In today’s marketplace, increasing insurance costs and inadequate insurance coverage are major issues facing many businesses. To address these issues, many closely-held and family-owned businesses have implemented captive insurance programs, allowing those businesses to have additional insurance protection by filling in the gaps in their current insurance portfolios.

What is a Captive Insurance Company?

Three hundred years ago, if someone had said they had a captive in the Caribbean, he most certainly would have been a pirate. But today, captives are held by the vast majority of Fortune 500 companies, as well as an increasing number of middle-market firms as an alternative risk financing vehicle. In its simplest form, a captive insurance company is an insurance company formed by a business owner to insure the various risks of the business owner’s operating business. Like any commercial insurance company, captive insurance companies issue policies, collect premiums and pay claims. With the enactment of favorable tax regulations and definitive guidance from the IRS, closely-held and family-owned businesses are realizing the benefits of forming captive insurance companies.

Among the many advantages in forming a captive insurance company, captive insurance companies provide a unique opportunity for businesses to reduce their annual tax liability. Under Section 831(b) of the Internal Revenue Code, small insurance companies meeting certain requirements are given special tax benefits. A business owner is able to underwrite the risks of his business by forming a captive insurance company and causing his operating business to purchase insurance coverage with premiums of up to $1.2 million annually from the captive insurance company. This gives the operating business a deduction for the premiums paid to the captive insurance company, but the captive insurance company does not pay any corresponding income tax on the premium income received from the operating business because of its exempt status. The potential annual tax savings for the operating business are upwards of $500,000 annually.

In the early stages, your captive insurance company will not replace your existing commercial coverage, but rather your existing insurance coverage will remain in place to cover any catastrophic losses.  The captive will be used to cover deductibles on your commercial policies and risks that are not being covered that can be properly managed.

A pictorial of the basic captive insurance structure looks like this:

The captive insurance industry as seen exponential growth over the last 20 years as sophisticated taxpayers have realized the risk management, insurance savings, wealth transfer, and tax advantages of captive insurance companies. Today, nearly all major corporations utilize captives and take advantage of the numerous benefits they provide.

How Can a Captive Help?

Captive insurance companies can potentially benefit taxpayers in a number of ways, some of which are highlighted as follows:

Insurance Savings: The first benefit of a captive insurance company is the potential for insurance savings. If the captive insurance company’s underwriting is successful, the business owner will gather the underwriting profits. Additionally, the business owner may be able to add certain unique insurance coverage that are otherwise unavailable or which are prohibitively expensive if purchased on the open markets. The business owner may also be able to use a captive as a tool to leverage insurance brokers into offering commercial coverage at lower rates.

Income Tax Savings: Captive insurance companies can also offer dramatic income tax savings because they allow the business owner to reserve for claims on a pre-tax basis. The use of a captive insurance company essentially creates a tax deduction to the operating business that would otherwise have been unavailable. Small captive insurance companies can accept up to $1.2 million per year in insurance premiums tax-exempt. If the risks that are insured never materialize, the captive insurance company makes a profit while the operating business keeps its deduction.

Wealth Transfer: Captive insurance companies also offer the potential for wealth transfer to successive generations without the payment of gift or estate taxes. This is because the payment of premiums is considered the purchase and sale of insurance, and not a gift. If the captive is owned outside of the business owner’s estate, then all underwriting profits from the captive’s insurance activities will be earned outside of the business owner’s estate as well. Moreover, the investment growth of the captive’s reserves and surplus will also be outside his estate.

What type of Coverage can be Written?

The following list is neither exclusive nor exhaustive and is a reflection of the versatility of a captive insurance company. By definition, a number of the categories listed below could fall into more than one class or be combined with other forms of insurance.

Property:  Fixed asset protection (buildings, equipment, plant, etc.), motor (own damage and third party), stocks, work-in-progress, all risks and contents, business interruption and consequential loss, natural catastrophes (including earthquake, typhoon, wind storm, tornado and flooding), and e-commerce (especially disruption of production and service following a virus).

Casualty: Employers’ liability, general liability, public liability, product liability, product recall, medical malpractice, environmental, and employee fidelity.

Other Liability: Employment practices (sexual harassment, labor laws, etc.), punitive damages, and disruption of supplies.

Hull and Marine: Marine hull and liability, aircraft hull and liability, and goods in transit.

Financial: Directors’ and officers’ liability, patent infringement, brand protection, credit default, miscellaneous financial losses, key man, political risks, financial risks, loss of key customers or contracts, pecuniary loss, and mortgage indemnity.

In conclusion, like most innovations, captives were created to solve a problem, and they continue to evolve and proliferate to address the growing need for alternative risk transfer in today’s ever changing economic financial markets. When properly employed, the use of a captive insurance structure can help business owners better manage insurance costs, control claims and accumulate surplus in anticipation of unforeseen risks. In addition, captive insurance companies can be used for wealth accumulation, estate planning and retirement planning.

The attorneys in the Captive Insurance Practice Group at Yedid & Zeitoune have a combined 15 years of legal experience and are ready to assist you with all your captive insurance needs.

Isaac Yedid, Esq. and Raymond Zeitoune, Esq.

Yedid & Zeitoune, PLLC

1172 Coney Island Avenue Brooklyn, New York 11230

Phone: (347) 461-9800 Fax: (718) 421-1695 Email: [email protected]

NYC Office – By Appointment Only:

152 Madison Avenue, Suite 1105 New York, New York 10016