Forming a captive insurance company? Understand the business and tax implications.

• Author: Fox, Gary A.

Many U.S. companies have formed captive insurance companies to achieve significant benefits, but the decision whether to form a captive is often clouded by misconceptions and a failure to recognize both the business and tax implications involved. This article reviews the most common business reasons for forming a captive and examines the various types of captives that can be formed. It also discusses the critical business and tax questions that must be weighed to determine the proper ownership, domicile, and corporate structure of a captive insurance company, particularly as they relate to third-party risk, captive tax implications, and insurance regulatory issues.

Captive Insurance Company Basics--A Changing Picture

For many executives, the term "captive insurance company" still has some negative connotations. In the past, captives often were regarded primarily as tools for providing problem coverage or coverage not readily available in the commercial market. Today, captives offer other advantages, particularly after several revenue rulings by the Internal Revenue Service in 2002 provided guidance on the tax treatment of captives.

A captive insurance company is a legally licensed limited-purpose property and casualty insurance company. A captive's main business purpose is to insure the risks of its owners or the companies affiliated with its owners. Captives can be formed by any type of business--financial institutions, manufacturers, construction companies, and automobile dealerships, to name only a few of the most common ones.

A captive can provide virtually any type of insurance, as long as the laws of the state or country in which it is domiciled (i.e., incorporated, licensed, managed, and operated) allow the line of business to be underwritten. Some of the most common types of insurance captives offer are:

* Builders' risk

* Contractors' professional liability

* Pollution

* Directors' and officers' liability

* Cyber security

* Professional liability/error and omissions

* Fiduciary liability

* Crime

* Property damage/business interruption

* Automobile liability

* General and umbrella liability

* Workers' compensation (reimbursement)

* Employment practices liability

The types of coverage captives offer continue to evolve. For example, faced with rising employee health care costs, some companies have recently begun incorporating employee benefits programs into captive insurance companies.

Business Reasons for Forming a Captive

A common misconception about captive insurance companies is that they are formed primarily to secure certain tax benefits, particularly the ability to accelerate the deduction for losses. This advantage over self-insurance or a simple rainy-day fund is significant because the premiums paid to the captive insurance company generally are a deductible business expense to the company that formed it and thus accelerates the deduction of future losses.

Tax considerations alone, however, should not be the primary reason for forming a captive. Instead, relevant business considerations should drive the decision. Although the relative importance of these considerations varies with each situation, there are some significant factors that can influence the decision to form a captive.

1. Improved Risk Management and Risk Financing

   A captive insurance company can be a highly effective tool for gaining better control of an organization's risk-management and risk-financing functions. A captive can enhance the overall organizational view of risk management and provide valuable ways to identify and quantify risks, both insured and uninsured. Forming a captive also can help management demonstrate to the board of directors, audit committee, and relevant regulators that the company is pursuing a prudent and transparent approach to risk management at various levels of the organization.

2. Lower First-Dollar Insurance Costs

   Another common misconception about captives is the belief that their primary use is to replace existing commercial coverage. This is true in some situations, but more commonly, the captive is used to augment existing commercial insurance, especially by providing first-dollar coverage for losses. When a captive is available, most companies use it to provide coverage for selected commercial policy deductibles.

   For many companies, a captive also offers the opportunity to reduce the cost of commercial policies by increasing deductibles to reduce premiums. Since the captive has the flexibility to insure any risk it chooses and to customize the terms and conditions of its policies, many companies are able to use a captive to take better advantage of their positive loss history or their relatively high tolerance for certain categories of risk.

3. Plugging Gaps in Commercial Insurance Coverage

   Every company has gaps in its insurance coverage. Historically, many companies simply self-insured any risks that were excluded from commercial polices. Today, forming a captive allows businesses to plug gaps in their commercial policies by writing coverage the conventional market is unable to offer at an affordable rate or unwilling to offer at all.

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   For example, business interruption from commercial carriers often is offered only with numerous exemptions. A captive policy can be written to overlap the commercial policy and fill in those gaps. Captive policies also commonly insure against cyber risk, workplace violence, fraud and other crimes, directors' and officers' liabilities, and employment office liability.

   In addition to plugging gaps in existing policies, captives often are used to cover deductibles or to add coverage above the...