Actively Manage Your Risk with a Captive Insurance Company (article)
Captive insurance companies are increasingly being considered as part of insurance and risk management practices. They hold benefits for companies across a range of industries, and may be of particular interest to the Commercial Real Estate sector. Companies managing everything from Class A office space to strip malls, health care REITs, industrial warehouses, and multi-door habitational enterprises are all exposed to traditional risks that can be easily funded into a captive.
Risks such as workers compensation, general liability, and auto liability are common captive targets. Additionally, risks such as flood, windstorm, hail, earthquake, environmental liability, mold remediation, loss of rents, and reputational risk are significant exposures for real estate owners. All of these risks, and more, can be efficiently and cost effectively funded into a captive. Scrutiny of captive insurance companies has been increasing, however. A clear understanding of what captive insurance companies are and what the benefits they may offer is essential to determining whether they would be a good fit for your operations.
Briefly, a captive insurance company is a special purpose insurance company formed to insure the risks of its owner and affiliated companies. The ownership may range from corporations to sole proprietors and partnerships, etc. There are several formation types but most companies in the middle market focus on three options:
- Pure/Single Parent Captives
- Group Captives
Which structure is best for your company will depend greatly on your insurance needs, ability to retain risk, and size. For most middle market companies, group captives and micro captives are generally the most likely arrangements. That said, larger, more diverse organizations with multiple subsidiary companies may qualify for consideration as pure or single parent captives.
A pure captive is wholly owned subsidiary of the parent company. It will primarily insure the risks of the parent company and all subsidiary companies but can offer coverage to unaffiliated third parties as well. These structures offer the greatest level of flexibility with regard to coverage and program design. But, they also typically require a minimum number of subsidiary companies, with each contributing roughly equivalent risk elements, in terms of size and scale. Premium size is only limited by the actuarially predictable losses for the coverages being underwritten.
Group captives are typically owned by multiple member companies and insure the risks of those owners. Coverage can’t be extended to any other third parties. In these structures, each owner is responsible for their own claims and expenses as well as some risks shared among the other members. Group captives are generally established to write very specific risks such as workers compensation, general liability and auto liability. However, some also offer auto physical damage and property coverage. These are excellent options for smaller companies that are not able to establish a captive on their own or need to participate in a risk pool or shared arrangement with unrelated entities in order to qualify for captive status. As in pure captives, the premium size is only limited by the actuarially predictable losses for the coverages being underwritten.
Micro-captives or 831 (b) captives are actually considered to be Single parent captives that operate as property/casualty insurance companies and are established to provide coverage to their parent companies. In that regard, they are similar to a pure captive. However, these structures are typically developed for smaller, middle market companies that are unable to meet the diversification requirements of a pure captive. Micro-captives can be developed to write standard or traditional coverage like workers compensation, general liability, product liability, auto liability and professional liability. But, many captive managers have developed more of an “enterprise risk” management approach and will offer a wide array of coverage options beyond traditional insurance products. These structures are therefore very flexible with regard to program design, eligibility, lines of coverage and operating structures.
As of Jan. 1, 2017, a company can now write up to $2.2 million in premium to its owned micro-captive. Micro-captives offer tremendous financial advantages to qualified owners. For example, captive underwriting profits and surplus accumulation are tax exempt and only the investment income generated from funds held as surplus for paying future claims are taxable annually. Once an underwriting profit is declared, distributions back to the owner are treated as qualifying dividends.
This flexibility comes with a price, however, in the form of additional diversification requirements, ownership limitations and disclosure requirements.
Traditionally, captives have been used to provide coverage for risks that can be easily forecast by qualified actuaries. Risks like workers’ compensation, auto liability and general liability are included in this category. They’ve also been used to provide funding for risks that can’t be insured in the commercial marketplace, are too costly to insure commercially or where adequate coverage (terms, conditions, pricing) is unavailable. So, risks such as professional and product liability and catastrophic exposures like earthquake, flood and windstorm are frequently ceded into captive formations.
As mentioned in the micro-captive discussion, enterprise risks can also be insured in a captive vehicle. There are roughly 63 or 64 lines of coverage that have been vetted by captive sponsors and tested by the IRS and U.S. Tax Court. Not all of them will apply to all companies, but many of them are somewhat universally applicable to some degree or another. Exposures such as administrative actions, computer system failure, deductible reimbursement, reputational risk, gaps in coverage from commercial policies, loss of intellectual property, judicial delay, uncovered legal expense, regulatory changes, supply chain risks, product recall, mergers/acquisition risk and workplace violence, to name a few, can form the basis of a formalized, well-funded risk management plan that protects the company’s balance sheet while creating additional benefits for the owners.
Advantages and Disadvantages
Captives can absolutely assist with a certain amount of “leveling” of market-based pricing, thereby assisting with cash flow and budgeting. They also are often used to fund for deductibles, thereby minimizing unplanned balance sheet impact. But, perhaps more importantly, when used as a foundation to the client’s overall risk management plan, they help sharpen organizational focus on core risk management principles, thereby leading to an opportunity to reduce frictional insurance costs and return dollars back to the organization from reduced loss experience.
On the flip side, captives are highly regulated by the states (or countries) where they are domiciled. Captive owners incur additional audit expenses, start up and management fees, regulatory and licensing fees, legal expenses, and surplus funding investments. In addition, 831 (b) captives are subject to increasing examination by the IRS due to abuses that have occurred over the years.
As a part of the PATH Act of 2015, the allowable premium investment in a captive was expanded from $1.2 million to $2.2 million. Along with this increased funding flexibility, however, came an additional disclosure requirement. In November of 2016, the IRS released Notice 2016-66, which essentially declares 831 (b) captives as “transactions of interest.” While simultaneously acknowledging that captives that take the 831 (b) election may be created for “legitimate risk management purposes,” the IRS now requires all 831 (b) owners, all insured entities, as well as all material advisors, to self-disclose involvement in these transactions. So, an 831 (b) captive owner will now be required to submit Form 8886, Reportable Transaction Disclosure Statement. For this reason, ensuring there is appropriate risk distribution and proper pricing of the insurance premiums must all be done with great care.
The true benefit to owning your own insurance company lies in the ability to take a long-term, strategic view of risk, including a plan for active management and proper funding for the unexpected. As a management tool, captives provide the advantages of tailored coverage, tax benefits (deductibility of premiums, deferred taxation of premium income) and the opportunity to capture underwriting profit as capital to be deployed in other areas of your business. Commercial real estate companies should evaluate their risks and determine whether a captive insurance company may make sense for their risk management strategy. For information about the benefits of captive insurance, please contact us.
Tony Consoli is President of the CBIZ Insurance Services Mid-Atlantic Region. Should you have questions or require additional information regarding captives or other risk strategies, feel free to contact Tony directly at 877-251-5345 or firstname.lastname@example.org.