Captive Insurance – Advantages & Disadvantages for Contractors
A thorough risk management program is vitally important to all contractors. The most effective risk management programs are run by highly skilled professionals who understand their company’s risk areas, insurance market dynamics, expected future trends and available options. Contractors are exposed to many different insurance risks, including builder’s risk, contractor professional liability, property damage, worker’s compensation and employment practices liability. The Patient Protection & Affordable Care Act has spurred many companies to consider “medical stop-loss captives.” Therefore, companies that strategically manage their insurance risk can protect their financial strength and reduce insurance costs.
Captive insurance companies were first formed in the 1960s in an effort to reduce insurance costs, address business risk and offer more control over the administration of insurance programs. Those concepts still apply today. Most large companies have used captives for many years. Today’s most likely captive candidates are middle-market companies that want to spread their risk, reduce insurance costs and protect their capital base.
There are a number of factors to consider prior to forming a captive, including defining the insurable risks, performing a feasibility study, assessing risk objectives, quantifying initial capitalization requirements, projecting future operating costs, determining the country or U.S. state of domicile and complying with insurance licensing requirements. The amount of the captive’s initial capital investment and ongoing capital requirement is determined by the entity structure and requirements of the country or U.S. state of domicile. After formation, the captive must meet operational qualifications of an insurance company and certain risk pool qualifications as defined by the IRS.
Captives can vary in size—anywhere from a single contractor to 50 or more companies working together. When a captive is formed, the parent or sponsor capitalizes a subsidiary that acts as an insurance company and manages the captive’s operations. If multiple companies form a captive, the participants could be part of a trade association, in the same industry or not related at all. A captive should be small enough to be manageable but large enough to achieve financial and performance targets.
Captive Insurance Program Advantages
- Stabilization of pricing over time – Insurance market fluctuations will have less effect, as pricing is based on the insured’s individual loss history.
- Tax advantages – A current-year ordinary deduction is permitted for premiums paid to the captive. If premiums paid to a domestic captive do not exceed $1.2 million and the captive makes an election under Internal Revenue Code (IRC) Section 831(b), the premiums are exempt from federal tax and the captive is taxed solely on its investment income. Dividends from the captive are taxed at the more favorable capital gains rates instead of ordinary income tax rates. The 3.8% net investment income tax may apply; thus, reducing some of the overall tax advantages.
- Ability to direct investment options – Captive reserves and surplus are invested at the direction of the captive owner.
- Coverage customization
- More control over claims handling
- Streamlined insurance renewal process
- Reduced exposure to commercial insurance market
- Lower markup costs from the primary insurance markets
- Reduced administrative overhead
- Shift of regulatory authority to a less restrictive domicile
Captive Insurance Program Disadvantages
- Capital outlay – A captive insurance program comes with formation costs and ongoing mandatory capitalization requirements.
- Tax regulations – The IRS has imposed stricter definitions and harsher penalties for noncompliance under newly emphasized IRC Section 953(d) related to offshore captives as well as increased scrutiny of domestic captives.
- Ownership of a captive may complicate mergers and acquisitions.
- Difficulty in closing entity – Liabilities may remain on a captive’s records for years.
- Administrative duties – The captive owner must take responsibility for oversight.
- Volatility of the reinsurance market – Captives will not fully eliminate susceptibility to pricing fluctuations.
- Mandatory formalities of running the captive like an insurance company
There are many factors to consider related to the formation and operation of captive insurance programs. Based on these and other considerations, a captive may or may not be right for your company and should only be considered after consulting with qualified tax and legal counsel. For more information on captives, contact your BKD advisor.