Whether it be choosing a high-deductible insurance policy or declining the extended warranty on a new purchase, people make the decision to self-insure their risks every day. Sometimes it is a thought-out decision, weighing the cost of coverage versus the cost of replacement and likelihood of loss, others it’s a spur of the moment choice.
However, when a business makes the decision to self-insure its risks, there are typically studies performed, the needed level of reserve funds are determined, and post-tax dollars are set aside as reserves. When a loss occurs the business dips into its reserve funds.
Benefits of Self Insurance
There are benefits to self-insurance over traditional insurance. The funds can be invested in areas of your choosing. You have the benefit of making investment income off of the monies set aside. You also control when money comes out of the funds to reimburse losses, rather than rely upon a traditional insurance company, which has an incentive to deny claims, to approve your claim and then wait for reimbursement. However, the money set aside into the self insurance fund is not tax deductible. Only when payments are made from the fund to replace a loss can the business take a deduction.
Captive insurance is a way to couple the benefits of self-insurance with the benefits of traditional insurance. A captive insurer is an insurance company formed by an operating business to insure its risks. Captive insurance companies are licensed by the department of insurance in the jurisdiction in which they are formed. They write insurance policies covering specified risks of the operating business. The operating business pays tax deductible insurance premiums to the captive insurer in exchange for the policy coverage.
Captive Insurance Programs
With a captive insurance program you retain control over the funds and can invest them in areas of your choosing, subject to regulatory oversight and approval of the department of insurance. Captive insurers generally must retain a required minimum reserve level in approved assets. You control the claims reimbursement process. No longer are you at the mercy of a company that has an incentive to deny your claims.
There are other benefits to captive insurance programs as well. A captive insurance company that makes less than CURRENT_PREMIUM_CAP million in premiums can make an election to be taxed only on investment income, meaning all of the premium income received by the captive insurer is tax-exempt to the captive insurer, while still being tax deductible expenses to the operating business. The captive insurer does not have to be owned by the operating business, or in an identical manner. This can open up other planning opportunities in allowing the captive insurer to be owned by junior generations.
Captive insurance arrangements are complex and involve an overlay of insurance law, tax law and regulatory oversight. There are many requirements for a captive insurance program to be treated as a bona fide insurance arrangement. Proper planning and advisory expertise are essential.
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