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Why the rationale for a captive

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Why Captive Insurance is being so quickly absorbed by the business comunity

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Why the rationale for a captive

  1. 1. Why? - The Rationale for Captive FormationOccasionally a new set of circumstances stampedes the insurance industry herd. Day CareCenters, Fungus and Mold, Products Liability, Malpractice Issues, E. coli and other “scares”have been met by withdrawal from markets and major premium increases, with the resultthat insurance became unavailable or unaffordable or both. We all love free markets butinsurers portray themselves as the oil and grease that enables the wheels of commerce.Take away the oil or grease and the commerce machine slows down or stops. To help dealwith these occasional glitches, Congress created legislation intended to provide moreunderwriting capital for insurers and make it more feasible for business owners andprofessionals to effectively insure themselves on the tax favored basis that admittedinsurers enjoy. Captive Insurance has been sanctioned by Congress. A Captive owner can fund a fair part of his/her business risk with federal and state incometax savings that result from the Captive.A Captive that is viewed by the IRS as an insurance company can turn a tax payment into taxsavings that can be used to fund other business matters and/or increase shareholderdistributions.As consequences of the above: The IRS has provided safe harbors.These are guidelines that define what the IRS views as legitimate insurance ventures (as opposed to tax avoidance scams). New opportunities for Pre-tax wealth accumulation have surfaced; Insuring difficult risks has become easier and less expensive. The overall cost of risk management is dramatically reduced for captive owners. Captive insurers have become profit centers and the impetus for major job safety gains.Specific Observations Asset Protection One role of an insurance commissioner is to assure that the insurers under his or her jurisdiction are capable of handling extraordinary loss. Consequently, the assets of insurance companies are difficult to attach. As with any other insurer a Captive’s assets are protected.
  2. 2. Leverage with Commercial InsurersThe more money that you spend on insurance, the more that you are of interest tocommercial insurance companies. If you are big enough to own a Captive Ins. Co.,the prospect of competing for your business becomes more challenging to the bigcommercial insurers. Or, they may want to insure you above a large deductible.Either way, you get more respect.Availability of CoverageCertain types of coverage are unavailable or difficult to obtain due to things such aspoor loss experience for an industry or occupation. Medical malpractice is a goodexample. With a captive, a business can self-insure such risks on a tax deductiblebasis. Additionally, the Captive creates access to reinsurance markets that have abetter overview of real risk.Avoid commercial insurance premium fluctuationsA Captive can charge consistent premiums while building surplus to sever its ownersfrom premium fluctuations associated with commercial insurance. Whencommercial market premiums are low, as is often the case when interest rates arevery high, the Captive’s risk manager can step outside the captive to take advantageof artificially low rates.Captives encourage more careful work habitsWhen employees become aware that the owner’s money is on the line they tend toadopt safer work habits and to pay closer attention to their products andoperations. In an environment where insurance is provided by a commercialinsurer, there is no potential to profit other than a vague suggestion of lowerpremiums at some uncertain point in the future. But with a Captive, employeescome to know that their special effort pays dividends to their employers.Recognition by upper management enhances safe thinking.Cash Flow BenefitsThe owner of a captive receives income earned on premium and claims reserves.Premiums are paid up front while claims are paid out over a longer period. Reservesaccumulate quickly to the owner’s benefit. To the extent that the sum of premiumincome plus interest income exceeds the sum of losses, loss adjustment expenseand the portion of premium income used to buy excess and stop loss insurance, theCaptive profits. For the first several years (and subject to actuarial review), nearly allthe profits are typically used to boost loss reserves and are therefore not taxed.Control over claims handling
  3. 3. The Captive contracts with a third party administrator (TPA) to manage many of theCaptive’s affairs, particularly the investigation and settlement of claims. Claims aresettled with the Captive’s money. There are times when most businessmen want topay a claim to please an important customer and times when they will want to fighttooth and nail to not pay a claim. In neither of the foregoing situation will acommercial insurer likely be helpful. Captives permit some latitude in thesesituations.Cost reductionsWhen a business owner pays a premium to a conventional insurance company hegives that insurer, on average, between 35 and 40 cents out of every dollar to coverthe insurer’s costs, taxes, profits and obeisance to Wall Street expectations,however wrongheaded they may be. With a closely held, privately owned Captiveinsurance company, costs and profits are internally controlled. Moreover, there isno padding for losses suffered by careless competitors. Also, when the owner’sdollars are on the line, safety tends to improve, as does loss experience.An Additional Profit CenterA captive can write insurance for third parties. For example, homebuilders,manufacturers, dealers and retailers use captives to provide warranty/extendedwarranty cover for their customers. Claims profiles for this type of business are verypredictable, so the captives make money.Estate PlanningBusiness owners who have estate planning objectives will find that Captives canfacilitate their accomplishment. This is one of the main reasons that CaptiveDynamics places so much importance on the selection of a Captive manager that iswell versed in estate planning as well as asset protection, taxation and law.ReinsuranceReinsurance is available to insurance and reinsurance companies only. Reinsurancebought directly by a Captive is generally less expensive than the reinsurancecomponent of premiums payable to conventional insurers. The Captive advantageallows a business a wider array of insurance products at less expense.Subsidiaries Get Extra Benefit From Corporate MuscleFor Captive owners whose subsidiaries are decentralized there may be significantdifferences between the levels of risk that each subsidiary can comfortably retain.The Captive makes it possible for every subsidiary to have large deductibles andretentions in their commercial insurance policies, thus reducing the parentcompany’s overall insurance costs. It is accomplished by enabling each subsidiary to
  4. 4. purchase insurance to pay for jumbo deductibles and retentions. Small subsidiariesgain muscle from the parent.TaxationNearly every web site and book that discusses captives will emphasize that taxbenefits should not form the rationale for establishment of a captive insurancecompany. True, but taxation is an important consideration in virtually every businesstransaction. When considering, planning or forming a Captive insurance company aprospective owner will do himself a favor by seeking out a Captive manager who isproactive on the issue of taxation. All too often, Captive management consultantswho soft-pedal on tax issues simply do not have sufficient understanding of tax law toconfront_the_IRS.The single biggest advantage of a Captive (an opinion) as opposed to a Combination ofCommercial Insurance and Self Insurance is that the Captive permits its owner tocreate loss reserves for otherwise uninsured losses, and to do so on a consistent,systematic and tax deductible basis. The uninsured losses are typically such things asDeductibles, Self Insured Retentions and losses excluded by standard insurancepolicies. There are many exclusions and the insurers don’t want to cover them so theyare dumped in your lap. In addition to the foregoing, there are dozens of “specialtylines” of insurance, many of which are only of interest to a fraction of the businesscommunity. They are policies that some business owners would like to have butcannot afford. They can be written by a Captive at an affordable price and are taxdeductible.When you are self- insured without a Captive, losses happen, you pay for them andyou have tax deductions. With a Captive, you routinely set aside premium to paylosses that the Captive will cover. Paid-in premium in excess of paid claims is movedto reserve accounts for succeeding years. Your premium payments are taxdeductible. Actuarially justifiable additions to claim reserves of the Captive are nottaxable. You begin to see how commercial insurers have grown so large.When a Captive owner introduces loss prevention technology or rigorous safety andoperational procedures his Captive can charge his constituent companies premiumscomparable to those of commercial market insurers. When his vision of improvedloss experience pans out, all the savings that result from it will flow into the Captive.Commercial insurers rarely return more than a small fraction of such savings, andeven then it is after they have used your money for a year or more.Therefore, Captive insurers create major incentive for safe operations. By reducingnet risk management costs they enhance profitability and competitive stature. Questions? Call 1-760-366-4670 or email to esb@captivedynamics.com or visit www.captiveinsurance.info