It is not surprising that captive insurance companies have been gaining prominence in recent years. There was an era when captives were primarily utilized by large corporations, but their adoption has accelerated among small and mid-market companies of late. There are two major reasons why captives are gaining traction with small and mid-size businesses.
The first is that captive insurance companies are a powerful financial vehicle that resolve a contradiction that most business owners and their advisors face. In business and in our human relationships, we usually expect to have to give up something to get something. For a business to enjoy more insurance protection and greater risk management flexibility, one would expect to have less money. In this regard, a captive insurance company can be a real game changer, enabling a business or business owner to have more insurance protection, greater flexibility and more money.
Second, captive ownership has become viable and accessible for small and mid-size businesses in the last few decades. The Tax Reform Act of 1986, created the 831(b) section of the Internal Revenue Code, making it advantageous for small and mid-market companies to own their own insurance company. Also, in the 1990s, Governor Howard Dean of Vermont kicked off the “Domicile Wars,” when he decided to undercut New York for cost and capital requirements to set-up and operate a captive insurance company. To this day, Vermont is the largest captive insurance company domicile in the world. Other states followed suit, making captives more and more affordable and accessible.
What Is An 831(b) Captive Insurance Company?
This question should really be rephrased into 2 separate questions. Any domicile regulator will tell you that there really is no such thing as an 831(b) captive. Domiciles license insurance companies. 831(b) is a tax election. Hence, the questions that should be asked are:
- What is a captive insurance company?
- What is an 831(b) tax election?
What Is A Captive Insurance Company?
Simply put, businesses or their owners can choose to OWN THEIR OWN INSURANCE COMPANY. A captive insurance company is a licensed insurance company. Captives are formed to provide insurance protection to businesses and related entities. They are usually owned by the business, business owners or other related parties. Businesses pay premiums as an ordinary business expense to their captive insurance company(ies). The captive issues insurance policies to the company. Captive policies are priced by an actuary. When the business files an insured claim, the captive pays it. Like commercial insurance companies, captives also accumulate loss reserves. Reserves can be invested in accordance with the captive’s Investment Policy Statement (IPS). The IPS is approved by the domicile.
What Is An 831(b) Tax Election?
Small captive insurance companies may make an 831(b) tax election. “Small” captives are defined as having underwriting profits of less than $1.2 million annually. Underwriting profit is simply calculated as premiums received less claims paid. Captives making an 831(b) election are taxed at a rate of 0% (zero percent) on their underwriting profits. The illustration below is a business that pays premiums of $1.2 million to its small captive insurance company. Its captive makes an 831(b) tax election, and is taxed at a rate of zero percent. In this illustration, resulting annual tax savings in $600,000.
How Does A Captive Insurance Company Give Business Owners MORE Insurance Protection, MORE Risk Management Flexibility and MORE Money?
When assessing all of the treats or risks facing their enterprise, business owners, CFOs, risk managers and risk advisors fundamentally choose which risks to retain and which risks to transfer. Risk is typically transferred to commercial insurers as the diagram below illustrates.
Owning one or more captive insurance companies gives businesses more flexibility in managing risk. Consider the illustration below. The business has more choices about how to transfer risk. Also, the captive insurance company enables the business to transfer more risk and enjoy greater insurance protection. Also, the captive is able to both retain and transfer a portion of the risk it bears via re-insurance or a risk distribution pool. As the captive builds up reserves over time, the business can rely on it more heavily. Over time, businesses can transfer risk from commercial insurance to their captive, reducing premiums paid to an unrelated third party.
As can be seen, the ability to transfer more risk, gain flexibility and benefit from advantageous tax treatment makes captive ownership a compelling proposition for small and mid-market businesses. For these reasons, captives can play a critical role in making businesses more survivable.