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Captive Insurance – Insurable Risks

Posted by admin On May - 2 - 2012

A captive insurance company (CIC) is an insurance company that insures the risks of operating business entities within the same “economic family”.

1. A CIC benefits its owner(s) generally through a combination of factors.

1.1 Policy premiums paid to the CIC stay in the economic family. Even if insurance policies are absolutely identical to a business’s previous
insurance policies, profits that would otherwise go to an outside insurance company remain instead in the CIC. Roughly 35–50% of premiums paid for conventional “retail” insurance go to overhead, administration and profit. A CIC keeps a large portion of those costs inside the economic family.

1.2 A CIC has access to reinsurers and, therefore, to “wholesale” insurance rates and can negotiate directly with a reinsurer for favorable rates.

1.3 A CIC customizes insurance policies directly to the needs and preferences of a business to improve insurance coverage and/or decrease premium costs.

1.4 A CIC customizes policies to insure risks that are otherwise uninsurable ortoo expensive to insure using conventional insurance.

1.5 A CIC is particularly well-suited for insuring “business loss” risks; for example, loss of business revenue resulting from loss of key employee or customer, change in governmental regulation, loss of operating license, etc. (see Section 5, below).

1.6 As with any conventional insurance premium, premiums paid from a business to the CIC are tax deductible expenses under IRC § 162(a).

1.7 A CIC that elects treatment under IRC § 831(b) is exempt from income taxation of premiums received up to $1.2 million annually. There is a public policy rationale for this favorable tax treatment. By including this provision in the tax code, the US Congress intended to increase competition among insurers and increase the range of choice for insurance consumers.

1.8 An 831(b) CIC is taxed only on its investment income. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.

1.9 CIC reserves and surplus are not exposed to general creditors of the operating business. Reserves are available for paying insurance claims
only. CIC surplus is not subject to claims and can be invested to maximize return.

1.10 When owned by one or more asset protection trusts, a CIC is a valuable part of an integrated asset protection, wealth accumulation and generational wealth transfer structure.

2. A well-designed CIC managed by a “turnkey” service provider can be operated and properly reinsured for less than 15% of annual premium payments. For example, if premiums of $1 million were paid to the turnkey CIC, total management costs including the cost of reinsurance could be less than $150K, potentially resulting in a profit of $850K at the end of the year if there were minimal non-reinsured claims.

Generally, a CIC makes good economic sense when the CIC receives about $250K or more in premium payments annually. The insurance licensing agency in the jurisdiction of formation requires initial capitalization of a CIC, typically about 20 percent of the first year’s premiums.

Generally, formation of a CIC is less expensive in one of the traditional foreign jurisdictions than in one of the states in the US. In any case, an 831(b) CIC usually elects to be taxed as a domestic company under IRC § 953(d), its operating account is located in the US, and its investment account (holding the bulk of its assets) can also be located in the US and controlled by its owner(s).

Unrelated owners of businesses (i.e., owners from different “economic families”) can form a multi-owner CIC, a so-called “group captive”. For example, four unrelated owners of businesses having similar types of risk could form a group captive that insures some or all of their operating business entities.

3. To qualify as insurance, an insurance policy must shift a genuine risk from the insured to the insurer. A rule of thumb used by actuaries is that there should generally be a 10% chance of a 10% loss of the policy limit. In any case, a good CIC manager employs underwriting and actuarial skills to provide sound insurance coverage, satisfy statutory and IRS requirements, and maximize profits for a given set of circumstances.

To avoid scrutiny by the IRS concerning the appropriateness of deducting insurance premiums under § 162, total annual premiums paid by a business entity to an 831(b) CIC should not exceed 10% of the business’s gross revenue.

For example, if a business has annual gross revenues of $3 million, insurance premium payments should not exceed $300,000.

For discussion purposes, risks can generally be characterized as follows.

3.1 Low-frequency/low cost (severity) risks. It might make sense for a CIC to pay claims directly out of reserves, rather than incur the expense of reinsuring the risks. The CIC can still write a policy covering the risk, however.

3.2 High-frequency/low cost risks. Conventional insurance for such risk can be expensive. It might make sense for a CIC to write a high-deductible policy to cover claims over a certain accumulated amount.

3.3 Low frequency/high cost risks. A CIC is well suited to insure this type of risk. An operating business might be paying high insurance premiums for high severity events that rarely if ever occur. Also, operating businesses are commonly completely exposed to such high severity events but do not insure them simply because they occur so rarely. A sensible approach for a CIC is to write a policy for stop-loss insurance, that is, reinsure risk only above a high stoploss amount.

4. Business Liability Policies. Liability policies cover claims made against the operating business by third-party claimants.
Direct policies directly pay claimants and pay legal fees and expenses. They could create an asset for plaintiffs to pursue and, therefore, are not preferred for a CIC.

Indemnification policies indemnify, or reimburse, the business for third-party claims that the business pays. The business decides whether it will pay third party claims. In other words, an indemnification policy could cover the risk for the business without offering an asset for plaintiffs to pursue.

Litigation expense policies pay only legal defense fees and expenses. These are good policies for a CIC because they do not create any rights in favor of third party claimants.

Business liability risks commonly exist in the following exemplary areas:

  • Vehicle use
  • Construction and design defects
  • Performance liability
  • Structural defects
  • Title insurance
  • Environmental impacts
  • Product liability
  • Professional malpractice
  • Advertising liability
  • Antitrust
  • Unfair trade practices (e.g., Lanham Act violations)
  • Director and officer liability
  • Errors and omissions
  • Sarbanes-Oxley violations
  • Employee relations (e.g., discrimination, sexual harassment)
  • Failure to investigate/control employees and agents
  • Libel and slander

5. Business Casualty Policies. A good type of policy for a CIC to issue is a business casualty (i.e., business loss) policy because only the business can assert a claim and no third-party claimant is involved. Most businesses consciously or unconsciously self-insure many potential business casualty risks.

Business casualty risks commonly exist in the following exemplary areas:

  • Unforeseen administrative action of a governmental body
  • Changes in state or federal law
  • Judicial or administrative delays
  • Extortion (even if not provable legally)
  • Market volatility
  • Inability of key individual to work
  • Loss of professional or business license
  • Loss of key client or investor
  • Business credit (e.g., credit loss, delayed or withheld loans)
  • Labor cost or strike
  • Property damage
  • Unfair calling of guarantees
  • Litigation costs
  • Tax audit defense
  • Business interruption (e.g., due to computer, supply chain, weather)
  • Lawsuit interruption (i.e., interruption by lawsuit into business operations)
  • Consequential damages
  • Contract frustration
  • Advertising and marketing failure
  • Business reputation
  • Commercial crimes (e.g., theft of trade secret)
  • Currency risks

6. Bonds. CICs are also suitable in some circumstances to underwrite surety, performance and other types of bonds.

Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Copyright 2012 Thomas Swenson

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