Captive insurance: Turning an expense into an asset

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Nobody likes paying costly insurance premiums. Now there’s an alternative.

by JOHN MEDWIN

Hotel owners are discovering that they can not only form their own insurance company with little effort but manage their expenses better and even turn them into an income stream.

So just what is a captive insurance company?
A captive insurance company (captive) is a licensed insurance company that is formed by a business or group of businesses for the purpose of providing insurance products for the business or businesses that formed the captive. The captive is a corporation that is formed and licensed under the corporate and insurance laws of the state in which it is domiciled and as such, must abide by the corporate and insurance laws of its domicile.

The captive’s primary purpose is to allow the operating business to take control of its risk management by transferring the risk to an insurance company controlled by the business. Risks inherent to the hotel industry may not be available or affordable, but could be effectively self-insured. Every insurance policy has a page called “exclusions.” Exclusions are the gaps left in your policy. Captive insurance allow a company to not only have better coverage, but it rewards the owners for the years when claims are low.

Captives are a form of self-insurance whereby the insurance company is wholly owned by the insured or insureds. Formed to cover a wide range of risks, the captive operates like any commercial insurer and is subject to strict state regulatory requirements, which include reporting and capital and reserve requirements. Although captives have existed for over 100 years, there has been significant growth in many “captive-friendly” states and countries. Today there are more than 6,000 captives globally as many Fortune 500 companies see them as a tool for reducing their cost of insurance and the ability to divert these savings to their bottom line.

The captive insurance concept
Captive insurance was created to be a primary tool for managing the inherent risks of operating a business, and at the same time, the captive provides other benefits to the controlling business beyond the purchase of commercial insurance.

Forming a captive, the operating business is allowed to take control of their risk management by enabling it to insure for risks which coverage may not be readily available or may too expensive in the standard commercial market. Captive insurance can typically be less expensive than standard commercial insurance because it can be specifically tailored to meet the needs of the operating business it serves.

An additional benefit is that since the captive and the operating business normally share the same ownership, the captive can become a profit center, instead of an annual drain on company resources. In most cases, the captive will also deliver favorable tax advantages for wealth transfer and preservation.

Using the captive insurance company model has become a proven strategy for managing risk that large corporations have taken advantage of for years. Because of recent changes in legislation, many small and mid-sized businesses have also realized the benefits of forming a captive.

Tax considerations
For businesses, insurance premiums are typically considered deductible under section 162(a) as normal business expenses and as such, it’s very important that the payments from the operating business to the captive are considered insurance premiums.

Although premiums remitted to an insurer are considered taxable income of the insurer, reserves to protect against future claims are deferred and only income in excess of the reserves is immediately taxable. If the insurer’s premiums do not exceed $1.2 million, section 831(b) of the code allows for the insurer electing to be taxed under 831(b) to be taxed on investment income only. Legislation just passed increasing the 831(b) limit to $2.2 million beginning in 2017.

The structure of the captive’s ownership also allows for other planning opportunities. If the captive’s shareholders are family members of the parent (operating) company or trusts with family member beneficiaries, the income of the captive would inure to the family members’ benefit. Since this is considered a transaction in the regular course of business, there would be no gift or estate tax on the transfer of wealth.

Captive insurance history
Originally, captive insurance companies were created by large associations. For example, New England textile manufacturers formed captives to address the issue of extremely high fire insurance premiums as far back as the 1800s.

The captives, as we know them now, have evolved into companies very similar to standard commercial insurers, but initiated to target specific industries and the unusual risks they present. From the 1960s up to today, countries such as Bermuda, the British Virgin Islands and the Cayman Islands created regulatory environments that are most friendly to the captive operating model by reducing capitalization requirements and offering civil servants with a wealth of knowledge and experience with captive insurance company administration and regulatory issues.

In response to the growth offshore, a number of U.S. jurisdictions have entered the captive insurance market with the intentions of capturing some of this business. The state of Vermont was the first to enact captive insurance legislation and as a result has become the largest domestic domicile when it comes to number of captives and premiums written. As a result of the Internal Revenue Service creating three safe harbor provisions for captives within the country, over 30 states have enacted captive insurance legislation. The final result is that there are over 6,000 captives currently operating and account for over $9 billion in premium.

How to determine if a captive is a good fit
It always starts with a phone call. Find an agent who is familiar with captives who will determine if you qualify by a fact-finding phone call. If it appears favorable, then an extensive third party feasibility study will determine whether it makes sense to move forward. Optional risk-management measures can also be realized as a result of this in-depth study that will include, but is not limited to, strategic objectives, risk retention analysis, overview of existing insurance, claims analysis of proposed lines of business, domicile review, capital requirements, and accounting and tax considerations.

Once the client decides that a captive is a viable solution to its insurance needs, the parent company’s team works with the client to establish the captive, and they do all the heavy lifting. The client needs to select a domicile, and your captive team will file the incorporation documentation with the appropriate authority in the domicile. Your team of experts will also prepare and file the application for an insurance license and will work with the insurance department of the captive’s domicile to get the license issued.

Don’t forget to floss!
The question I get asked most frequently is, “In which industries does it make sense for a business owner to own their own insurance company?” When I hear this question I’m reminded of a childhood experience at the dentist’s office. I remember asking, “Which teeth should I floss?” The dentist’s answer was simple and to the point, “Only the ones you want to keep.”

We have found that the hotel industry is a perfect fit for captives. If you are tired of flushing your premiums down the toilet each year, perhaps it’s time to take the step so many Fortune 500 companies have been doing for years. It never hurts to examine your options.           ■

John Medwin is a consultant at RMC, an international provider of risk management and actuarial consulting services. RMC specializes in the design and administration of innovative risk management and insurance products for the small-to-medium sized business. RMC does all the heavy lifting of forming a captive so the client can do what they do best. John can be reached at medwining@gmail.com.

Benefits of captive insurance

The benefits of forming a captive insurance company are numerous making the formation process well worth the capital and time required.

Broader coverage
Establishing a captive allows the operating business to take control of its risk management by allowing it to insure risks for which coverage may not be available in the commercial market or may be prohibitively expensive. Captive insurance is often less expensive than commercial insurance, because it can be tailored to the needs of the operating business.

Stability in pricing and availability
Many hotels can find not only more comprehensive insurance available, but usually at lower and more stable rates. Ironically enough, many owners will discover they will want to pay more for their coverage because of the tax advantages and income potential.

Improved cash flow
Cash flow improvements are achieved in a number of ways. Losses retained through a captive reduce or eliminate underwriting profits; reduced losses increase them. Captive insurance inherently offers financial rewards for effectively controlling losses and offers the opportunity to accumulate wealth in a tax-favored vehicle.

Estate planning and asset protection
A captive can offer the same estate planning and asset protection opportunities as any business. If the owners of the captive are the children of the owner of the operating business, then assets can pass from one generation to the next, often without gift tax considerations.

Tax advantages
There is also the opportunity for distributions for captive owners at much more favorable income tax rates. There are various other tax savings opportunities, including gift and estate tax savings for the captive owners.

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