Captive Insurance Companies: A Strategic Tool for Risk Management and Tax Efficiency

• Insurance costs are increasingly troublesome for small business owners
• Captive insurance companies offer tax benefits, greater risk-management control, and even financial planning upsides
• There are disadvantages, though, and captives may not be best for every entrepreneur

Small businesses are known to get creative. We like to try different methods, test new strategies, and act outside the box to solve problems. Breaking from traditional game plans can help grow the top line and keep costs in check. One sometimes overlooked solution to ‘Trad-Insurance’ is captive insurance. Like any plan worth its weight, it can cover everything from property damage and liability claims to cyber threats and supply chain disruptions. What’s more, you can tailor policies to your needs rather than accepting a blanket coverage set from a big carrier.

Captive insurance companies allow small business owners to more effectively manage risks, gain greater control over their entire insurance ensemble, and possibly unlock significant tax advantages. Let’s dig into this topic and help you decide if the captive insurance company route is right for you and your company.

What Is a Captive Insurance Company?

A captive insurance company is a wholly owned subsidiary created to insure the risks of its parent company or related entities. In short, it’s a form of self-insurance where the business protects against its own risks through a formal, regulated structure. Now, established small business owners know the usual runaround when procuring, purchasing, and managing company insurance policies—it takes up time, is expensive, and making claims can be a headache. And depending on the insurance type, you have to do it all again the following year.

But unlike traditional insurance, where premiums are paid to an outside underwriter, a captive allows you to retain underwriting profits, customize your coverage, and maybe reduce costs. Sounds perfect, right? Well, there are disadvantages, too, and we’ll note the risks later.

This self-insurance form could be right if your firm faces prohibitively high premiums, gaps in coverage, or unique risks that are simply hard to insure. Captives are popular with big companies—the NAIC notes that approximately 90% of Fortune 500 companies have captive subsidiaries. Nonprofits sometimes adopt them, as well. Moreover, captive insurance companies have been around for over a century, and small businesses are increasingly hopping onto the trend.^[1]

How Captive Insurance Works

I don’t claim captive insurance is the elixir to expensive and clunky traditional insurance. It’s one of myriad options today to consider. Here’s how it goes:

• Feasibility Study
  The process begins by calling on a professional captive manager, actuary, or risk manager to determine your business’s risks, insurance needs, and other financial considerations. This person analyzes your current policies to spot insurance gaps, then runs the numbers to price out the costs. The feasibility study should provide a go or no-go conclusion.
   
• Formation and Licensing
  If it’s found to be the best insurance strategy, then a captive is established as a licensed insurance company in a state or offshore jurisdiction. Each authority has its own capitalization and regulatory requirements, so you must ensure that the letters of the law are followed—the formation step requires legal assistance. For small businesses, “micro-captives” may be ideal due to their tax treatment.
   
• Premium Payments
  Once policies are inked and plans are in place, premium amounts are based on actuarial analysis to ensure they align with market rates. The business then makes tax-deductible premiums to the captive for all the usual suspects concerning small-business insurance needs, which we’ve discussed in detail on the Clear Harbor blog: general liability, professional liability, and niches like cybersecurity.
   
• Risk Management and Claims
  The captive acts like any other insurance company. It maintains reserves, digs into claims, and pays out valid claims. Here’s the big draw: Any underwriting profits (premiums less claims and expenses) stay in the captive and are available for reinvestment or distribution to owners. You can kind of be your own consultant in a way by using surpluses to improve coverage and enhance employee benefits. But don’t get carried away—end-of-year surpluses are generally returned as dividends (you can’t run your own form of a Berkshire Hathaway).a
   
• Tax Treatment
  The tax angle is intriguing. Premiums are tax-deductible, as they typically are with traditional insurance, though certain risk-shifting and risk-distribution requirements exist. Small companies can enjoy tax-exempt underwriting income; the captive is only taxed on investment income.

Benefits of Captive Insurance for Small Business Owners

There are several advantages and cost-saving opportunities with captive insurance companies. It may not be a total game changer, but some of the upside may be appealing to you and your company:

Targeted Risk Management

Creative business owners might prefer designing their own policies and addressing specific risks that may otherwise be unavailable or simply overpriced in the commercial market. You can really home in on protecting against the dangers that could threaten your firm and people.

Cost Efficiency

Of course, the broad appeal of any self-insurance type is eliminating an underwriter’s profit margin. The x-factor is the added administrative burden placed on you and your team, so it takes careful assessment to figure out if the juice is worth the squeeze. We help small business owners determine that from an objective point of view. Over time, the thought is that premiums paid accumulated with the captive, building a reserve that can be used to cover future claims or re-invest in the business.

Improved Cash Flow

Premiums paid also remain in your corporate structure, which might improve the business’s liquidity situation. If cash flow is light for whatever reason or economic uncertainty is high, that extra cash buffer can come in handy. Of course, claims must be held in check to prevent losses and generate captive surpluses. With traditional insurance, premiums are forfeited regardless of claim activity.

Access to Reinsurance Markets

Captives often partner with reinsurers (the insurance companies to insurance companies) to protect against catastrophic risks. This is helpful since it allows businesses to spread risk and potentially secure lower premiums and better benefits compared to typical insurance channels. With premiums soaring in recent years within some categories, this may be particularly appealing for some small businesses.

Financial Planning Opportunities

Captives offer some modest estate and gift tax benefits for closely held firms. Working with an attorney, we can structure ownership through trusts or family members for tax-efficient wealth transfer. This goes beyond the aforementioned tax benefits. Finally, there’s an added layer of asset protection since the captive’s assets are insulated from the parent company’s creditors.

Considerations and Compliance

The benefits may seem gaudy, but it’s not a slam dunk. You must be on top of changing IRS rules and practice prudence when deciding what to ensure. Regulators crack down on companies that are too aggressive in underwriting primarily for the tax benefits and not genuine risks (e.g., if you live in North Dakota, you should not have hurricane coverage!).

The parent company must transfer risk to the captive in exchange for reasonable premiums, and the captive is required to pool a sufficient number of unrelated risks, acting as a bona fide insurer—properly licensed, holding adequate reserves, and having a clear claims process.

Maintaining regulatory compliance comes with costs, including professional guidance to ensure no missteps. Captive managers, actuaries, tax advisors, and legal counsel should be at your ready. I’d say, in general, if you operate in construction, healthcare, or technology, you may be an ideal candidate for establishing a captive insurance company. Still, it demands a long-term commitment and ongoing risk management acumen.

The Bottom Line

Captive insurance could be right if you face unique and hard-to-insure risks while wishing to control your insurance umbrella. You must run your own cost/benefit analysis with a team of experts to get started. Ultimately, captives can be useful for managing risks, tailoring your insurance coverages, and capturing tax savings. The red tape can be a lot, and an increased regulatory burden keeps many entrepreneurs from taking this path, however.

^[1] https://content.naic.org/insurance-topics/captive-insurance-companies