Captive Insurance Companies (CICs) are insurance companies established by businesses or owners of businesses with the specific objective of insuring risks of those businesses. CICs were first established in the 1950s and have since been an integral part of the risk management portfolios of many large companies. Over 90% of Fortune 1000 companies have one or more CIC, and over half of all property and casualty premiums are written through captives.
CICs are generally more effective in managing self-insured or uninsured risks for which commercial insurance coverage is either not readily available or is cost prohibitive. They are a very effective tool to optimize and augment existing commercial policies, like insuring the deductible layers, covering exclusions, or writing excess coverage.
In addition to being a powerful risk management tool, CICs offer strategic, financial, and possible tax benefits. They also encourage a focus on a business’s risk management program by identifying currently uninsured or under-insured risks and establishing safety initiatives and best practices. As a result, reduced claims can translate directly into realized profits for the CIC.
In order to encourage private middle-market businesses to form captives, in 1986, Congress adopted Section 831(b) of the Internal Revenue Code. People often refer to 831(b) captives as small captives. Small captives are easier and less expensive to form and operate than their large counterparts, but in turn carry more restrictions in terms of scope and flexibility. In addition, small captives carry potential tax incentives, transforming them not only into a flexible and potent risk management tool, but also into a useful wealth management, asset protection and estate planning instrument.
Unlike large captives which traditionally focus on higher frequency, lower exposure risks like automotive or health care coverages, or even operate as profit centers with products like extended warranty coverages, small captives generally focus on low frequency enterprise and catastrophic risks like business interruption caused by problems with key suppliers, customers or employees or regulatory and technology risks as well as certain professional liabilities and selected catastrophic risks.
IRC Section 831(b) provides a special federal income tax exemption benefit for underwriting premium revenue of up to $1,200,000. At the same time the full qualified underwriting premium is a deductible operating expense for the parent company, effectively reducing its taxable income by the full premium amount.
The Internal Revenue Service requires levels of risk distribution and risk transfer for the CIC to be considered a legitimate insurance company. Based on several revenue rulings, a CIC should have over half of its annual premium income exposed to third party risk (risk transfer) and have at least 12 independent insureds (risk distribution). Since for tax purposes disregarded entities do not qualify as independent insureds, this requirement is difficult to meet for most small to middle market businesses. A solution to this problem is for the CIC to enter into reinsurance and retrocession agreements with a reinsurance facility, which exposes each participant to true and sufficient third party risk.