The document discusses the rationale for forming captive insurance companies. It provides several key benefits of captives including: 1) providing insurance coverage for risks that are unavailable or unaffordable in the commercial market; 2) allowing businesses to deduct insurance premium payments which provides tax savings; 3) giving businesses more control over their insurance programs and claims handling. Overall, captives help businesses better manage their risks at a lower cost compared to traditional commercial insurance.

1. Why? - The Rationale for
Captive Formation
Occasionally a new set of circumstances stampedes the insurance industry herd. Day Care
Centers, Fungus and Mold, Products Liability, Malpractice Issues, E. coli and other “scares”
have been met by withdrawal from markets and major premium increases, with the result
that insurance became unavailable or unaffordable or both. We all love free markets but
insurers portray themselves as the oil and grease that enables the wheels of commerce.
Take away the oil or grease and the commerce machine slows down or stops. To help deal
with these occasional glitches, Congress created legislation intended to provide more
underwriting capital for insurers and make it more feasible for business owners and
professionals to effectively insure themselves on the tax favored basis that admitted
insurers enjoy. Captive Insurance has been sanctioned by Congress.
A Captive owner can fund a fair part of his/her business risk with federal and state income
tax savings that result from the Captive.
A Captive that is viewed by the IRS as an insurance company can turn a tax payment into tax
savings that can be used to fund other business matters and/or increase shareholder
distributions.
As consequences of the above:
The IRS has provided safe harbors.These are guidelines that define what the IRS
views as legitimate insurance ventures (as opposed to tax avoidance scams).
New opportunities for Pre-tax wealth accumulation have surfaced;
Insuring difficult risks has become easier and less expensive.
The overall cost of risk management is dramatically reduced for captive owners.
Captive insurers have become profit centers and the impetus for major job safety
gains.
Specific Observations
Asset Protection
One role of an insurance commissioner is to assure that the insurers under his or her
jurisdiction are capable of handling extraordinary loss. Consequently, the assets of
insurance companies are difficult to attach. As with any other insurer a Captive’s
assets are protected.

2. Leverage with Commercial Insurers
The more money that you spend on insurance, the more that you are of interest to
commercial insurance companies. If you are big enough to own a Captive Ins. Co.,
the prospect of competing for your business becomes more challenging to the big
commercial insurers. Or, they may want to insure you above a large deductible.
Either way, you get more respect.
Availability of Coverage
Certain types of coverage are unavailable or difficult to obtain due to things such as
poor loss experience for an industry or occupation. Medical malpractice is a good
example. With a captive, a business can self-insure such risks on a tax deductible
basis. Additionally, the Captive creates access to reinsurance markets that have a
better overview of real risk.
Avoid commercial insurance premium fluctuations
A Captive can charge consistent premiums while building surplus to sever its owners
from premium fluctuations associated with commercial insurance. When
commercial market premiums are low, as is often the case when interest rates are
very high, the Captive’s risk manager can step outside the captive to take advantage
of artificially low rates.
Captives encourage more careful work habits
When employees become aware that the owner’s money is on the line they tend to
adopt safer work habits and to pay closer attention to their products and
operations. In an environment where insurance is provided by a commercial
insurer, there is no potential to profit other than a vague suggestion of lower
premiums at some uncertain point in the future. But with a Captive, employees
come to know that their special effort pays dividends to their employers.
Recognition by upper management enhances safe thinking.
Cash Flow Benefits
The owner of a captive receives income earned on premium and claims reserves.
Premiums are paid up front while claims are paid out over a longer period. Reserves
accumulate quickly to the owner’s benefit. To the extent that the sum of premium
income plus interest income exceeds the sum of losses, loss adjustment expense
and the portion of premium income used to buy excess and stop loss insurance, the
Captive profits. For the first several years (and subject to actuarial review), nearly all
the profits are typically used to boost loss reserves and are therefore not taxed.
Control over claims handling

3. The Captive contracts with a third party administrator (TPA) to manage many of the
Captive’s affairs, particularly the investigation and settlement of claims. Claims are
settled with the Captive’s money. There are times when most businessmen want to
pay a claim to please an important customer and times when they will want to fight
tooth and nail to not pay a claim. In neither of the foregoing situation will a
commercial insurer likely be helpful. Captives permit some latitude in these
situations.
Cost reductions
When a business owner pays a premium to a conventional insurance company he
gives that insurer, on average, between 35 and 40 cents out of every dollar to cover
the insurer’s costs, taxes, profits and obeisance to Wall Street expectations,
however wrongheaded they may be. With a closely held, privately owned Captive
insurance company, costs and profits are internally controlled. Moreover, there is
no padding for losses suffered by careless competitors. Also, when the owner’s
dollars are on the line, safety tends to improve, as does loss experience.
An Additional Profit Center
A captive can write insurance for third parties. For example, homebuilders,
manufacturers, dealers and retailers use captives to provide warranty/extended
warranty cover for their customers. Claims profiles for this type of business are very
predictable, so the captives make money.
Estate Planning
Business owners who have estate planning objectives will find that Captives can
facilitate their accomplishment. This is one of the main reasons that Captive
Dynamics places so much importance on the selection of a Captive manager that is
well versed in estate planning as well as asset protection, taxation and law.
Reinsurance
Reinsurance is available to insurance and reinsurance companies only. Reinsurance
bought directly by a Captive is generally less expensive than the reinsurance
component of premiums payable to conventional insurers. The Captive advantage
allows a business a wider array of insurance products at less expense.
Subsidiaries Get Extra Benefit From Corporate Muscle
For Captive owners whose subsidiaries are decentralized there may be significant
differences between the levels of risk that each subsidiary can comfortably retain.
The Captive makes it possible for every subsidiary to have large deductibles and
retentions in their commercial insurance policies, thus reducing the parent
company’s overall insurance costs. It is accomplished by enabling each subsidiary to

4. purchase insurance to pay for jumbo deductibles and retentions. Small subsidiaries
gain muscle from the parent.
Taxation
Nearly every web site and book that discusses captives will emphasize that tax
benefits should not form the rationale for establishment of a captive insurance
company. True, but taxation is an important consideration in virtually every business
transaction. When considering, planning or forming a Captive insurance company a
prospective owner will do himself a favor by seeking out a Captive manager who is
proactive on the issue of taxation. All too often, Captive management consultants
who soft-pedal on tax issues simply do not have sufficient understanding of tax law to
confront_the_IRS.
The single biggest advantage of a Captive (an opinion) as opposed to a Combination of
Commercial Insurance and Self Insurance is that the Captive permits its owner to
create loss reserves for otherwise uninsured losses, and to do so on a consistent,
systematic and tax deductible basis. The uninsured losses are typically such things as
Deductibles, Self Insured Retentions and losses excluded by standard insurance
policies. There are many exclusions and the insurers don’t want to cover them so they
are dumped in your lap. In addition to the foregoing, there are dozens of “specialty
lines” of insurance, many of which are only of interest to a fraction of the business
community. They are policies that some business owners would like to have but
cannot afford. They can be written by a Captive at an affordable price and are tax
deductible.
When you are self- insured without a Captive, losses happen, you pay for them and
you have tax deductions. With a Captive, you routinely set aside premium to pay
losses that the Captive will cover. Paid-in premium in excess of paid claims is moved
to reserve accounts for succeeding years. Your premium payments are tax
deductible. Actuarially justifiable additions to claim reserves of the Captive are not
taxable. You begin to see how commercial insurers have grown so large.
When a Captive owner introduces loss prevention technology or rigorous safety and
operational procedures his Captive can charge his constituent companies premiums
comparable to those of commercial market insurers. When his vision of improved
loss experience pans out, all the savings that result from it will flow into the Captive.
Commercial insurers rarely return more than a small fraction of such savings, and
even then it is after they have used your money for a year or more.
Therefore, Captive insurers create major incentive for safe operations. By reducing
net risk management costs they enhance profitability and competitive stature.
Questions? Call 1-760-366-4670 or email to esb@captivedynamics.com
or visit www.captiveinsurance.info