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What is Captive?

The use of alternative risk transfer vehicles, which includes Captive insurance companies, has almost become the norm rather than an innovation for larger organizations. These vehicles represent roughly half of the U.S. insurance market. A Captive is a closely held insurance company whose insurance business is primarily supplied and controlled by its owners, and which the original insured's are the principal beneficiaries.

In its simplest form, a Captive is a privately held insurance company that insures a business. It issues policies, collects premiums, and pays claims, just like a commercial insurer, but does not offer insurance to the public. Historically, Captive insurance companies were only for large corporations: 80% of the S&P 500 use Captive insurance programs. With the enactment of favorable tax regulations and other legislation, however, Captives are no longer just for large corporations. Middle-market and family businesses can take advantage of the same benefits. Insurance agents have historically marketed Captive insurance to businesses as a way of replacing conventional insurance. But Captives can offer much more. Instead of looking at the usual business risks, savvy financial experts consider risks not covered by conventional insurance policies.

This raises the question of why a business would want to insure additional risks that it otherwise would not. Consider, however, that those additional risks were always there; they were simply risks that were self insured. In reality, most businesses knowingly—or unknowingly—self insure an alarming amount of risk, including the following kinds of items:
  • Policy exclusions, such as mold and pollution
  • High deductibles and self-insured retention's
  • Operating risks, such as product recalls
  • Credit default
  • Loss of key customers and suppliers
  • Disability
  • Types of insurance unavailable in commercial markets
  • Natural disaster
  • Construction defects
  • Administrative actions
The cost of this “self insurance” outside of a valid and qualifying Captive structure is not tax-deductible. A properly formed and operated Captive may deduct insurance premiums that are paid into a privately owned insurance company. Claims are paid with pre-tax dollars. If no claims are made, the Captive retains the premiums for future business risks or distribution. In addition to giving a business better control over its insurance costs, a Captive program can provide the following benefits: The deduction of insurance premiums that flow tax-free to the Captive, where they accumulate on a pre-tax basis in anticipation of future claims.

The ability to distribute underwriting profits to shareholders as dividends or upon liquidation; ownership by a family trust or other entity for the benefit of future generations; and the ability to give key employees restricted ownership in the Captive, in order to provide an increased incentive to manage risk effectively and reward loyalty.

Captive insurance companies can also be a powerful year-end planning tool because insurance premiums are deductible and insurance companies receive favorable tax treatment as well as give the captive owners complete management control of their various risks.

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