Imagine being able to have control over your insurance costs and claims. What if you could not only reduce your insurance expenses but have better management of risk, and act as your own insurance company keeping and investing these profits. By owning a captive insurance company, businesses can save up to 20-30% on insurance premiums and earn returns on the investments.
Captive insurance is a self-insurance strategy where a business forms its own insurance company, a wholly owned subsidiary, to underwrite and manage specific risks of the parent company. A captive operates independently from the insured business, with separate governance, financial accounts, and decision-making processes. It is commonly used by companies seeking greater control over their insurance risk, create cost efficiency, and grow assets on a deferred tax basis.
Small captive insurance companies, sometimes referred to as micro-captive, can be structured to fall under a specific code section of the Internal Revenue Code. This election allows the captive insurance company to only be taxed on their investment income, and not their underwriting profits. Most small and medium sized businesses are attracted to this ‘micro-captive’ election, which will be the focus of this article.
Micro-Captive Insurance Company
Risk management remains a critical component of long-term business success, paired with the business owner’s long-term wealth, succession and retirement goals. One approach that has gained the attention of small and medium-sized businesses is the establishment of micro-captive insurance companies. When structured correctly, a micro-captive can not only enhance risk mitigation strategies but also provide significant tax benefits. It’s essential when considering this structure to understand regulatory compliance, economic substance, and operational purpose.
A micro-captive insurance company is a privately held insurance entity that insures the risks of its parent company or related businesses. It operates under section 831(b) of the Internal Revenue Code (IRC), which allows qualifying insurance companies to elect to be taxed solely on their investment income, so the captive grows its reserves tax efficiently. Annual premium receipts are capped at $2.80 million (as of 2024, subject to inflation adjustments). Premiums paid to the micro-captive are typically deductible expenses for the insured business, creating an opportunity to manage risks and achieve potential tax savings.
Benefits of a Micro-Captive Company
First, a micro-captive enables businesses to create tailored insurance solutions for risks that may not be covered or inadequately covered by commercial policies. This could include business interruption, supply chain disruptions, cyber risks, or reputational harm. By forming a micro-captive, businesses pay premiums to their wholly owned subsidiary rather than paying them to external insurers. This allows for the building of reserves and greater control over claims management.
Second, there are multiple tax benefits with a micro-captive. Premium payments made to the micro-captive are generally tax-deductible for the insured business. Micro-captives can elect under IRC 831(b) to be taxed only on investment income, allowing underwriting profits to grow tax-free within the captive. The premiums and investment income accumulated in the micro-captive can serve as a strategic tool for wealth accumulation by investing in income-generating assets, creating a secondary revenue stream. Surplus funds can eventually be distributed to the parent company as dividends, potentially at favorable tax rates.
Additionally, micro-captives allow for the distribution of risk across multiple businesses. To qualify as an insurance company under tax law, a micro-captive must demonstrate appropriate risk distribution. This is often achieved by insuring multiple entities within the same corporate group or participating in risk pools with other captives. Many small business owners also own their real estate in separate entities which would assist in achieving compliance in becoming a qualified insurance company.
Micro-Captive Insurance Company Structuring
A well-structured micro-captive requires a comprehensive approach that addresses regulatory requirements, operational legitimacy, long-term financial planning of the business and alignment with the business owner’s wealth, exit and retirement goals.
When establishing a micro-captive, conduct a thorough risk assessment to identify areas where current insurance coverage is insufficient or could be enhanced. Determine if the business faces unique or non-traditional risks and desires coverage that a micro-captive can address more efficiently. A feasibility study can ensure that forming a micro-captive is financially justifiable and aligns with the business owner’s long-term wealth and estate plans. This includes evaluating projected premiums, potential claims, operational & compliance costs for the business, as well as the business owner’s succession and exit plans for retirement. The cost of forming and maintaining a micro-captive, including legal, actuarial, and regulatory fees, can be substantial so evaluation of the business benefits and business owner’s personal wealth plan objectives are considered.
Micro-captives must comply with both federal tax regulations and state insurance requirements which includes compliance with IRC section 831(b) provisions and Treasury guidelines. The micro-captive must be licensed in a jurisdiction (domestic or offshore) with regulatory oversight that meets the business’s goals.
The micro-captive must be adequately capitalized to ensure it can meet its insurance obligations. Policies issued by the micro-captive must reflect legitimate insurance agreements, with clear terms, premiums, and claims procedures. The coverage should be priced appropriately, reflecting the actual risk and market standards. An independent actuarial analysis can be conducted to ensure that premiums are appropriate. Premiums must be defensible based on the risks insured and should not be excessive or arbitrary. The micro-captive operates as a bona fide insurance company, which includes processing claims in a timely and consistent manner with proper documentation and claim procedures.
Micro-captive Compliance
The Internal Revenue Service (IRS) monitors micro-captive arrangements to ensure they in compliance with IRC Section 831(b), and not being used solely as tax avoidance vehicles. As discussed previously, these structures are carefully designed to be properly capitalized with appropriate premiums and claim management. Appropriate captive insurance design safeguards against audits, penalties, or disqualification.
Engage legal, tax, and actuarial experts who specialize in captive insurance to ensure compliance and proper structuring. Periodically reassess the micro-captive’s performance, risk coverage, and regulatory compliance to maintain its effectiveness for the business and alignment with the business owner’s wealth objectives.
Conclusion
A micro-captive insurance company can be a valuable tool for businesses seeking to enhance risk management and achieve significant tax savings. This structure should enhance and align with the business owner’s wealth accumulation, succession and retirement plans. Careful planning gives the business and their owners access to advantageous benefits while adhering to regulatory guidelines. By working with experienced professionals and maintaining transparency and operational independence, businesses can ensure that their micro-captive functions as a legitimate and effective component of their overall risk management, business growth and wealth accumulation strategy.
