Recently, clients and their advisors—accountants, specifically—have been asking for information about captive insurance companies (“captives”). Questions revolve around how a captive might help their business, from both a risk-management and a cash-flow perspective.
A captive is a licensed insurance company that insures or reinsures the risks of its parent, affiliates or certain unrelated entities. One of the more popular types, a small-enterprise risk captive, generally insures property and casualty risks not exceeding $1.2 million in annual premiums. It is governed by IRS Code Section 831(b). Captives owned by a parent company may accept premiums that normally would be paid to a third-party commercial insurer and may use them to cover claims.
Captives must follow the general rule of insurance: to transfer and distribute risk. Transferring risk occurs when losses pass from an insured to an insurer. Risk distribution mandates that a captive pool enough independent risks of unrelated parties to invoke the law of large numbers. Captives accomplish risk distribution via the reinsurance market. Companies seeking to establish one should retain the services of a third-party administrator specializing in formatting, licensing and administering captives.
Captives provide their parent company distinct advantages: One is more comprehensive, versatile insurance options: The parent is not beholden to the “off-the-shelf” coverage insurance carriers offer. Captives may also insure unique risks rarely offered in the marketplace. Another advantage is their ability to reduce overall insurance costs by removing third-party insurers.
Only after demonstrating legitimate insurance needs may a captive provide ancillary, non-insurancerelated benefits. One benefit here is that the parent company may shift up to $1.2 million per year in deductible premiums. This deduction is not counted in gross earnings for that specific year and is not realized as income for the captive.
To the extent that claims are less than the premiums collected, the captive’s reserves increase. A loss ratio of 50 percent is not unreasonable for a properly managed captive. Then there are tax advantages. The parent company is using pre-tax dollars to insure risks previously not insured or insured with post-tax dollars.
Second, should the captive be dissolved, a dividend distribution may be paid to the owners and taxed as a qualified dividend. While captives enjoy certain tax benefits, their primary objective should not be tax mitigation!
Asset protection is another non-insurance-related benefit. The assets of the captive are no longer owned by the parent company, and thus are not subject to creditors.
William Knox of HDH Group emphasizes that captives are suitable for businesses with: genuine insurance needs; steady strong cash flows, to make the yearly premium contributions; and should have qualified leadership to adequately manage the business.
Captives are an excellent risk-management tool for businesses with unique risks. Like other financial planning strategies, the captive should be part of an overall financial plan.
For more information, ask for the Pioneer Financial article on cash-balance plans for a pure tax deferral strategy, by James L. DiNardo CLU®, ChFCsup>®, CFPsup>®, MSFSsup>®.
James L. DiNardo offers advisory services as a representative of Northwestern Mutual Wealth Management Company (WMC), a limited purpose federal savings bank, and a wholly owned subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, Wis. (NM). Northwestern Mutual is the fleet name for NM, its subsidiaries and affiliates. Investments held with or managed by WMC are not insured by the FDIC, are not deposits or other obligations of, or guaranteed by WMC or its affiliates and are subject to investment risks, including loss of the principal. James L. DiNardo is an insurance agent of NM (life insurance, annuities and disability income insurance), and Northwestern Long Term Care Insurance Company, a subsidiary of NM, and a registered representative of Northwestern Mutual Investment Services, LLC (NMIS), an NM subsidiary, broker-dealer, investment advisor, member FINRA, SIPC. Pioneer Financial is a marketing name used by a group of Northwestern Mutual representatives (not all of whom are affiliated with WMC) including DiNardo (referred to as the “firm”), and is not a legal entity, partnership, investment advisor, broker-dealer or affiliate of NM. The information contained in this article is not a solicitation to purchase or sell investments or securities. The views expressed herein are those of the author and may not necessarily reflect the views of Northwestern Mutual. Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP ®, CERTIFIED FINANCIAL PLANNER ™ and federally registered CFP (with flame logo), which it awards to individuals who successfully complete initial and ongoing certification requirements.
This article was originally published in the December/January 2015 issue of Worth.