A Captive Insurance Company (captive or CIC) is a property and casualty insurance company established to provide coverage primarily for a Parent Operating Company. Captives are an effective risk management strategy to insure against risk for which commercial insurance is not available or maybe too expensive.
Examples of exposures often incorporated in captive insurance arrangements include enterprise risks such as business interruption resulting in loss of income due to: breach/release of data, deductible reimbursement, loss of licensure, legislative and regulatory changes, loss of franchise, reputational risk, supplier/supply chain interruption, etc.
Many operating companies face losses from these low frequency/high liability risks, which can be better managed through coverage from a captive insurance company rather than self-insuring. A policy issued by the captive insurance company will have the features and coverage drafted to meet the specific risks unique to your business.
Captive insurance companies are not new. In fact, most Fortune 500 companies have their own captives, organized and regulated in various domestic and international domiciles. Today, the majority of domestic domiciles offer specialized statutes for captive planning, which thousands of small to mid-size companies have utilized to more effectively manage to cooperate risks. Congress passed laws dating back to 2001 and the Internal Revenue Service has issued guidelines for captive insurance companies dating back to 2002.
The captive insurance company must be properly organized, operate for bonafide business purpose and demonstrate both risk shifting and risk distribution in order for the arrangement to meet the requirements to qualify as insurance in the commonly accepted sense. Adherence to all known guidance is essential in order for this risk management tool to commence business with predictable results and maintain Federal, State, and insurance regulatory compliance.
Risk management process generally begins with a review of the clients existing commercial property and casualty policies and the identification of all exposures, perils and hazards existing in the organization. An in-house or independent risk manager and the insurance broker play important roles in the identification of potential causes of loss. They should consider all aspects of the organization’s operations, in addition to the business and regulatory environment within which they work. If a captive insurance risk identification process will be utilized in the preparation of the captive’s underwriting, feasibility study, and business plan.
There are many different types of captive insurance arrangements in the marketplace today. Through our strategic partners, we can offer a variety of captive insurance solutions, in coordination with numerous respected domestic domiciles. Small to mid-size companies often elect to have their captive insurance company taxed according to IRS Section 831(b). This code section states that captive insurance companies are taxed only on their investment income, and do not pay income taxes on the premiums they collect, provided premiums to the captive do not exceed $2.4M per year per captive. This important provision aids the captive in the ability to quickly build up insurance company profits (called surplus) year to year increasing the capacity to pay claims.
Over the years, as the captive generates profit, after adjustment for expenses and claims, those dollars belong to the captive, not a third party insurance company. The profit and surplus may be invested a reasonable manner, often accumulation excess reserves over time. Subject to regulatory approval, distributions to the owner(s) of the captive insurance company, distributions may qualify as long-term capital gains.
It is important for the captive to maintain appropriate liquid reserves in order to pay expenses and meet potential claims liabilities. Therefore, captive insurance companies need to have a well- designed, disciplined investment policy statement in order to maintain sufficient liquidity and long-term growth objectives as a regulated entity.