Captive Insurance: Protection and Profit, Part II

Part II: Profit

Dealerships establish captive insurance companies to provide stable and cost-effective insurance. Their captives protect them from risks against which they are underinsured or for which they cannot get coverage from a commercial insurer. But they also deliver financial benefits, helping dealers control costs by protecting against unpredictable premium swings and improve their bottom lines with income opportunities and tax advantages.

Premiums can be reduced by “super high” deductibles. And when premiums exceed claims and operating expenses, any actuarially determined excess reserves are available for more aggressive investments or returned to owners. (Can you think of a commercial carrier that returns your premiums when you haven’t had claims?)

There are also tax advantages when a captive is properly structured and registered. You can deduct capital reserves and premiums fully from your income as you transfer them to your captive, and returned premiums are taxed as shareholder dividends at lower capital gains rates. Like other insurance companies, captives can deduct for future losses, meaning your captive company can hold funds without paying income tax, up to $1.2 million in premium income in 2016, $2.2 million in 2017. You owe taxes only on investment earnings.

Setting up a captive insurance firm is not complicated, but in order for you to reap the tax benefits, it has to be structured properly, that is, according to IRS and state regulations for insurance companies. The IRS has issued guidance and private letter rulings related to risk distribution and risk shifting strategies to determine whether a captive qualifies as a true insurance company.

To qualify for the federal and state tax advantages:
– A captive must be an independent business able to cover participants’ claims.
– There must be a transfer of risk in reasonable proportion to the premium being charged.
– Premiums must be determined by an actuary.

Your own pure firm or participating with others, you’ll need to consider multiple operational issues:
– Your overall management goals
– Investment policies for the premiums
– Where the firm will be domiciled (Delaware? Off-shore?) and those requirements
– What type of dealerships will be covered
– What kind of reinsurance will you purchase
– What are the procedures for returning premiums or for shortfall in funding claims
– How a member can exit the firm

Domicile selection is key to saving on state taxes. No matter where you reside, you can choose where you will domicile your captive insurance company. Delaware is a popular choice, but Vermont and South Carolina are also corporate friendly states, as are some off-shore locations. Your selection will be based on the location’s initial capital requirements as well as its tax policies.

You can also use a captive to transfer wealth to next generation by making children part owners of the captive. Their participation does not compromise gift and estate tax strategies. And your captive can be structured to accommodate different retirement objectives of different shareholders.

The goal of establishing a captive is to provide stable and cost-effective insurance. But when a captive is formed and operated according to the rules as established by case law and the IRS, including guidelines governing risk transfer and distribution, they can also provide substantial tax and other financial benefits.

See Part I of “Captive Insurance: Protection and Profit” for insights on setting up a captive company for protection against uninsured or underinsured risks.