How Does Captive Insurance Work?

Insurance companies are very different from other companies. Other companies have to pay upfront for buying raw materials. They get paid later when they finally sell the product. Also, the difference between their selling price and their buying price is termed as profit which they have to pay taxes upon.

On the other hand, insurance companies function very differently. They collect money today and may have to pay it out two, five or even ten years later. Hence, even if an insurance company has not paid out all the premium received in the same year, that doesn’t mean that they have profited. They may have to pay a claim at a later date. It is for this reason that governments allow insurance companies to set aside huge sums of money as reserves. These reserves allow insurance companies to reduce their profits for the current year and therefore pay fewer taxes.

Tax Advantages

Over time, Fortune 500 companies started realizing that there were numerous tax advantages possible if they could create their own insurance company. For instance, a company like FedEx could pay out a lot of money as insurance premiums. Since these premiums are a legitimate business expense, they would reduce the taxable income and hence would bring down the taxes paid.

On the other hand, the premiums would be received by the group’s own insurance company as income. However, it would not be taxed immediately since insurance companies are allowed to have huge reserves. Hence, in effect, Fed Ex was paying itself the money and was using a different subsidiary to invest the same and earn income.

It is obvious that there are huge tax advantages to using this model. This is why many Fortune 500 companies like Verizon, FedEx, and British Petroleum use captive insurance companies. These companies are basically very sure about the prudence with which they run their business. Hence, they are of the opinion that why should the AIG’s and the Zurich’s profit from their prudence. Since they have the financial wherewithal to manage their own risks, they are setting up their own insurance company.

What Is A Captive Insurance Company?

A captive insurance company is just like any insurance company in the eyes of the law. This company needs a proper license to operate. Also, captive insurance companies must follow due process and are subject to all kinds of regulations that any normal insurance company is. Hence, from the regulator’s point of view, there is actually no difference between a captive insurance company and a regular insurance company.

The real difference is that captive insurance companies only serve entities related to one corporate group. On the other hand, regular insurance companies have a wide variety of clients. Hence, logically, the captive insurance company is simply an extension of the same company.

Arm’s Length Premiums

It is also important to note that since the captive insurance company and the insured companies belong to the same corporate group, the principles of transfer pricing apply. This means that the insurance company must make sure that the premiums that they collect must be in line with the premiums that other insurance companies collect. If insurance companies start charging excessive premiums, then it becomes a case of tax evasion. This issue becomes even more severe when captive insurance companies are located in known tax havens. This is why in some jurisdictions it is important for captive insurance companies to explain their premium calculation process, i.e. their underwriting process to regulators.

Payback

Captive insurance companies are just like any other insurance company. This means that they are also allowed to pay dividends to their shareholders when they make a profit. Also, since profits have already been taxed, dividends are usually not taxed in most jurisdictions around the world. Hence, this becomes a very cost-effective way for captive companies to pay back the money to their parent companies. Firstly, the tax liability is reduced by using reserves. Then the money held in reserves is invested to make even more money. Finally, the profit earned is paid back tax-free to the parent company! No wonder, some many Fortune 500 companies want a piece of the captive insurance action.

Lines of Business

From a legal standpoint, captive insurance companies are allowed to undertake any risk that a normal insurance company would be allowed to undertake. This means they can underwrite various types of policies such as workman’s compensation claims, general liability policies, auto insurance, etc. However, it is possible that the captive company may not want to undertake all the risks. Hence, in such cases, the captive insurance company does have access to the reinsurance market. It is, therefore, possible for insurance companies to decide exactly what kinds of risks they want to undertake vis-à-vis the kinds that they want to outsource.

The conclusion is that there are lots of benefits for using captives to insure risks in the normal course of business. This is the reason why close to 90% of Fortune 500 companies use captive insurance. About 50% of all the insurance in the world is underwritten by captives. Many critics argue that captive insurance companies are only being used as a tool for tax evasion. However, since there is nothing illegal about the business, there is nothing that the government can do to stop this.