This is the first post in what will be a series discussing captive insurance companies, what they are, how they are used, how they are taxed and who should consider using them. To begin, I thought it would be good to explain them with a broad overview which I can build upon to give more details.
In case you’re wondering why I would be writing about the topic of captive insurance, let me start by telling you about my background. You can read the details in my About Me page, but the short story is I’ve worked with insurance companies for about 11 years. My firm performs audits of insurance companies, prepares their tax returns and provides accounting consulting related to financial and tax topics in the insurance industry. My experience is mostly in the tax field of the insurance industry, but you have to understand the financial parts of the industry before you can translate them into the tax parts of the industry.
So let’s start with the basics of insurance. We’ve all heard the phrase (or variations of it) “In this world nothing can be said to be certain, except for death and taxes.” This is usually attributed to Benjamin Franklin (hint: there are earlier variations of this phrase) but at the time this was probably true. In our current economy, I’d also add insurance to this list. We’re required to have automobile insurance and in some form or fashion, most people are required to have health insurance, homeowner’s insurance and/or renters insurance. If you’re a business owner, you have additional insurance requirements, such as liability insurance, which are more specialized and something most people aren’t familiar with.
There are many sources that businesses use to get the insurance they need. Most businesses use an insurance broker to help them find the best mix of value in terms of cost versus the risk being insured. This is where captive insurance companies can come into play. A captive insurance company is similar to any other insurance company, except that it is used to write insurance for its owner or affiliated companies.
The big picture is that a company or group of companies sets up an insurance company and then uses this insurance company to provide them insurance coverage for specific risks. Typically, these risks are customized to the company and provide the company with more control over what is being insured. Because the company owns the insurance company, any profit that comes from the insurance company stays within the family of companies.
A captive insurance company doesn’t work for every business, and some small businesses are simply too small to make this a cost-effective solution. However, for profitable small businesses that have high insurance costs, a captive insurance company can be used to help control your insurance costs while also providing a financial planning tool that keeps the profits close to home.
In a simplistic example, assume Company A sets up an insurance company, Company B. Company A pays premiums to Company B to provide insurance coverage to Company A. Company B uses the premiums to cover the risk that comes with providing the insurance. In the meantime, Company B takes the money and invests it, typically in safe investments like high rated bonds. If A has an insurance claim, B will liquidate enough of its investments to cover the insurance claim. However, if A doesn’t have an insurance claim, B keeps its investments and earns income on the investments. In a perfect world, the investments and their related income, will grow faster and larger than any insurance claims that A makes. Subject to regulatory requirements, B can make dividend distributions up to A or make loans for other uses of the money.
The growth of the investments that B makes is what makes a captive insurance company desirable in many situations. Financial planners have learned that this is a unique way to transfer wealth and avoid some inheritance related taxes.
Let me say right now that there are a lot more nuances and regulatory requirements than my simplistic example but it should give you a big picture idea of how these companies work. I plan on going into more details of the nuances and regulatory requirements in future posts. Plus, as an additional bonus, I’ll go into even more details about the tax specific treatments of the insurance companies.
If you have any specific questions, please use the contact me tab to get in touch with me.