In an ever-changing economic environment, businesses are looking for new and innovative ways to effectively manage capital and assets. Some companies are seeking alternatives to traditional insurance coverages through the use of a captive insurance company.
What is Captive Insurance?
Basically, a captive insurer is an insurance company that is completely controlled and owned by its insured. However simplistic as this may sound, the scope and administration of a captive are far more complex than it may seem at first glance.
Traditional insurance companies operate by assessing their clients’ propensity for risk in the areas of coverage and charging premiums to provide the coverage. Using insurance management software and insurance underwriting software, these companies use risk models with complex algorithms to gauge a client’s risk factors for premium and coverage determinations.
Captive insurers essentially create their own insurance companies by investing business capital into the formation of the captive in hopes of engaging in the risks as well as the rewards as opposed to paying traditional insurers to use their capital.
What are the Advantages of Captives?
Captive insurers exercise a greater degree of control over the use of capital funds to mitigate risk exposure over a large expanse of coverage areas. For instance, many companies are using captives for workers compensation, professional liability, credit risk and property coverage.
Companies with captives are often eligible for special tax considerations, although it should be noted that the tax laws in this area are complex and should be sought through the services of a tax consultant or other professional.
What are the Disadvantages of Captives?
The tax advantages should not be construed as the sole reason for structuring a captive. In fact, it should be an area of caution because the IRS, U.S. Treasury Department, and other government agencies have been watching the small captive insurance sector with greater intensity than ever before.
Another disadvantage is the required amount of capital set aside by the captive for risk management. The risk must not only be accounted for, it must have an equitable distribution, which can be difficult for smaller companies.
A U.S. Tax Court has ruled that four specific items must be addressed in order for captive insurance transactions to qualify under federal income tax guidelines:
- Risk shifting
- Risk distribution
- Insurance risk
- Compliance with commonly accepted concepts of insurance
Summing It All Up
While structuring a captive insurance agreement can be complex and expensive, it may be a viable solution to companies seeking to use their own capital to better manage and control the manner in which their insurance is administered and funded.