For decades, captive insurance has proven its value to companies across numerous industries. In fact, captive insurance can serve as a key cost-control tool during what is becoming an economic era marked by an increasing number of mergers and acquisitions.
In the first article of this series on captive insurance, Captive Insurance: Understanding the Benefits & Available Options, we provided readers with an overview of captives and we asked the following question: Why have captives become an emerging insurance platform of choice?
In the second article for our series, we will explore three key questions:
- Is a captive insurance platform the right fit for your organization?
- What are the main strategies behind employing a captive insurance platform?
- What is the biggest misconception related to captive insurance?
As a reminder of the basic requirements for establishing a captive insurance platform, organizations examining captive options typically look at two key financial metrics to make a cost/benefit determination – annual business insurance premiums and overall annual facilitation cost for the captive. While there are some variances depending on industry, a good candidate for a captive insurance platform is a group or company that typically pays in the neighborhood of $300,000 in premiums per year for its current commercial coverage, and the organization should have better-than- average claims experience for their industry. In addition to premiums, the group or company utilizing a captive must be prepared to cover claims administration fees, actuary fees, captive manager fees, audit fees and premium taxes.
For organizations with consistent cash flows and a strong risk management program, captive platforms provide an opportunity to leverage premiums in a manner that is not available through traditional commercial insurance. By minimizing claims against the premiums paid, those entities utilizing captive insurance platforms can realize additional cash savings that can be accessed for future use or investment.
Captive Insurance: Gaining Strength as a Strategy to Build ‘Layers’ of Coverage
For those entities which meet the optimal financial parameters, captive insurance options offer an avenue to access improved rate structures and the ability to focus coverage on particular areas of risk. By establishing either primary or excess layers of insurance through a captive, organizations again are in a position to realize savings provided the claims experience is less than the amount of premiums paid. Some companies using captive structures may be required — in some cases due to regulation or contractual requirements — to use an arrangement called “fronting” to achieve a captive structure.
In a fronting arrangement, the captive insurance company utilizes the services of a commercial insurance company to serve as the fronting company. The commercial insurance carrier must be licensed in the same state in which the risk to be insured resides and actually issues the insurance policy. Meanwhile, the risk moves from the fronting company back to the captive through a reinsurance agreement. At the end of the day, the insured party will gain insurance coverage through a policy written under the authority of the commercial insurance company. But, due to the fronting arrangement, the insurance risk rests in the captive insurance company. These type arrangements will frequently require cash deposits or letters of credit be established to ensure the ability of the captive to pay claims.
One of the greatest advantages captive insurance platforms can provide any company can be found in the decision-making process related to pending litigation. The decision to move forward with litigation or reach a settlement in a lawsuit is much different within a captive construct than how it is viewed by a commercial insurance provider – which, more times than not, will seek to achieve a settlement in the effort to mitigate the claims cost. Meanwhile, the decision-making process for a captive insurance organization allows the owners and directors of the captive to make more strategic risk management judgments independent of the interests of commercial policy underwriters.
The savings potential and the flexibility offered through captive insurance platforms continue to gain greater acceptance throughout the business world. Today, captives are becoming commonplace among a wide range of companies across various industries.
Risk Management , Asset Protection & Wealth Transfer: Main Strategies Behind Employing A Captive Insurance Program
Establishing a captive insurance platform takes detailed planning and a commitment by the organization. A captive insurance start-up also takes cash on hand. Companies have to be able to initially capitalize the captive insurance program, and funding has to be present to continue to operate through the years. For example, consider the start-up funding needed to establish a captive in the state of Tennessee. A captive insurance program in Tennessee is generally going to require an initial capital commitment of $250,000. Additionally, it will likely take up to $80,000- plus to facilitate the setup with a feasibility study and the other information needs related to the legal work. This includes an initial actuarial study, which has to be performed in order to establish premium funding levels needed to pay claims and operate the captive.
The strategies that most often drive the formation of a captive are the ability to establish a highly effective risk management program, the opportunity to better control and protect the organization’s assets and the tax shelter provided for wealth transfer of profits realized by the captive. Of these three motivations for forming a captive, risk management rises above the rest. Without a focus on reducing potential claims to the lowest levels, organizations could see a reduction in available assets due to claims coverage. And, if the claims experience is equal to or greater than the premiums, the strategy of wealth transfer will become a moot point. Simply stated, the level of commitment paid to risk management will determine in large part the level of success for the captive entity.
Risk Management: Organizations with strong risk management structures understand that they are not just paying premiums to the captive. The premiums are an investment and their money is at stake. Increased losses translate into increased funding needed. Organizations operating captives quickly realize this brand of insurance is not the same as a monthly payment to a commercial provider – money that they will never see again. Like commercial insurance payments, captive premiums come out of the pockets of the organization, but the organization has the opportunity to still control that money through effective risk management.
Asset Protection: With the savings capability, organizations have a greater capacity to facilitate asset protection. Captives offer organizations a mechanism for insuring non-traditional risks. Cyber-security risk, major customer loss, earthquake and a builders warranty are examples of non-traditional risks, with circumstances that do not occur with a great amount of frequency. However, when they do occur, the results can be catastrophic. Due to the low likelihood of these types of claims, captive insurance coverage for these and other boutique risks create opportunities for organizations to retain more of their cash within the organization’s control.
Wealth Transfer: Profits from operating captive insurance companies offer a unique opportunity for wealth transfer, which can also be viewed as another form of asset protection. When the captive is owned by a trust, wealth transfer can take place when an exit strategy comes into play as the captive winds down. Current tax rules governing off-shore captives can provide an avenue for the surplus held in the captive to be transferred to beneficiaries outside the estate tax structure.
Tax Avoidance is NOT Tax Evasion: Dispelling the Biggest Misconception About Captives
Among the misconceptions related to captive insurance, the concept of tax avoidance is highly misunderstood. Because the history of captives is primarily aligned with offshore locations, the uninformed, along with some critics, will unfortunately view captives and the concept of tax avoidance as a business approach that is questionable.
While it’s true that anything associated with tax avoidance will invariably be seen as a tax shelter and an IRS audit risk, organizations which meet the financial criteria for establishing and operating a captive as part of their business plan should not be afraid to move forward. In 2002, the IRS released safe harbor rules that, if followed, ensure that captive arrangements will be recognized as valid insurance and that premiums paid to the captive owners will be tax deductible. Unquestionably, there is a well-establish body of tax law which exists that recognizes the validity of well-structured and well-administered captive insurance arrangements. Simply stated, captives provide a structured, legal way for organizations to keep more of your money. If it makes business sense and would work for your organization, why not take the first steps to explore establishing a captive insurance program?
Getting Your Captive Started: We Can Help!
Is your company or organization a candidate for establishing a captive insurance program? Elliott Davis Decosimo has assembled a strong team of experienced professionals who can help your company initiate a feasibility study and find the right team of professionals to walk you through every step of building a strong captive insurance program for your business.