More and more businesses are turning to captive insurance arrangements as a way to save money, obtain tailored coverage, and gain greater control over their business insurance. A captive is a limited purpose insurance company whose main purpose is to insure the particular risks of its parent company, affiliates, and/or third parties. The captive can be an insurance company in its own right, or a reinsurance company that works with a third-party insurer.
There are a wide array of captive arrangements available to suit many different needs, but if not structured properly, your insurance arrangement could trigger an IRS audit.
The issue concerns micro-captives, a particularly appealing kind of captive that offers a big tax break to small- or mid-size companies. Under tax code 831(b), insurance companies with less than $1.2 million in annual premiums pay no income tax on insurance profits. That's a big tax break, and one that some companies are taking advantage of.
The IRS is pursuing companies who they believe have insured themselves against risks that are not real. For example, a company might take out excessive coverage on a product recall that is highly unlikely to happen. They'll pay high premiums for that coverage and get the deduction for the insurance expense, knowing full well that there is no real risk. This sets the captive up as a tax haven.
The punishment, if found guilty of tax fraud, is severe: steep fines, forfeiture of property and even jail time. As a business owner, the way to avoid having the IRS knock at your door is to follow the letter of the law and make sure that any captive you participate in insures against real risk.
"What we typically do for clients who are interested in captives is to put them into group captives where they are sharing risk with either heterogeneous or homogenous businesses," said Darren D. Caesar, executive vice president and chief marketing officer, who specializes in captive insurance for HUB International Insurance Services in California.
A group captive insures the assets of several companies that have a similar risk profile. For example, a group captive might insure the automobile fleets of several unrelated companies. Alternatively, captives can also transfer risk by bringing on board an insurance company that issues a policy. In this form, the captive acts as a reinsurance company. This ensures that the captive and the insurance company are both involved, sharing the risk among these two parties and the company they are insuring.
This is just one option among the many a company faces when setting up a captive insurance company. With the right kind of guidance, this arrangement can be both legal and beneficial.
"With a captive arrangement, you avoid the retail marketplace and pursue more of a wholesale and commercial marketplace where the cost of insurance is more level," said Caesar.
What are the benefits of a captive?
First, a captive allows a business to have greater control over its insurance coverage, tailoring it to meet the business' specific insurance needs. A captive can also insure unusual risks and allow a business to choose how it administers claims.
Second, a captive can offer opportunities for tax breaks, asset protection and profit through earned interest and investment income coming out of the captive itself.
Third, it can save businesses money on insurance costs.
For these reasons, more businesses are moving toward captive insurers, with more than 6,000 in existence today.
If you are interested in exploring a captive arrangement, talk to a HUB International advisor to better understand if this option is right for your company.