What is a captive?

A "captive insurance company" (captive) is an insurance company that issues coverage for specific risks to a business for which coverage from commercial insurance carriers may be unavailable or unaffordable. Instead of paying premiums to a commercial insurance carrier, premiums are paid to a captive. Any money that is not utilized or paid in claims stays in reserves, is investable, and may become profit in the captive.

A captive is a smart risk management insurance structure that, when executed in compliance with state insurance regulations and IRS guidelines, may provide more cost effective business risk coverage while simultaneously building equity.

Are captives new?

No. Captive insurance strategies have been around for over 50 years. Allstate Insurance was a captive insurance company of Sears before Allstate was sold in 1995. For many years, large corporations, such as ExxonMobile, ADM, Verizon and AT&T, have utilized captives as alternative risk transfer strategies to reduce insurance costs, improve risk management, and save taxes.

Where does the term "captive" come from?

Captives were first organized in the 1950s, when Youngstown Sheet & Tube Company formed its own insurance subsidiaries, with the intention of providing insurance exclusively for their corporate-owned mines. Soon they were referred to as captive insurance companies, because of the direct connection and exclusivity between the company and what it insures. The term today is used to describe instances where the policyholder owns the insurance company; i. e., the insurer is captive to the policyholder.

What risks can a captive cover?

In general, a captive is structured to cover first party risk; that is, losses that the insured may suffer related to the operation of the business. As part of a comprehensive risk management program, creating a captive can allow the business owner to supplement or extend the existing commercial policies by covering the gaps, limitations, retentions and exclusions of the existing business policies, and to customize coverage to meet its unique needs.

Are captives recognized by the IRS?

Captives are recognized by the Internal Revenue Service, starting with the landmark opinion United Parcel Service v. Commissioner, 254 F.3rd 1010 (11th Cir. 2001). Although captives have been in use for the past 50 years, the IRS has provided specific guidance, starting in 2002, to explain how a captive insurance company (captive) must be structured to satisfy the risk transfer and risk distribution requirements necessary for the insurance premium paid to the captive by the business it insures to be deductible.

Furthermore, IRC Section 831(b) provides for an election to exclude from taxable income premiums paid to the captive, up to $2.2 million annually.

The potentially tax-deductible premiums from the business can accumulate as cash, or cash equivalents, in your captive insurance company. Annual accumulation of premium reserves typically does not result in the recognition of any income; rather, profits accumulate over time, and your captive is taxed only on income derived from investing its reserves—ultimately accumulating wealth for the owners on a tax-favored basis.

Equity in the captive is available for distribution to the owner as dividends, subject to reserve requirements, or upon liquidation, as capital gains. Subject to certain restrictions, distributions occur at the owners’ discretion.