Captive insurance companies: opportunities and pitfalls.

• Author: Shanbrom, Paul

Paying insurance premiums is a normal cost of doing business. In the case of commercial insurance, companies that manage risk well often find that their high premiums subsidize less-prudent businesses. Other firms find that insurance is simply unobtainable. A "captive" insurance company can solve both problems in an economical and tax-efficient way. However, a captive company that is not respected for tax purposes is neither economical nor tax-efficient.

Benefits

A captive insurance company can allow a business to obtain insurance on risks it could not otherwise insure. It can also provide a lower-cost alternative to commercially available insurance. If a firm has favorable claims experience, the savings will benefit the captive insurance company (rather than a third-party insurer).

The tax benefit of the structure is that the business can deduct insurance premiums paid to the insurance company as if they had been paid to any other third-party insurer. (Note: This discussion applies only to nonlife insurance companies. Different rules apply to life insurance companies.)

The insurance company also receives favorable tax treatment. The most important benefits are provided by Sec. 832(b)(5), which permits them to deduct predicted but unpaid losses (reserves), and Sec. 831(b), which taxes them only on their investment income if premiums received during a tax year do not exceed $1.2 million. (See also Sec. 501(c)(15), which provides a full tax exemption for very small insurance companies.) Because of the exemptions, many captive insurance companies elect under Sec. 953(d) to be taxed as U.S. corporations, even if they are formed outside the U.S.

There can be additional benefits to the entity or its owners. The insurance company may be owned by the business or the business's owners, but not necessarily; other possible owners include family members or key employees. As long as the owners obtain their interests in arm's-length transactions, they may be in a position to profit from the company's success without being treated as having received taxable transfers.

If all goes well, a captive insurance company will normally generate reserves over time. Because amounts set aside for reserves are tax-deductible, the amount of reserves available to invest will not be reduced by taxes.

Mechanics

Before establishing a captive insurance company, it is important to determine the type and extent of risks for which insurance is needed. This requires a good understanding of the...