Captive insurance, honestly

In short

A friend of mine runs a small manufacturing company, and he once asked me whether he could just insure himself and call it a day. If you own a business that pays real money for insurance every year, you have probably wondered the same thing. A captive is an insurance company that a business owner sets up to cover that owner's own business risks. The company pays premiums to it, and the captive pays claims when they happen. The tax rules are strict, because the Internal Revenue Service wants to see real insurance and not a tax trick with a nice name. Before anyone thinks about one, the owner should know what it costs, what the law requires, and how often these plans get challenged.

The whole of it

What it is

I once sat on a porch with a man who had paid the same insurance bill for twenty years and never filed a claim. He said it felt like feeding a horse that never pulled the plow. That feeling is where captive insurance comes from.

A captive is a small insurance company owned by the business it insures, or by the owner's family. The business pays premiums to the captive. The captive holds that money in reserve and pays claims out of it. If claims run low, the money stays inside the family of companies. If claims run high, the captive pays them, and it may buy reinsurance, which is insurance for insurers, to cover the big ones.

Some plain facts help here. A captive is a real company with real rules. It needs a license from a state or a foreign place, and it must keep records and file reports. Section 831(b) of the Internal Revenue Code lets a small insurer pay tax only on its investment income if its premiums stay under a yearly cap. That cap is the current figure, which the official source publishes each year. This is the part that draws most of the attention. It is also the part that draws most of the scrutiny.

How it works

If you are holding a business that pays $180,000 a year for liability, property, and other cover, here is the plain picture. The business buys the coverage it already needs from regular insurers. It may also pay premiums to its captive for risks that the regular market covers poorly or not at all, such as a key supplier shutting down or a cyber event beyond the policy limits.

The business deducts the premiums as an ordinary expense, but only if the arrangement counts as insurance. The IRS looks for risk shifting and risk distribution. Risk shifting means the business truly hands the risk to another entity. Risk distribution means the captive pools many different risks, so no single claim sinks it. The premiums must also be set at arm's length, meaning a price a stranger would call fair. The Internal Revenue Service has said in Notice 2016-66 that some small captive deals are transactions of interest, and the people who promote or take part in them have to disclose them on a form.

Then comes the captive itself. It pays its own costs: a license fee, a manager, an actuary who prices the risk, an auditor, and legal help. Those costs are real and they come every year.

The numbers, and where to find yours

You have probably heard that costs run high, and that is fair. Setup fees, yearly management, an actuary's study, and a tax return for the captive all add up. Quotes vary a lot from one firm to the next, so an owner should ask for every fee in writing and add them up.

The premium cap lives in the tax code. It is the current figure, which the official source publishes each year for the current year. The diversification test under the same section has its own percent thresholds, and those are the current figure, which the official source publishes each year. Both figures change over time, so check the current text of Section 831(b) of the Internal Revenue Code, or the IRS page on small insurance companies, before relying on any number.

To find your own numbers, start with your current insurance bills for the last three years. Add up what you pay in premiums and what you have received in claims. That gap tells you how much room a captive might even have to work with. Then ask a licensed captive manager for a feasibility study, which is a written report on whether the plan makes sense for your company.

A worked example

A woman I will call Dana owns a landscaping company in Ohio. She pays $140,000 a year to regular insurers and has filed claims worth $22,000 over five years. She also worries about a few risks her policies exclude, such as a long shutdown after a storm.

Dana hires an actuary, who prices those uncovered risks at $90,000 a year in premium. Dana forms a captive and pays it $90,000 each year. Her yearly captive costs look like this. The license and filing fees are $8,000. The manager charges $25,000. The actuary charges $12,000. The audit and tax return cost $10,000. Legal help adds $5,000. That totals $8,000 plus $25,000 plus $12,000 plus $10,000 plus $5,000, which is $60,000 a year.

So of her $90,000 premium, $60,000 goes to running the captive. Only $30,000 is left to build reserves for claims. If no claim comes, her reserve grows slowly. Say it grows by $30,000 a year for ten years. That is 10 years at $30,000, or $300,000, before any investment earnings and before any tax on how the money comes out.

Now suppose a storm closes her company for two months and the loss is $200,000. In year two, her reserve holds only $60,000. The captive cannot pay the claim in full unless it bought reinsurance. Dana learns what insurers know well. Reserves take years to build, and a claim does not wait.

Her tax picture matters too. She deducts $90,000 a year in premiums if the arrangement qualifies as insurance. If the IRS later decides it does not, the deduction can be denied, and she may owe back tax, interest, and penalties on every year in question.

Where it goes wrong

I have watched good people get talked into things at a dinner table. The warning signs for captives are common enough that the IRS has named them in public.

The first trouble is a deal sold mainly as a tax saver. The IRS has said that a plan built around the deduction, with little real risk behind it, may not be insurance at all. The courts have sided with the government in several cases, including Avrahami v. Commissioner and Reserve Mechanical Corp. v. Commissioner, and the Tax Court looked closely at how those arrangements were built and run. Both cases are public, so an owner can read them.

The second trouble is premiums set far above what the risk is worth. If the actuary prices the cover at $30,000 and the owner pays $150,000, the extra looks like a transfer of money and not a purchase of insurance.

The third trouble is a thin pool. If a captive insures only the owner's own business, or swaps risk with a few friends, the risk may not be truly spread. The fourth is loose handling. A captive that lends money back to the owner, skips its own paperwork, or pays claims late looks like a pocket and not a company.

Fifth, the costs. A captive that eats most of its premium in fees has little left to do its job. And last, getting out. Closing a captive can trigger tax on what is inside it, and the owner has to plan for that on the day it opens.

Questions to answer before you leave this page

Have you added up what you pay for insurance now, and what you have actually received in claims over the last five years? Do you have a real business risk that your regular policies leave uncovered, one you could explain to a stranger without mentioning taxes? Have you asked a licensed captive manager for every fee in writing, and added them up as Dana did? Can your company carry a large loss in the early years, before reserves have grown? Have you read Section 831(b) and the IRS notice on small captives, and found the current premium cap and diversification test for yourself? Who will price the risk, and are they independent of the person selling the plan? And if the plan fails an audit, could your company pay the back tax, the interest, and the penalties? What would closing the captive cost, and have you seen that figure in writing?