Is Your Organization Evaluating a Captive? 5 Key Considerations
While there are many potential benefits in forming a captive, several key issues and potential challenges should be considered before establishing a captive insurer. Thoroughly evaluate the following cost and operational considerations:
1. Start up and annual operating expenses. When evaluating the ongoing financial and operational value associated with using a captive insurer, take into account the start-up and annual captive operating expenses, such as:
- Captive feasibility study.
- Tax opinion (optional).
- Start-up fees, including implementation consulting, actuarial, regulatory, and legal.
- Annual operating expenses, including captive management, actuarial, regulatory, audit, and legal.
- Premium taxes, including captive domicile, self-procurement, and US federal excise.
2. Capital commitment. The parent must contribute the capital required to support the captive’s business plan, as determined by the insurance regulator in the captive’s chosen domicile. While these funds remain within the parent’s consolidated group, they may not realize the same return as they would have if invested in the parent’s operations. However, most captive domiciles permit the captive to lend assets back to the parent (contingent upon regulatory approval), which helps to mitigate any opportunity cost associated with segregating premium and capital into a wholly owned captive.
3. Risk of adverse underwriting results. The captive’s capital could be eroded by adverse operating results. Although it is normal to build a degree of protection against adverse underwriting results into any captive program, it is only possible to minimize the risk to the captive, not to eliminate it. It is especially important to note that if unrelated risks are written in a captive, the risk of unprofitable underwriting results increases.
4. Time commitment and related costs. The parent company’s management will need to devote time to the captive. In addition, some travel costs are also likely. Generally, such costs will be more than offset by the financial benefits of the captive program. The day-to-day management is typically subcontracted out to a captive manager who handles the preparation of the captive financials, coordination of the annual audit and board meeting, and all regulatory compliance work (e.g., premium tax filings). The scope of responsibilities which lie with the captive parent involves the following:
- Annual board meeting.
- Review of captive audit.
- Consolidation of captive financial results.
- Approval of annual captive budget and business plan.
- Provision of periodic claim data.
5. Tax treatment. While not the primary business driver for forming a captive, tax benefits are a critical economic driver considered by potential captive owners. For a captive insured to recognize premiums paid to a captive as tax deductible, the captive must qualify as an insurance company for federal tax purposes, which is more challenging in the US than outside it.
In the US, for example, in order for premiums paid by a parent company to its wholly owned captive to be treated as tax deductible, the transaction must demonstrate the existence of risk transfer and risk distribution to support the notion of insurance. The terms “risk transfer” and “risk distribution” are not defined in the US Tax Code, but rather through precedent-setting case law and Internal Revenue Service (IRS) revenue rulings involving wholly owned captive arrangements.
Such court cases and IRS revenue rulings have set forth two principal ways for a captive to qualify as an insurance company for US federal tax purposes. Several of the decisions made by the courts over the past 20 years suggest an emerging criterion in establishing whether a captive insurance company is a bona fide insurer, and thereby entitling the owner of captive to recognize an accelerated tax deduction for premiums.
While the above factors are key considerations, you must weigh such factors against the benefit a captive may afford based on insuring various risks. The captive feasibility process is key to achieving credible conclusions, so we recommend speaking to captive experts to better determine the potential value proposition associated with your company using a captive insurance company.