Benefits of Forming a Captive
There are many reasons for starting a captive insurance company. These reasons tend to change in priority over time as the needs of the owners evolve. For the most part, companies form captives to benefit from internal risk financing. Today, cost and capacity are key drivers for the use of a captive.
Owners have started or continue to use a captive for:
- Premium Stability. Premium costs become stable and equitable for the captive’s owners over time because a captive can set its own insurance rates and customize coverage and policy language. That means the captive can establish premium rates that reflect its’ own expected losses.
- Cost Savings. Although captives will incur certain operating expenses they should be lower than the expenses incurred by commercial insurers. Reductions result from the elimination of the profit element built into premium charged by commercial insurers and reduction of expenses through the avoidance of high sales, marketing and administration costs of commercial insurers
- Exert Control. Captive premiums are not directly subject to variable and often unpredictable commercial insurance markets. In contrast to commercial markets, the captive and its insureds receive an immediate economic reward for controlling losses.
- Cash Flow. With underwriting stability along with the ability to reduce costs and manage claims along with the timing of premium payments to best suit the parent can provide significant cash flow benefits not available in the conventional market.
- Profit Center. Captives are often able to create a new profit center. For instance, the level of underwriting profit on premiums paid by related parties is generally set by captive owners. Moreover, many captives can earn investment income by investing the net premiums retained.
- Coverage Availability. A captive can expand the scope of insurance coverage for all of its insureds. Sometimes, it can offer better terms than commercial insurance carriers. Alternatively, a captive may provide coverage for risks that are commercially uninsurable, or even uneconomical.
- Improved Risk Management. Financial self-interest encourages the adoption of risk-management best practices at most companies. Captive owners and their affiliates make continual and diligent efforts to improve their own risk practices because they have a direct impact on the size of their captive premiums and overall profitability.
- Taxation. A properly structured captive insurance company achieves certain tax benefits including, but not limited to: (1) deductible premiums for the insureds; and (2) taxation as a property and casualty insurance company – and in the case of a 831(b) captive, exemption of taxation on underwriting income up to $1.2 million; and (3) the owners of the captive (often the insured or related parties) can receive favorable tax treatment on any dividends paid by the captive in the form of a capital gain.
- Access to Reinsurance. Captive insurance allows participants direct access to the reinsurance market. When the market is soft, the captive can take advantage of the low rates by reinsuring a relatively large proportion of its risks. The low cost of reinsurance allows the captive to build its reserve base. When the market hardens, the captive is able to retain a larger proportion of its risks, and can maintain cover for its parent even when commercial insurance is unavailable or prohibitively expensive.
- Favorable Regulations. The insurance industry is heavily regulated in all developed economies, with minimum capital and surplus requirements, solvency margins, specific ratios of premiums written to net assets (and requirements) and, in some cases, restrictions on investments. Captive insurance companies are generally subject to less regulation than conventional insurance companies, even more so for small (831(b) insurance companies.
- Asset Protection. A properly structured captive insurance company provides the shareholders or members (owners) significant protection from creditors (to the extent of their investment in the captive) since most captives are formed as either a corporation or a limited liability company. Furthermore, ownership information is kept in strict confidence by the insurance regulators and corporate registrars of the various domiciles that permit captives to be formed and operated in their jurisdiction. In addition, if the captive is formed and domiciled in a foreign jurisdiction, a creditor wishing to bring an action against the captive would have to use the foreign domiciles courts and laws in order to pursue their claim. Positioning the assets of the captive in a reputable institution within the foreign jurisdiction with which the captive is domiciled would force any creditor(s) to bring legal action in the domicile's courts using its law, creates a formidable if not insurmountable obstacle for even the most aggressive creditors.
- Estate Planning. A captive insurance company may be structured in such a way to provide substantial benefits to business owners with estate planning objectives. Before you formalize a plan for forming a captive, it may be worth the extra effort to discuss ways in which the captive can be incorporated into your estate planning objectives.
