An Introduction to Captive
Insurance
Lucy A. Steitz, CFP ®
CoreStates Capital Advisors, LLC
(267) 759-5000
What is a Captive?
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A privately-owned limited purpose
insurance company
It is licensed in a U.S. state or foreign
jurisdiction. IRC 831 (b).
A captive’s purpose is to insure the risks
of the operating company which has an
above-average risk profile.
Financial Planning Magazine’s
November 2009 calls forming captives
“one of the best risk management and
wealth planning tools available to
business owners... Captives are one of
the best – if not the very best- asset
protection tools available to business
owners.”
Which Companies Are More
Likely to Benefit From a
Captive?
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Doctors (specialists) and other professionals
Manufacturers
Exporters and Importers
Dry Cleaning
Construction Related Professions
◦ Contractors
◦ HVAC
◦ Plumbing
 Oil and Gas
 Hotels, Motels, Restaurants and Inns
 Transportation Companies
Which Companies Should
Consider Forming a Captive?
 Companies with an above-average risk profile (one which
has substantial uninsured or under-insured risks).
 Companies which have a good combination of income and
risk.
 Ideally, a company should have $3 million in gross revenue.
 Some companies with $1 - $3 million may have enough risk
to warrant forming a captive.
Captive Benefits:
 Insurance needs MUST be present! Think custom
Insurance Policies.
 Direct Access to Reinsurance
 Program Control
 Program Stability
 Tax Savings
 Operating Cost Savings
 Cash Flow and Capital
 Program Flexibility
 Wealth Transfer
 Asset Protection
Sample Coverages Written by Captives:
 Directors & Officers Liability
 Errors & Omissions
 Employment Practices
 Copyright, Trademark, Patent Infringement
 Loss of Franchise, Vendor or Customer
 Machinery Breakdown
 Antitrust & Unfair Competition
 Credit Default/Accounts Receivable
 Business Interruption
 Loss of Key Employee
 Environmental/Pollution
 Product Liability
 Employee Benefits
 Workers Comp
 Cyber-risk
 General Liability
 Professional Liability
What Are the Benefits to
Forming a Captive, con’t.?
 Underneath the insurance and risk management purposes of
a captive insurance company is a great tax arbitrage
opportunity.
 In the current year, the insured lowers his taxable income
through the payment of insurance premiums. In forming
the captive, the insured is most likely insuring a large
amount of risk which was previously “self-insured,”
meaning the insured paid for losses out of current
earnings and savings.
 The premiums are placed into a tax-advantaged vehicle –
captives under IRC 831(b) are taxed on their current
portfolio income rather than their current earnings.
 When the insured sells his/her captive shares, the
transaction is taxed as a capital gains transaction rather
than as an ordinary income transaction.
An Example of the benefits:
 A group of Ob/Gyn physicians form and own a captive to
insure against medical malpractice risks. The captive allows
them to again perform high risk procedures.
 Power of the pen to write their own policies.
 Control of Claims process.
 If claims are well-managed during life of captive, insurance
reserves within the captive may be paid to doctors on
retirement or sooner.
 Assets in the captive are protected from creditors, divorce,
bankruptcy, lawsuits, etc. No deep pockets.
 Wealth transfer vehicle – captive established as C Corp. Can
be owned by multiple entities (LLCs, FLPs, Trusts, Owners).
Compare to traditional ins.:
 Commercial Insurance priced at 50% loss ratio.
 The “other 50%” is for overhead and profit.
 Captive may allow owners to retain a portion of their
premiums.
 For Example, a group of physicians form a captive under 831
(b) with $1 Million in annual premiums
 With average claims, owners keep extra $500k/yr in captive
 Grows to $5 Million in 10 years
 Investment income taxed annually at ordinary income
 Use reinsurance to limit excess exposure per claim
What Are the Steps to Forming
a Captive?
After a company decides to form a captive,
the next step is to perform a feasibility
study, which has three objectives:
 Frist, it provides a blueprint for the entire
captive program.
 Second, it aids in compliance.
 Third, the study illustrates captive benefits to
key decision-makers within the organization
regarding the plan.
What Are the Steps to Forming
a Captive?
 The jurisdiction where the captive is being
formed must determine if forming the
captive is in the jurisdiction’s best interest.
To do that, they will consider
◦ (i) The character, reputation, financial standing
and purposes of the incorporators;
◦ (ii) The character, reputation, financial
responsibility, insurance experience and
business qualifications of the officers and
directors; and
◦ (iii) Such other aspects as the insurance
commissioner shall deem advisable.
What Are the Steps in Forming a
Captive, con’t.
 Next, the applicant must make a formal
application to open an insurance company. The
application must typically contain the following
information
 (A) The amount and description of its assets relative to the
risks to be assumed;
 (B) The adequacy of the expertise, experience, and
character of the person or persons who will manage it;
 (C) The overall soundness of its plan of operation;
 (D) The adequacy of the loss-prevention programs of its
parent, member organizations, or industrial insureds, as
applicable; and
 (E) Other factors considered relevant by the commissioner
in ascertaining whether the proposed captive insurance
company will be able to meet its policy obligations
 Finally, there is the issue of original capital and
surplus.
Running the Captive
Domicile manager
Captive manager
Legal counsel
Audit
Actuarial Services
Investment manager
Shutting Down the Captive
 In most states, one of the following seven reasons
will allow a state regulator to shut down a
captive:
◦ 1. Insolvency or impairment of capital and surplus.
◦ 2. Refusal or failure to submit an annual report … or any
other report or statement required by law or by lawful
order of the director.
◦ 3. Failure to comply with the provisions of its own
articles of incorporation, bylaws or other organizational
document.
◦ 4. Failure to submit to an examination or any legal
obligation related to the examination.
◦ 5. Refusal or failure to pay the cost of an examination.
◦ 6. Use of methods that, although not otherwise
specifically prohibited by law, render its operation
hazardous or its condition unsound with respect to the
public or to its policyholders.
◦ 7. Failure otherwise to comply with the captive statute.
The IRS Fought Captive
Insurance For Nearly 30
Years
They used three arguments
The Economic Family
Nexus of Contracts
Assignment of Income
No Court Accepted Any of the
IRS’ arguments
Safe Harbor Guidance, Part I
Under Harper v. Commissioner, a captive
must comply with a three prong test:
(1) whether the arrangement involves the
existence of “insurance risk”;
(2) whether there was both risk shifting
and risk distribution; and
(3) whether the arrangement was for
“insurance” in its commonly accepted
sense.
The duck test – does the company “walk
and talk” like an insurance company?
Safe Harbor Guidance, Part II
The IRS has issued several Revenue Rulings that
provide further safe harbor guidance
 A captive must derive at least 50% of its
insurance revenue from a non-parent.
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◦ Harper lowers this amount to 30%
◦ This is accomplished through reinsurance
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Or, a captive must have at least 12 subsidiaries
in order to have sufficient risk distribution.
Private Letter Rulings, or, the
Ultimate Safe Harbor
A Private Letter Ruling (or PLR) is "issued
for a fee upon a taxpayer's request and
describes how the IRS will treat a proposed
transaction for tax purposes."
Private Letter Rulings create certainty – we
know how the IRS will view a specific
transaction
IRS Revenue Rulings:
 Revenue Ruling 2001-31 IRS Gives Up on "Economic Family
Theory"
 Revenue Procedure 2002-75 - Private Letter Rulings on
Insurance Co. Issues
 Revenue Ruling 2002-89 - 50 Third Party Insurance Risk
 Revenue Ruling 2002-90 - 12 Brother / Sister Subsidiary
Requirement
 Revenue Ruling 2002-91 - Spreading of Risk in Captive
Group
 Presentation sourced from F. Hale Stewart, Esq., Author of
U.S. Captive Insurance Law, and Stewart Feldman, Esq. with
permission.
QUESTIONS?