A captive insurance company (“captive”) is an insurance company that is created by the parent organization to underwrite the insurance needs of its operating affiliates. An oil company might, for example, form a captive insurance company to provide environmental cover to its various exploration, refining, and transportation subsidiaries.
The goal of a captive is to reduce insurance costs, by having the captive retain the underwriting profits that might ordinarily be lost to the third-party commercial insurance carriers from whom the business previously bought its insurance.
But of course, one might suggest, the business doesn’t need an insurance company to do that — it could simply self-insure against these risks internally by setting money aside for claims. The fallacy of that argument is that risk and liabilities often last for many years, but the business can only lawfully deduct in a given year the amount of claims that it pays out.
The benefit of a captive is that the business is allowed to take a current-year deduction now for risks that might not materialize or be paid until some years in the future. That, in a nutshell, is why businesses form captive insurance companies as opposed to simply self-insuring themselves by setting aside internal reserves.
For a captive insurance arrangement to be valid, as opposed to a disguised self-insurance arrangement, the captive must engage in the spreading of risks among many insureds, what is known as “risk distribution”. Here, the IRS has given us two safe harbors to determine if risk distribution has been met.
In Revenue Ruling 2002-90, the IRS said that if the captive was insuring at least 12 insureds, with each insured having between 5% and 15% of the total risk (not premiums) in the captive, then risk distribution exists even if all the insureds are wholly-owned by the same common parent as the captive. Nearly all of the largest American companies now have captive insurance companies, and nearly all of these meet the requirement of risk distribution by this method. This safe harbor is known as the “12 insured” safe harbor
A captive insurance company (“captive”) is an insurance company that is created by the parent organization to underwrite the insurance needs of its operating affiliates. An oil company might, for example, form a captive insurance company to provide environmental cover to its various exploration, refining, and transportation subsidiaries.
ReplyDeleteThe goal of a captive is to reduce insurance costs, by having the captive retain the underwriting profits that might ordinarily be lost to the third-party commercial insurance carriers from whom the business previously bought its insurance.
But of course, one might suggest, the business doesn’t need an insurance company to do that — it could simply self-insure against these risks internally by setting money aside for claims. The fallacy of that argument is that risk and liabilities often last for many years, but the business can only lawfully deduct in a given year the amount of claims that it pays out.
The benefit of a captive is that the business is allowed to take a current-year deduction now for risks that might not materialize or be paid until some years in the future. That, in a nutshell, is why businesses form captive insurance companies as opposed to simply self-insuring themselves by setting aside internal reserves.
For a captive insurance arrangement to be valid, as opposed to a disguised self-insurance arrangement, the captive must engage in the spreading of risks among many insureds, what is known as “risk distribution”. Here, the IRS has given us two safe harbors to determine if risk distribution has been met.
In Revenue Ruling 2002-90, the IRS said that if the captive was insuring at least 12 insureds, with each insured having between 5% and 15% of the total risk (not premiums) in the captive, then risk distribution exists even if all the insureds are wholly-owned by the same common parent as the captive. Nearly all of the largest American companies now have captive insurance companies, and nearly all of these meet the requirement of risk distribution by this method. This safe harbor is known as the “12 insured” safe harbor