Have you ever paid an insurance premium and not put in a claim? In that instance, who made the money? It’s obvious that insurance companies have a very profitable business model.
In 2003 the state of Utah passed legislation that allows business owners to own 831(b) captive insurance companies. A captive is an insurance company established to insure the specialized risks of an affiliated business entity. It issues policies, collects premiums, and pays claims. Businesses typically have a number of risks that fall outside of the underwriting guidelines of traditional insurance and these specialized risks may be insured through utilizing a captive structure to finance potential losses in a formal structure. A captive can be owned by one or more business owners and can be a very efficient tool in managing risk in a tax-efficient way.
Good candidates for an 831(b) captive generally meet one or more of the following criteria:
• $5M+ gross revenue
• Pre-tax profits of at least $1M,
• Substantial self-insured/uninsured business risk
• 10+ employees
Below is a brief summation of some of the benefits of forming a captive.
• Risk Management. Effectively managing business risk is critical in today’s ever-changing world. A captive can provide the structure for a company to better understand its current risks so it can plan and manage the risk financing activities of the business more effectively.
• Unavailable Coverage. In the commercial insurance market, there are a number of risks where coverage is simply not available. A captive can provide a way to insure against specialized risks where commercial coverage is not available.
• Captive Profits. Effectively managing risk can result in significant profits to the captive insurance company thus risk management at the business level can be viewed by the business owner as an additional profit center. In establishing a captive, the business owner retains any profits within the captive rather than seeing them go to an outside party.
• Tax Advantages. Although a captive should not be formed specifically for tax purposes it can provide substantial tax benefits to a business and its owners. Through the 831(b) election a small insurance company can receive $1.2 million in premiums a year without paying any income taxes on those premiums. However, the election does not affect the deductibility of the premiums paid by the operating business. This has the effect of creating up to a $1.2 million deduction in the operating business with the premium being transferred to the captive tax-free.
• Lower Insurance Costs. Commercial insurance premiums must be adequate to pay the cost of claims. It is no secret that insurance companies are in the business to make a profit and therefore they include in premiums their acquisition costs, overhead, and profit. This portion of the premium can represent as much as 35% to 45% of the total premium. A captive does not have many of the expenses associated with a commercial carrier and therefore can charge less premium to cover an insurable risk.
• Risk Retention. The desire for a business to retain more risk through increasing deductible levels may be hindered by the inadequate discount offered by a commercial carrier. This can make it difficult for the business to establish appropriate reserves to pay future claims. A captive allows a company to retain additional risk in an efficient manner and provides the business with a way to efficiently build appropriate reserves.
If you would like to learn more about 831(b) captives, contact your tax professional at CMP today.
