Frequently Asked Questions

How widespread is captive insurance planning?

What goes into forming and operating a captive?                                         

What is a "domicile"?  How do I select a domicile?

Are there benefits to locating in a well regulated domicile?  Or should I select the jurisdiction with the most lax regulation, the lowest capitalization requirements, and in general the one that is least expensive?

What are the tax rules related to captive insurers where the ultimate beneficial owners are U.S. persons?

What are the essential ingredients for a contract of insurance to qualify as bona fide insurance?

What is the purpose of a feasibility study, what information does it contain, and who performs it?  What does a feasibility study cost?

Does a captive insurance program replace my conventional insurance program?  Will my business be insuring all of its risks through the captive or only some of them?

What is the difference between risk management and risk financing?

Does the captive need to have an actuarial review, and does it need to be audited each year by an independent CPA firm?

Is a captive just a tax dodge?

 

 

How widespread is captive insurance planning?

Captives are widely used both domestically and abroad.  For example, A.M. Best, one of the world's most respected information sources on the insurance industry, estimates that there are over 5000 captives worldwide.  While statistics do not exist for the size of the captive insurance market, it is estimated by many professionals to be larger than the conventional insurance market.  Certainly, it is very large by any standard.  Nevertheless, smaller businesses use captive planning much less often than the larger companies with the typical captive sponsor being a Fortune 1000 company with tens of millions of dollars a year of premiums.  Such companies can afford to cover the substantial investment in the formation and administration of a separately capitalized and regulated insurance arrangement.

Mid-sized companies have a more difficult time covering the sizable captive formation and administrative costs and are faced with spreading such costs over much smaller premium volumes.  To address the problem of restraining costs, Capstone developed its turnkey captive program which is specifically tailored to the privately-held, middle-market company with the objective of bringing this planning technique within the reach of the middle market.  Nonetheless, captive planning remains a substantial undertaking, and no business should contemplate use of this type of risk management program unless it is willing to make a long-term commitment of 3 - 5 years to the planning.  In all cases a team of seasoned professionals is necessary to design, implement, and then continuously monitor your captive insurer, which is a full blown insurance company.

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What goes into forming and operating a captive?

Insurance is a highly regulated industry, and the operation of a captive -- just like any other insurer -- requires staying in compliance with multiple regulatory authorities.  The task of forming and operating a captive is a challenge that calls for expertise in many areas and ongoing attention.  Implicit in accomplishing this are the crucial roles played by risk managers, insurance regulatory lawyers, accountants, outside auditors, investment professionals, resident insurance managers, tax lawyers, finance and corporate lawyers, reinsurance specialists, underwriters, and often actuaries, among others.  Coordinating the activities of these many persons calls for a effective overall manager.

Capstone has negotiated preferred arrangements with our suggested team of service providers.  This allows Capstone to provide the full range of needed expertise to form and administer a captive at an affordable price and through one domestically-based company, with just one phone call to us.  Capstone offers affordable captive planning to the middle market, with regulatory & licensing fees, risk management services, resident manager fees, lawyers, accountants, bookkeepers, auditors, and other contracted professionals all included in our turnkey fee.  Where commissioned separately, it is not uncommon to incur first year costs of $250,000.00 or more, which for a small captive with limited premium revenue is not feasible.  Our fees are a function of this.

For a summary of the many tasks involved with captive set up and operation, see our Turnkey Services [LINK] page.

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What is a "domicile"?  How do I select a domicile?

A domicile is the jurisdiction in which a captive insurer is incorporated and regulated.  There are many domicile options, both domestically (i.e., within the U.S.) and internationally.  Many of the factors involved in the selection of the best domicile are included as part of a feasibility study that is coordinated by a qualified insurance professional who can marshal input from other professionals as needed.

Some of the questions that bear on the selection of where to locate the captive include: What is the domicile's image in the insurance industry, and how politically stable is it?  Is there a supportive infrastructure for needed captive services?  Is the domicile respected by reinsurers and fronting companies, and what is the local tax structure?  More detailed analysis involves addressing issues such as: capitalization and solvency requirements, initial and ongoing fees and expenses, and specific regulatory requirements regarding approval of coverage forms and types of coverage permitted, policy pricing, loss reserves, minimum premiums, and admissibility of various classes of investment assets. 

Even a foreign (i.e., non-U.S.) insurer not operating in the U.S.,  where it is beneficially owned by U.S. persons, comes under U.S. tax law and is subject to U.S. tax.  This is the case even where, for example, the captive is domiciled in Bermuda.  Under certain circumstances, a foreign insurer can elect to be treated as a domestic corporation.  When this election is properly made, the captive operates as if it were a U.S. insurer, just like any domestically domiciled insurer.  Again, in all instances it is subject to U. S. tax laws.

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Are there benefits to locating in a well regulated domicile?  Or should I merely select the jurisdiction with the most lax regulation, the lowest capitalization requirements, and in general the one that is the least expensive?

There are many things to consider when choosing a domicile, whether such is domestic or international, with some of the international domiciles being better suited for smaller captives.  Offshore domiciles are monitored by the Organization for Economic Cooperation and Development ("OCED"), the International Monetary Fund ("IMF"), and other international monitoring organizations in order to ensure that the domicile meets international standards, ensuring compliance with financial controls to prevent money laundering, tax fraud, etc.  In less regulated jurisdictions, the absence of strict compliance with these international standards can be a concern.  In general, only a bona fide regulatory jurisdiction should be considered.  Capstone encourages this.  Of course, a bona fide jurisdiction can be onshore or offshore. 

A major consideration in selecting a domicile should be the availability of support services which will be needed by the specific captive; such infrastructure support services include local professionals with the requisite work experience, acceptability of the domicile to reinsurers, regulators with specialized knowledge of the captive's industry.  Also, the best approach for finding the domicile that best fits your particular needs is to conduct a properly implemented feasibility study. 

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What are the tax rules related to captive insurers where the ultimate beneficial owners are U.S. persons?

There are both federal and state tax issues to consider.  At the state level, most jurisdictions levy a "premium tax" (variously labeled as "independently procured premium tax" or "self-procured insurance tax") that runs 3% - 5% of the gross premium.  This tax is the equivalent of a state sales tax targeted at insurance policies from non-admitted carriers, and historically, has been levied against the insured rather than against the insurer.

At the federal level, there is a 4.5% excise tax to consider as well as income tax rules.  Federal excise taxes are eliminated by non-U.S. domiciled captives electing to be taxed as U.S. insurers, waiving as well the benefit of any tax treaties.  There are also several sections of the Internal Revenue Code ("IRC") that must be mastered to properly determine the income tax position of a particular insurance company.  Some IRC sections provide certain income tax advantages for smaller insurance companies to help them level the playing field with their larger, multi-billion-dollar insurance company competitors.  Overall, this is a complex area of the tax law, and consultation with a tax expert qualified to advise in this area is strongly advised.

Also, in addition to the tax area, there is a whole host of state insurance laws and regulations relating to the location of the insureds which must be navigated in designing a captive insurance program.  This is all in addition to the regulations governing the captive insurer in its home domicile.

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What are the essential ingredients for a contract of insurance to qualify as bona fide insurance?

Generally accepted criteria for insurance include:

(a) Bona fide insurance must involve a contract between an insured and an insurer providing indemnification or reimbursement by the insurer to the insured for loss from an insurable risk.

(b) There must be a transfer or shifting of risk.  In a conventional insurance arrangement, this criterion is easily met because the insurer is unrelated to the insured.  In a captive insurance arrangement, this criterion must be shown by means of formal contractual transfers of risk.  These companies can be related, and usually are best structured as brother-sister subsidiaries within the same group of companies.

(c) There must be sufficient distribution of risk.  Sufficient risk distribution may be accomplished by means of reinsuring (assuming) risks underwritten by unrelated insurance companies or by directly writing sufficient coverage for unrelated persons.  In any case, the specifics of each situation must be evaluated, and differing risk distribution structures should be considered to meet the objectives of each plan.

And of course, the captive should be licensed by the domicile to engage in the lines of business that it is underwriting.

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What is the purpose of a feasibility study, what information does it contain, and who performs it?  What does a feasibility study cost?

As its name implies, a feasibility study determines the practicality of the formation and operation of a captive insurance company for a particular business entity.  It also explores alternative risk financing mechanisms available to the insured  Although studies are not required by all domiciles, the feasibility study is a key component to establishing the appropriateness of alternative risk planning and are a component of good planning.  Additionally, a feasibility study helps establish the bona fide business reasons for a captive's formation.  Where required, some domiciles also specify the format in which the final report must be presented.  Some require that a formal actuarial study be carried out as well.

As a practical matter, a feasibility study should be conducted whether it is required by the domicile or not; the foremost reason for doing such a study is that it provides management with a formal  and contemporaneous compilation of the key factors that went into evaluating the practicality of adopting such planning given their objectives.

Most studies will include a general section on the background of captive insurance companies and their advantages and disadvantages, how the proposed captive sponsor addresses these advantages and disadvantages, and a comparison of captives with other alternative risk management options.  The study will also include a summary of the captive sponsor's business operations and its goals with respect to forming a captive insurer, addressing pricing inequity examples, market condition issues, and loss control issues.  The substance of the study includes a detailed selection of coverages to insure, a discussion of how policy pricing and loss reserves will be determined (sometimes actuarial data is required), a segment identifying the preferred domicile(s), and sometimes a set of financial statement forecasts for the captive's initial years of operation.

Capstone customarily provides a feasibility study as part of its turnkey fee.

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Does a captive insurance program replace my conventional insurance program?  Will my business be insuring all of its risks through the captive or only some of them?

A captive insurance program is generally designed to provide the consistency of a stable insurance environment for a particular coverage or set of coverages.  Sometimes it replaces parts of your conventional insurance program, sometimes all of it and sometimes none of it.  More frequently, a captive program fills the many gaps in conventional coverages or replaces certain parts of that program.  In general, the best types of coverages for a captive are those that (i) have premiums that fluctuate significantly from year to year; (ii) where a client's loss experience is different from others in its industry causing a pricing inequity in premiums; and (iii) other coverages that are not practically available on consistent and comprehensive policy forms and at fair prices.  Also, the comprehensiveness of a captive insurance program should be evaluated in light of the risk tolerance of the insured.  For example, some insureds are very risk averse and seek out a comprehensive risk program that significantly reduces the volatility of losses. These matters should be addressed in further detail in a feasibility study.

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What is the difference between risk management and risk financing?

Risk management is a general term referring to the identification, quantification, and handling of all the risks your business is subject to.  Risk management includes safety programs, contractual "hold harmless" agreements, regular legal review of your internal procedures, and other non-financial methods of addressing identified risks.

Risk financing is a process that identifies the most efficient way to finance an identified risk.  In many cases where insurance is readily available through the conventional marketplace at affordable prices, the answer is to buy conventional insurance.  In cases where insurance is not readily available or not affordable, risk financing includes the analysis of other options, including  self-insurance (i.e., setting up and paying into reserve liability accounts), and forming a captive insurer.

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Does the captive need to have an actuarial review, and does it need to be audited each year by an independent CPA firm?

Respected domiciles will require an annual audit by an independent CPA firm or its equivalent, with industry specific experience in the insurance industry.

Many domiciles require a formal actuarial review of your captive's policy pricing and loss reserve methodology, while some jurisdictions do not.  Absent a formal actuarial review of premiums and loss reserves, your captive will, nevertheless, need to properly document its policy pricing and loss reserve methodology.

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