– The parent company in a captive insurance arrangement is allowed to self-insure, withhold insurance premiums paid to the captive, control the investment of the premiums (consistent with regulatory requirements), and is eligible to get tax-free treatment with the liquidation of the captive.
– Captive insurance companies are allowed to deduct a portion of their reserves for unpaid claims – IRC 832(b)(5) and IRC 846.
– Captive insurance companies are generally allowed to reduce the recognition of collected but unearned premium income to 20% (example: 80% deferral on unearned premium reserves). – IRC 832(b)(4)(B)
– As losses are paid out over time, the insured would recognize a tax deduction (under a self-insured arrangement). But the insured would not generally be able to deduct a reserve for losses.

– Under IRC 831(b), insurance companies with less than $2.4 million in annual premium income can make an election to be taxed solely on investment income.
– Under IRC 501(c)(15), insurance companies with $600,000 or less in gross receipts may be eligible for tax exempt.
– Under IRC 953(d), a captive insurance company that is formed in a foreign jurisdiction can make an election and be taxed as a US corporation. Opting for taxation as a U.S. corporation avoids the federal excise taxes on insurance premiums paid to a foreign insurance corporation and may eradicate withholding tax burdens.

The term “insurance” is not defined by the Internal Revenue Code. Four factors are the focus of the courts:
1. Risk Shifting: The transfer of the impact of possible loss from the insured to the insurer.
2. Risk Distribution: The distribution of risk to a larger population to decrease the changes that a single loss event will affect all insured parties in the same way.
3. Insurance Risk: Normally implied within the first two factors. The insured must encounter some risks, or insurance cannot be present.
4. Insurance in the Commonly Held Sense: With emphasis on whether the insurance arrangement itself is legal, the captive should be organized and operated as an insurance company and certified as an insurance company (with its primary business as an insurance).

Captive insurance companies may be subject to state and/or federal excise taxes.
– Premium taxes owed by the captive insurance company or a licensed “fronting” company.
– Self-procurement taxes for insurance companies that autonomously procure insurance.
– Federal excise taxes if the insurance company is formed in a foreign jurisdiction.

– Insurance companies with $600,000 or less in gross receipts are free from federal income tax if insurance premiums at least 50% make up of those gross receipts.
– Due to the low threshold ($600,000), 501(c)(15) tax-exempt insurance companies are rare
– The threshold cannot be avoided by forming several related insurance companies ( given that threshold limit applies on an aggregate basis).

Forming a captive insurance company goes beyond being a vehicle for self-insurance. It is an accredited, regulated insurance company that is lawfully established in one’s home state or nation. It is a legal entity that complies with the rules and laws of one’s domicile (that is totally separate from the businesses owning it).

The standard requirements for capitalization and reserves, detailed actuarial requisites, periodic reviews, captive management, and other reporting obligations are needed when forming a captive insurance company.

There are different ways to set up a captive insurance company:

“Pure Captives”: Where only the owners are being insured.
“Single-Parent Captives”: Wherein there’s a single owner (i.e. a Fortune 500 company)
“Group Captives”: Where there are multiple owners (can be from a single industry so their special risk needs are being covered).
Captive insurers can be either formed in the US or in several jurisdictions worldwide (as every country has its own restrictions on capitalization and the required surplus amount to retain).

The option to form such exists when the parent company…

– Is unable to find an appropriate outside firm to cover them against specific business risks
– Finds better tax savings with the premiums paid to the captive insurer
– Finds the insurance as more affordable
– Discovers that the insurance can provide better coverage for business risks of the parent company.

In a mutual insurance company, policyholders are the owners but they don’t have control over the insurer.  Though they are given the right to assign deputy approving members of the board of directors, they cannot directly control the company. Insured companies lose their ownership once they stop making premium payments. On profitable years, mutual insurance companies have the authority to issue dividends. But most of them only use those profits to augment their funds. In a captive insurance company, the owners (who are also the policyholders) are the people that it insures who both have ownership and control of the company.

Despite the charm of the tax benefits associated with the smaller captives, company owners sometimes forget that the captive must operate as a real insurance company. This is where the role of an experienced and competent captive management company comes in. The following are needed when operating a captive insurance company:

– Annual actuarial reviews
– Annual financial statement audits
– Continuing tax compliance oversight
– Claims management
– Other regulatory compliance needs that are needed for the daily management of a captive insurance company that are outside the skills of the majority of the general business people

Similarly, the participation of the management company in the investment activities of the captive is necessary from a planning standpoint to guarantee that the captive’s liquidity needs are met.

Managing a business’ risks is the core reason for forming a captive insurance company. Getting profit from the company’s sound underwritings is an additional benefit because captive insurers generally allocate dividends to the owners.

To increase returns, the amount that would be spent on claims must be reduced. How?
– Having better business practices through ensuring safety procedures are in place
– Reviewing each claim (reasons and occurrences of the claims) to get a better understanding of how each claim should be handled moving forward
– Controlling expenditures

IRS Revenue Ruling 2002-89 and 2002-90 detail the rules on how captive insurance comprises insurance for federal income tax functions to make premiums deductible. Captive insurance is considered a real insurance (where premiums are deductible) based on the following safe harbors:

– 50% Third Party Insurance Safe Harbor: The captive insurance company is comprised premiums from at least 50% third-party insurers that are unrelated to the owners (to assure adequate risk distribution)
– Twelve Insureds Safe Harbor: The captive insurance company has not less than 12 insureds (each should have 5%-15% of the total risk). Again, this is to ensure that there is sufficient risk distribution.
Revenue Ruling 2002-89

In December 2002, the IRS published three Revenue Rulings which dealt with captive insurance companies. In Revenue Ruling 2002-89, the Service ruled on the issue of the deductibility of premiums paid by a parent to its wholly owned captive subsidiary. The Service addressed the issue using two fact patterns. In situation 1, 90% of the premiums received by the captive were received from the parent of the captive and 10% was received from unrelated third parties. In situation 2, the premiums received from the parent by the captive constituted less than 50% of the total premiums received and more than 50% was received from unrelated third parties. The Service ruled that the arrangement in situation 1 lacked the requisite shifting and risk distribution to constitute insurance for federal income tax purposes.

Hence, the premiums were not deductible. In situation 2, the Service relying on the holdings in Ocean Drilling and AMERCO, ruled that risk shifting and distribution were present, and therefore, the premiums paid were deductible. In addition to the captive receiving more than 50% its premiums from unrelated third parties, the ruling contained other important factors including the following:

– The premiums were established according to customary industry rating formulas,
– The parties conducted themselves consistently with the standards applicable to an insurance arrangement between unrelated parties,
– The parent did not provide any guarantees of the captive’s performance,
– All funds and business records were kept separately, the risks were homogeneous and the captive did not loan any funds to the parent.

Revenue Ruling 2002-90

In Revenue Ruling 2002-90, twelve geographically dispersed subsidiaries of a common parent company (each subsidiary operated in a separate state) insured their professional liability risks with a captive insurance company (also owned by the common parent). The IRS ruled that the payment of premiums by the 12 separate subsidiaries to the captive did result in risk shifting and that the transaction did constitute insurance for federal income tax purposes. The IRS relied upon the courts in Humana and Kidde in reaching its conclusions. Revenue Ruling 2002-90 provided confirmation that the IRS would respect an insurance arrangement between ‘brother-sister’ entities.

Transfer the use of the captive to a new business activity OR go through a normal dissolution process (of the C-Corp and unlicensing the reinsurance company). The captive can also be repurposed. The captive is a C corporation with an insurance license. The owners of the captive can choose to cancel the insurance license when it is no longer needed. The Captive becomes a regular C corporation that can be used for some other business purpose.

To build tax efficient reserves through insurable risks that exist in the business. Captives can provide business insurance coverages that are not commercially available or for which premiums are excessive.

TAXATION – LIQUIDATION: There is really only a short list of liquidation mechanisms being a reserve asset of a C-Corp (the captive itself); a qualified dividend to the owner/shareholder (which has better tax treatment then ordinary income); a promissory note-loan is not liquidation but possibly relevant in planning or use of capital; and Fortress can provide support on overall liquidation – or estate planning approaches.

• Contemplate a short-term impact (penalties and ordinary gain for tax purposes)
• Annuity or recurring payments back to the owner and how that manifests in terms of cash flow/tax impacts.
• Keep in mind that a Captive is a C corporation. Planning for the liquidation of a Captive is no different from planning for liquidation of other C corporations. The liquidation strategies can include (without limitation) charitable remainder trust, qualified opportunity zone, etc.

Insurance Manager requires 200K of reserve capital to be retained on the balance sheet of the captive itself as the minimum threshold; in the beginning years, the captive can choose to contribute 20% annually of premium as non-deductible equity to build to the 200K minimum in the early years versus posting 200K day 1 as non-deductible equity to capitalize the company.

• The Captive is a licensed insurance company. As such, it must have adequate capital and reserves for the risks it insures.
• Captives can insure only genuine business risks.
• Risks must be underwritten.
• Appropriate premiums must be established by qualified insurance actuaries per industry guidelines and professional judgment.
• Risks insured by the Captive cannot duplicate commercial insurance coverages.
• Risk sharing must occur with other businesses. This arrangement is sometimes referred to as the insurance “Pool.”
• Risk shifting must be present. Risk must be shifted away from the insured business to the Pool where it is shared by other insured businesses.
• A claims process must be established and followed. Claims cannot be handled on an “ad hoc” basis.
• Dividends must be reported in shareholders’ income (1099 issued from Captive).
• Loans must be evidenced by a promissory, bear an appropriate rate of interest and must be performing.
• The Captive files a tax return each year and pays its own tax on investment income.
• Risks, premiums and reserves of the Captive should be reviewed at least annually and whenever warranted by changes of the insured operating company.

General answer is broad marketable securities (stocks, bonds, etfs, etc.). Year 1 more liquidity is needed to be addressed to ensure potential claims; year 2 onward (after premium has been earned and is then on the balance sheet in reserves) there is a little more latitude for some less liquid assets, private equity, real estate, etc. Overall, it is an insurance company so the balance sheet should reflect the ability to pay claims but investment options are generally broad and flexible. Premiums are generally earned over a 12-month period and must remain liquid during that time. Earned premiums are booked at net income and become a part of retained earnings. It’s important to keep in mind that the Captive is an insurance company. As such, it must retain adequate liquidity to participate in the claims-sharing process of the Pool. The Captive may also need to pay a share of a claim of the insured operating company.

You are a good candidate for captive insurance if:

– Your company is paying high insurance premiums with low and consistent claim numbers.
– Your company has a steady cash flow.
– Your company has a manageable and predictable risk portfolio and you have good risk management practices and procedures.
– You need to consult with a Credo Advisor if:
– You think your company has poor risk management practices and procedures.
– You are experiencing any or all of the following:
– high loss ratios
– short-term outlook or price driven
– financially less strong
– highly volatile or catastrophic exposures without the support of stable lines
– too small to accept the risk of loss