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Learn about Captive Insurance: Tutorial
We encourage you to read through this multi-page guide to learn all about captive
insurance companies and what is involved in setting one up. Use the links at the bottom of the page to guide you
through the tutorial.
Introduction and Definitions
Business owners and organizations from practically every industry have formed their own (captive) insurance
companies. Faced with high premiums or the unavailability of insurance coverage in many cases, businesses and organizations have
formed captive insurance companies to self insure selected risks. The captive insurance company is a separate legal entity which bears
these risks in exchange for premiums paid by its affiliated non-insurance businesses, creating a dedicated risk management fund to
cover claims, administration, and prevention programs. The captive's assets are invested by the captive owner until needed. Captive
profits can be returned to the captive owner in the form of dividends or reinvested. And if structured properly, a captive insurance
company offers a number of tax advantages over self insurance to the captive owner and affiliated entities.
One of the best general definitions we've come across is from the International Risk Management Institute, as follows: "A captive insurance company can be
defined as a special purpose insurer whose source of business is the primary business activities of its participants, shareholders, or their
affiliates which put their own capital at risk in order to:
- provide a stable financing mechanism for selected risks (provide unique business insurance)
- allow owners and participants to take part of the insurer's operations, claims administration, underwriting decisions, and investments; (maintain control);
- develop and implement tailored risk management services for owners and participants (customized to your business needs)
- encourage and provide incentives for good safety and loss control practices (promote prevention); and
- create an opportunity for owners and participants to reduce expenses over the long-term." (save money)
If structured and operated as a bona fide insurance company, a captive can also provide tax advantages to its
insureds and owners. For example, insured entities are able to deduct premiums paid into the captive and the captive's loss reserves are also
immediately tax deductible, unlike reserves associated with self insurance or deductible claims. And if the captive qualifies
as a "small electing insurance company" under Section 831(b) of the US tax code, its underwriting
profits are not subject to federal taxation until they are distributed as dividends to owners who then pay tax at reduced capital gains rates.
Let's take a closer look at what the above definition tells us and elaborate a bit more.
First, captive insurers are formed to provide commercial insurance coverage to one or more entities. Captives can write property, liability
workers compensation, surety, warranty, life, health, disability, and possibly other coverages as allowed by its insurance
license. Risk retention groups (basically group captives that are formed pursuant to the federal Liability Risk Retention Act of 1986) are restricted to writing only liability
insurance.
The vast majority of captives are owned, either directly or indirectly, by their insureds or affiliated entities. Captives can be
formed as a corporation (either for profit or not-for-profit), as a mutual insurance company, or as a reciprocal.
Captives allow owner/insureds the opportunity to financially benefit from good loss experience.
Underwriting profits and investment income earned on the captive's assets can be returned to shareholders as dividends or used to reduce
premiums going forward.
Captives are usually formed and licensed in a regulatory jurisdiction (such as Montana, Vermont, or Bermuda) that
offers special captive legislation which is more lenient than laws imposed on typical insurance companies. These jurisdictions do not
impose local corporate income tax on captive profits, another key benefit.
Captives provide many other benefits to their owners and insureds. A captive can be used to replace or expand coverage
that is deemed too expensive and/or it can insure unique risks for which coverage is just
not available in the commercial market. Because ownership of the insured(s) and captive are essentially the same (with the exception of
sponsored or protected cell captives), the captive is able to design insurance programs that are closely aligned with the insureds goals and
needs. Contrast this with purchasing insurance from the commercial marketplace, whereby the insurer dictates policy form, price, payment
terms, and claims management.
Captives can reduce the organization's cost of risk over the long term. Captive expenses as a percentage of premiums are
typically much lower than the 35% to 45% expense loads of commercial insurers. And with good loss experience under a captive
arrangement, excess funds (accumulated underwriting profits and investment income) can be returned to captive owners or reinvested. Captives can also access
the reinsurance market to obtain coverage at "wholesale" prices.
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