Congress Wants You To Own A Captive Insurance Company

I remember a few years back, when a good friend of mine pulled up in a brand new, massive, American made pick-up truck.  It was black with shiny chrome and a tan leather interior – absolutely stunning. 

“It looks like someone is going through a mid-life crisis,” I quipped.

“No, I’m just being a great American.  You should thank me,” he replied. 

“OK, how does buying an over-sized, ego boosting truck make you a great American?”

“Congress wanted me to buy it.”

“Congress wanted you to buy it?”

“Yes.  Congress wants me to buy it, and they have made it possible for me to take all the depreciation – all $45,000 of it – this year.  How about that?  I have helped my fellow Americans in Detroit have a job and Congress lowered my taxable income by forty-five grand.  That’s what I get for being a great American”

I really didn’t have a comeback.  I just wished I had a big shiny truck of my own.

It’s no secret that Congress uses tax laws to incent businesses to alter their behavior.  This includes incenting behaviors like hiring more workers, providing education to employees, choosing green energy, buying or accelerating the purchase of new equipment and, even, owning your own insurance company.  Clearly, business owners aren’t going to make a ridiculous purchase just to reap a tax benefit.  I wouldn’t expect my friend to drive up in a cement truck or a crane he would never use simply to reduce his taxable income.      

Congress wants small and medium sized businesses to own their own insurance company, known as a captive insurance company (CIC).  In the mid-80s, Congress passed captive insurance legislation that established the 831(b) tax election for small insurance companies.  This legislation opened the door for many small and mid-sized business owners to enjoy the same benefits of CIC ownership that large corporations had enjoyed since the 1950s. 

Congress wants small and mid-sized businesses to own their own CIC for a variety of reasons.  Captive ownership isn’t the right move for all businesses, but for many businesses, the pros of CIC ownership outweigh the cons of CIC ownership.  A few reasons Congress encourages CIC ownership are as follows:

• Most businesses are under-insured but don’t want to buy more commercial coverage
• Businesses that own a CIC typically benefit from a vastly improved risk management approach
• Businesses that own a CIC tend to be forward-looking and better prepared to weather adverse events in the future
• CIC ownership boosts long term business viability which, in turn, is good for the economy and good for employees
• CIC ownership enables businesses and business owners to reap insurance profits and grow wealth (gasp)

For these reasons, and many more, captive owners are great Americans. 

What Is A Captive Insurance Company?

Simply put, a captive insurance company is an insurance company.  It is a C corporation and is licensed and domiciled like any large insurance company.  Captives also have their own reserves, policies, policyholders, and claims.  Owning a captive insurance company is a sophisticated way to self-insure, and captives are generally formed to insure the risks of a business, group of businesses and related or affiliated third parties.

What Are The Benefits Of Owning A Captive Insurance Company?

First, the parent company is able to benefit from a more robust risk management approach.  Specifically, the parent company or companies can now formally insure risks that may have previously been uninsured.

Second, the overall (or aggregate) wealth of one or more companies with a captive insurance company is almost always higher – significantly higher – than the overall wealth of companies without a captive insurance company.  This occurs for two primary reasons.  First, the parent company takes an expense as it pays its insurance premium to its captive.  This lowers the parent companies taxable income.  And, the captive does not pay taxes on the premium it collects (up to $1.2 million annually).  Second, the captive is able to earn a return on its reserve pool (or assets).  And, the captive’s asset pool has been amassed with pre-tax dollars, enabling asset growth on a larger starting base.    

There are numerous risks that many businesses regularly face and informally self-insure.  Which means that if an event occurs, the business “bites the bullet,” often taking a loss, laying off workers and possibly facing partial or total closure.   With a small captive in place, making an 831 (b) tax election, businesses can formally insure risks not normally insured by third party insurers. 

Adverse events are going to occur whether or not a business has a captive insurance company in place.  Businesses with a captive in place have a much larger pool of funds to address adverse events (typically 80% to 100% more) because captive assets are comprised of pre-tax dollars.  Hence, the captive effectively acts as a legal tax shelter for the premiums received from its insured.

Premiums are paid from the parent company to the captive with pre-tax dollars, and accumulate tax-free as reserves of the captive (up to $1.2 million annually).  Captive reserves can be translated into virtually any other type of asset (some domiciles have restrictions).  Hence premiums paid to the captive are in effect a “transfer of wealth” and are protected from the parent company’s creditors and lawsuits. 

Over time, a well- structured captive can often double a business owner’s wealth. 

Now what could be more American than that?  I love this country!