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A Look Into the Potential Benefits of Small Captive to Private Companies

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Today, small captives have become a popular option for many smaller companies due to the assortment of financial benefits they offer to their risk management strategies. Besides providing tax benefits through deductibles, small captives help reduce the cost of insurance premiums and provide adequate coverage where commercial insurance is prohibitively priced or unavailable.

Origin and changes

Captive insurance – which hedged against uninsurable risks – were once the sole domain of large corporations. Small captives were first legalized as part of the 1986 tax overhaul, which opened the door for smaller companies to have captive insurance companies of their own.

In the ensuing years, they became popular with medium-sized enterprises and sophisticated family-run enterprises as a tax-advantaged option. Changes made in the wake of Notice 2016-66, however, have altered the rules surrounding how companies can define and organize their small captive insurance subsidiaries.

Today, compliance with new 831b regulations demands the owners of small captives to divulge transaction details if their loss ratios are below 70% or if they have recently provided a loan to their parent companies.

The higher risk distributions that captive insurers now must take can be a challenge to many smaller captive insurance companies, which may not always have the same risk tolerance profile that commercial insurers have. More significant risks can leave many less robust captive insurers bankrupt.

Planning and assessment

Once a feasibility study has ruled in favor of a captive insurer, company leadership must carefully consider the types of risk that their captive insurance should cover. Risks too expensive to underwrite through commercial insurers, for instance, may be nominally be covered by captive insurance.

Care must be taken to confirm that the risks covered count as insurable. Working with a commercial insurer may also yield additional benefits for companies with captive insurance. Often, insurance companies are more than happy to defer these to captive insurance while getting premiums from more substantial risks.

These minor yet frequent “nuisance claims” could quickly make up the bulk of risks taken by the captive insurance company. At a specific size, there are plenty of tax advantages to insurance companies

Due diligence

The parent companies of captive insurers must not forget that their subsidiaries are still insurance companies. Captive insurers must perform the typical regulatory compliance functions as their commercial counterparts, including annual actuarial reviews, financial statement audits and tax compliance oversight.

Because the tasks at hand are often outside the purview of a parent company’s core management, captive insurers must have their own dedicated team of experienced actuarial and accounting management.

Besides saving on the number of premiums paid to manage substantial risks, companies can also benefit from the tax advantages offered by writing off captive insurance premiums as expenditures. Small captives often have an additional benefit in that only their investment profits are counted as taxable.

Establishing a subsidiary insurer is a complex undertaking, involving careful management of an independent subsidiary and regulatory compliance with the IRS. Despite the complications involved, however, the benefits companies stand to gain is often enough to justify considering captive insurance as an option in their greater risk management strategy.

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