The far-reaching benefits of establishing captive insurance companies
A captive insurance company (captive) is a sophisticated risk management tool that can play an important role in helping protect your business, reducing your tax liability, and succession planning.
What Is a Captive Insurance Company?
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What Is a Captive Insurance Company?
Essentially, any risk underwritten by a commercial insurer can be covered by a captive. Captives are private insurance companies established to meet the risk-management needs of a corporation or group of companies. A captive is a formalized form of self-insurance where the insured maintains the business deductions and risk transfer benefits of a traditional insurance premium payment. Just like a commercial carrier, captives are subject to state regulatory requirements including reporting, capital and reserve requirements.
Captive owners benefit from underwriting profits as well as favorable tax treatments afforded insurance companies. Captive owners are often the parent companies, key individuals or even trusts benefiting owners’ children. An owner can use a captive to cover a wide range of risks. A captive is not limited to insuring one business – an owner can use it to insure customers and suppliers, or a group of companies.
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Who Uses a Captive Insurance Company?
Both middle market companies and large corporations can use a captive insurance company (captive) to potentially reduce costs, generate profits or take advantage of varying tax laws. Business owners often use captives to create a secondary business that serves the needs of their primary business.
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Why Establish a Captive Insurance Company?
Captive insurance companies can provide sound risk management tools for many businesses and, with careful planning, a number of additional benefits for your closely held businesses.
Get coverage you need and tax benefits
Insurance coverage that is unavailable or too costly in the commercial market can be provided by a captive. This means that previously self-insured, under-insured and uninsured risks are converted into tax-deductible premiums paid to your captive. A captive also reports profits differently from other companies, which can provide a significant tax advantage, too.
Potentially lower costs and capture underwriting profits for your business
A large portion of commercial insurance premiums go to cover litigation, overhead costs and profits. Using a captive enables you to reduce or eliminate those portions of the premium and potentially benefit from underwriting profits yourself.
Stabilize insurance costs
Captive insurance may stabilize your risk management costs. Market factors beyond your control often lead to volatile insurance pricing. When you insure through a captive, premiums are determined by your company’s own loss experience rather than the experiences of a peer group.
Help protect assets and plan for the future
Assets in a captive are difficult for creditors to reach. Since you determine the ownership of your captive, you determine who owns the potential assets that may accumulate over time. While some of these assets will be required to back the policies issued by the insurance company, a portion of those assets may be available to benefit the company. As assets of the captive insurance company grow, they can often be distributed to the owners as tax-advantaged dividends or capital gains.
Manage cash flow and create a new profit center
Your cash flow can be significantly improved by creating a flexible premium payment plan. You also retain premium and investment income. By underwriting the risks of others, such as customers or suppliers, your captive can create a new profit center and help you retain key clients.
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How do you manage and invest captive assets?
Managing and investing the assets of a captive is critical, yet often overlooked. The Wellspring team has been managing captive assets for decades, and investing captive assets is our expertise. Implementing a captive requires some heavy lifting, and it’s common for captive owners to suffer from “startup fatigue,” which can manifest in an ill-fitting investment strategy. We consider a well-structured investment portfolio to be integral to a captive’s long-term success.
Here are some of the most important considerations for captive investments:
Investment Policy Statement
A thoughtful investment policy statement (IPS) provides the foundation for captive asset management. A good IPS does the following:
Defines the primary objectives of preserving core capital and providing liquidity to meet current and ongoing claims
Outlines expected frequency and severity of outgoing cash flows (claims and expenses) to guide investment duration
States strategic asset allocations, diversification requirements and credit requirements consistent with the underwriting risk of the insurance policies
Provides a timeline for periodic review of actuarial changes and portfolio risk and performance
Regulated Entity
Captives are regulated insurance companies required to maintain adequate liquidity to cover claims. Investments are also subject to tax scrutiny by the IRS. Investments need to be consistent with the investment strategies and portfolios of traditional commercial insurance companies.
Liability Matching
Insurance companies have a stream of known liabilities (expenses) and potential liabilities (claims). Understanding the timing and potential severity of those liabilities provides a framework to match your captive’s assets to those liabilities. Creating this asset/liability glide path is at the core of managing insurance company investments and is fundamental to sound captive asset management.
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Are You a Good Candidate?
We work with some of the best captive insurance service providers in the country, and we can work with you to find out if you’re a good candidate. Wellspring Financial Solutions does not design the legal or underwriting framework for a captive, nor do we provide accounting or actuarial work. We help captives manage their assets. If you are a business owner and are curious to find out if a captive is right for you, we’ll connect you with the right people who can help you explore how a captive may benefit you.
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Case Study: How a captive insurance company can change your future
Situation
Company: DMC Distribution is a 25-year-old automotive parts and electronics distributor.
Ownership: Peter Frost 100%
Employees: 500
Annual Sales: Approximately $30mm
Business Valuation: $15mm
Event: In 2011, an earthquake and tsunami in Japan disrupted DMC’s supply chain causing a 30% reduction in annual revenues, and DMC had a net loss for the first time in history. When DMC evaluated adding supply chain, as well as other enterprise risk coverages to their commercial insurance program, the cost seemed prohibitive given the low likelihood of an event. The use it or lose it approach of traditional insurance wasn’t an effective solution.
In 2012, with Peter in his mid-50s and his son, John, joining the company, Peter realized that his ability to pass this company on to his children was going to trigger significant estate taxes.
Primary goal:
- To provide a tax-efficient funding mechanism to stabilize the revenues of DMC in unlikely but high cost events.
- The solution could not be use it or lose it. The funds had to remain available for an event but could not be lost without a claim.
- Minimize the tax liability when DMC passes between the generations.
Potential Solution
Peter could potentially accomplish all of his goals by establishing a captive insurance company called DMC Risk Management. This new insurance company would be owned by his two children, John and Susan. DMC Risk provides enterprise insurance policies for DMC Distribution including supply chain, cyber risk, directors and officers, etc.
DMC Distribution would make annual tax-deductible premium payments to DMC Risk of approximately $1 million and will file claims as necessary if the business experiences losses. Because of the structure, DMC Risk isn’t required to recognize the premium payments as taxable income. DMC Risk will pay operating expenses and claims (if any) as they are presented from DMC Distribution. The surplus after DMC Risk pays claims and expenses are invested and are continuing to compound in DMC Risk and are owned by John and Karen.
This case study is for illustrative purposes only. Individual cases will vary. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Prior to making any investment decision, you should consult with your financial advisor about your individual situation.