by Prof. Beckett G. Cantley
Atlanta’s John Marshall Law School

 

I. Introduction

 

Captive insurance companies (“CIC”) are formed by their owner(s) (“Owner”) to insure or re-insure business risks.  A parent company (or other affiliated company) Owner may form a subsidiary (or related) CIC to issue an insurance policy to the Owner to cover specific risks known to be of particular import to the Owners.

 

Some of the most common generalized risks may include property and casualty, general liability, products liability, or professional liability.  In addition to such normal lines of insurance, captive insurance companies may be used to provide employee benefits.

 

The CIC may insure these risks or may be used as reinsurance by the direct insurer. A CIC can also be used to provide supplemental insurance in addition to things already covered by another insurance company. As supplemental insurance, a CIC may provide coverage for events not normally covered under normal policies, such as high-risk events.

 

A CIC provides an alternative to self-insurance for companies. Unlike with self-insurance, captive insurance provides up front tax deductions for premium payments made, so long as the premiums are reasonable. Amounts set aside for self-insurance cannot be deducted until a loss event has occurred. Thus, captives have a major incentive for companies with many outstanding uninsured risks.

 

The CIC industry has been booming in the U.S. since the 1970s. In addition, captive insurance has been credited for encouraging businesses to better manage their insurance needs. Moreover, the use of captive insurance has also made the corporate insurance market more competitive, which has the effect of improving cost, coverage, service and capacity.

 

II. The Internal Revenue Code Size Requirements

 

The Internal Revenue Code (“IRC”) provides for different levels of CIC, making it possible for a CIC to be designed for any size company. A CIC that seeks to qualify as a “small CIC” can take in up to $600,000 in premiums per year. A medium “small business CIC” can have premiums between $350,000 and $1.2 million per year. A large CIC allows for total premium amounts in excess of $1.2 million. The CIC format is not one-size-fits-all, and each size has its own benefits and burdens. A small CIC is a non-taxable entity, while a medium sized CIC is taxed only on its investment income.  Of course, the IRC and related IRS pronouncements and case law require that a CIC be created and operated properly for the tax benefits to be realized.

 

A. Small Captives

 

Small captives are governed by IRC section 501(c)(15), which allows these companies to be exempt from taxation. Currently, a captive can qualify for this as long as its annual premiums do not exceed $600,000. Previously, the maximum limit was set at $350,000 per year. An additional requirement is that fifty-percent (50%) of the gross receipts consisted of insurance premiums for the year. Under this annual premium test, the company’s annual premiums received are conside