To Captive? Or Not To Captive?

The captive insurance market is booming, but that doesn’t mean a captive is a good choice for every business. Forming a captive insurance company can be a great idea, if you’re the right kind of business and you’re forming it for the right reasons.

And, while there’s definitely a perfect time and place for a captive, forming one for tax reasons isn’t it. Unless, of course, you enjoy fighting with the IRS.

A captive can be a great risk management and risk transfer tool. In fact, as far as the IRS and most regulators are concerned, you’d better be thinking about it as a risk management tool. You also need to remember that captives aren’t for those with short attention spans. A captive is a long-term play requiring a significant capital investment; and if you aren’t willing to view it as such, a captive isn’t right for you.

A captive also requires a significant commitment to loss control. That’s one of the things that makes a captive a great risk management tool—it forces you to look closely at your losses and take steps to control them. If you’re not willing to make that commitment, again, a captive isn’t right for you.

Basically, a captive is the sort of risk transfer play that works best for a stable long-term entity. If yours is a family-owned business that’s planning to buy and hold companies, you might be the perfect prospect for a captive. Among other sorts of businesses, staffing firms could be good captive insurance candidates, for example, so can trucking companies.

On the other hand, a captive might not be the right idea for a private equity firm. A P.E. business wants to buy and sell target companies quickly to deliver returns to investors as soon as possible. The relatively long-tail exposures that can exist on a captive’s books don’t play well in that scenario. Similarly, a captive might not be the right call for any business that has a large and regularly changing shareholder or equity base, businesses like law firms or insurance agencies.

For some businesses, a group captive might make sense. Any group captive, though is an arrangement you want to enter with your eyes wide open. You probably don’t want to have the group’s only A risk management player—remember, you’re tied to the experience of all the other members of the group and you don’t want them dragging you down. Rather than the only A player, you might be better off being the D player in a group captive setting.

For many mid-size and even small businesses the Internal Revenue Code’s section 831(b) can provide an additional captive benefit. Captives choosing an 831(b) election are taxed only on investment income so long as their annual premiums don’t exceed $2.2 million. Again, though, think long and hard about why you’re forming the captive. Genuine risk transfer has to come first—the IRS has been turning a keen eye lately in the direction of so-called “microcaptives” formed strictly with tax advantages in mind.

“We think it’s clearly on the IRS’s radar and they’ve clearly earmarked it, so we think you don’t want to play on the fringe, you don’t want to be very aggressive,” said Tom Montgomery, a partner at Montgomery Coscia Greilich L.L.P. “We do think the business aspects have to be substantial, and it can’t be primarily for tax purposes.” But, if you do approach a captive with legitimate risk and genuine insurance needs, there are tax benefits to be had, he said.

“At the end of the day I think what you have to do is treat a captive as real insurance,” Montgomery said. “I would play middle of the road. I would be very conservative—make sure you have real risks that you’re underwriting. We think that will play out long-term for our clients.”

Ultimately, there’s a perfect time and place for captives. They can be a great risk financing tool, if yours is the right kind of business and you’re willing to embrace a captive as a long-term play. And always, always place risk transfer ahead of any tax considerations. Unless you enjoy visiting with the IRS.

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