, microcaptives are defined as those whose annual premiums don’t exceed an inflation-adjusted threshold ($2.8 million in 2024) and meet certain diversification requirements.
However, smaller group captives that meet these requirements should think carefully before making the election. The IRS has been closely scrutinizing microcaptives and challenging those it views as mere tax avoidance schemes. It’s particularly interested in microcaptives involving purported insurance contracts between related parties.