Magazine article The CPA Journal

Captive Insurance Companies: A Common Sense Approach to Improved Risk Management

Magazine article The CPA Journal

Captive Insurance Companies: A Common Sense Approach to Improved Risk Management

Article excerpt

Although many believe that captive insurance companies are a relatively new phenomenon, the captive insurance industry can be traced back to the 19th century. Today, nearly all Fortune 500 companies and thousands of midsized companies maintain captive insurance companies, and this author believes the captive insurance industry will continue to evolve as companies continue to face multiple threats to their survival on multiple fronts. Commercial insurance companies are struggling to create the risk management products many businesses need. This article provides an explanation of captive insurance companies, how they are regulated, and how they can help companies manage the myriad risks of doing business.

What Is Captive Insurance?

A captive insurance company is a subsidiary formed by a private company to finance its retained losses in a formal structure under the guidance of an appropriate state insurance department. Captive insurance companies are normally formed to supplement commercial insurance, allowing companies to retain the money that would otherwise be spent on insurance premiums.

The first active captive insurance company in the United States was started in Ohio by Fred Reiss, who in 1953 founded Steel Insurance Company of America for Youngstown Sheet & Tube Company in Ohio. Reiss drew the term "captive" from the steel company's captive mines, which were sending ore back to the company's mills. In a short time, U.S. businesses began to realize that they could create a profit center out of an ordinary business expense: the cost of insurance.

By 1960, there were more than 100 captive insurance companies in the United States, providing insurance that was commercially unattainable or purchasing supplemental insurance to round out an existing commercial insurance coverage portfolio. This was a paradigm shift from simply buying insurance, as businesses realized the value of the tax advantages, asset protection, improved cash flow, and the ability to create significant equity created by moving to captive insurance.

Businesses continued to see the benefits of captives; in 1980, the number of captives established both onshore and offshore had reached 1,250. Many state governments were beginning to recognize both the economic and social benefits that captives could provide to their individual states. Captive ownership had proven to be tremendously positive for mid-sized businesses, as it permitted businesses to manage risk more effectively, thereby improving their survivability. By 1981, the number of captive insurance companies had reached 1,400, and it grew to 1,600 by 1983. Within another three years, the number of captives exceeded 2,200, and the annual premiums rose above $7 billion.

In 1986, a pivotal year for the captive insurance industry, the definition of controlled foreign corporations changed. Owners of group captives were obligated to declare their share of captive income, and loss reserves had to be discounted. In addition, Congress enacted section 831(b) of the Internal Revenue Code, which allowed insurance premiums paid by a business to be 100% deductible to the sponsoring business while not being considered income to the captive when the premiums are received. This permitted captives receiving premiums of $1.2 million or less in annual premiums to exempt the premium received from their underwriting income when calculating income for taxation. Thus, premiums received, less claims paid and expenses incurred, resulted in an underwriting profit that would be taxed at 0%.

Congress's rationale was that it should encourage smaller companies to create the necessary insurance coverage to protect their enterprises. While commercial insurance is a prudent component of sound business development, it represents a cost that frequently limits the growth of smaller businesses. IRC section 831(b) allowed midsized businesses to grow their balance sheets more quickly to support the risk of their owners and resulted in a rapid growth of captive insurance companies among mid-sized businesses. …

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