- Robert Ferguson
What is Reinsurance?
Updated: Aug 30
Chances are, you are already familiar with the term Reinsurance (sometimes call a "captive" or “micro-captive”). If you’re not familiar with this increasingly popular, powerful and flexible captive structure, you should see if this middle-market platform is right for your business. Read on.
COMMERCIAL INSURANCE: CAPTIVES AND TAX ELECTIONS
What Is It?
A captive that may be taxed, which provides that a captive qualifying to be taxed as a U.S. insurance company may pay tax on investment income only in any year that its written premium is at or below the threshold for the applicable tax year, which in 2017 was set at $2.2 million or less with the premium cap subject to inflation adjustments. Today, the cap is $2.65 million annually per structure.
Forming your own captive insurance company to reap this financial benefit sounds like a no-brainer, but it’s vital that you keep in mind the following characteristics that must be met in order to conform to the definition of “insurance company:”
Business purpose must be legitimate: your captive’s primary activity must be insurance, and it needs to be operated like an insurance company
Premiums and policies must be market-comparable and risk-based
Initial capitalization must be adequate: a 4:1 premium to capital ratio is a good rule
It must meet the requirements to be considered an insurance transaction, which means two very important features must be present:
Risk transfer – the shifting of risk from one party to another. There must involve a significant chance of loss to meet this requirement.
Risk distribution – risk can be spread amongst one or more entities
What’s Covered?
Often, the micro-captive reflects business risks which are uninsured or under-insured (not currently covered by business owner's commercial P&C provider). Examples can include:
Business Interruption (domestic terrorism or pandemic)
Gap fillers
Deductible layers
Cyber risk
Directors & Officers
Intellectual property
Errors and Omissions
Warranties
Malpractice
Legislative Risks
Reputational Risks
Keyman
Loss of Key Client/Customer
Loss of Key Vendor
Legal Risks
Generally, if a potential liability exists for the captive owner and an actuarially-supported premium can be developed.
What Industries?
While 90% of franchise automobile dealers have successfully used micro-captives since the 1970s, ANY business which has risks (which is all of them) should explore this powerful and flexible business tool signed into law by congress and President Ronald Reagan in 1986. There is a reason 92% of Fortune 500 companies use some sort of captive and more than 70,000 middle-market business have adopted a micro-captive strategy. Industries which typically participate include:
Agriculture and Agribusiness
Automobile
Aviation and Aerospace
Construction
Law Firms
Health/Medicine
Hospitality & Restaurants
Manufacturing
Medical and Dentistry
Oil & Gas/Energy
Real Estate and Development
Retail and e-Commerce
Technology
Transportation
...many more
What Are Next Steps?
If you can meet the above requirements, Reinsurance might be a good choice for you. However, due to their popularity and subsequent abuse, this structure came under scrutiny by the IRS due to some non-compliant structures (notable cases were prevalent in 2016). Since associated tax-advantaged benefits and asset protections are significant, it’s been oversold by accountants, wealth managers, financial planners and the like, often without meeting the requirements listed above (e.g., not using a licensed, third-party actuarial assessment to correctly identify risk exposures).
It’s vital that you reach out to a seasoned resource and subject-matter-expert representing a legitimate service provider - preferably one with a team of experienced professionals, hundreds of established clients and decades of IRS approval letters/positive testimonials within the industry. These top providers will help determine your eligibility and discuss how to proceed.
To learn more about setting up a captive insurance company, contact us today. At Reinsurance Specialties™, we help business leaders mitigate business risks, adjudicate claims, protect assets and build wealth through tax-advantaged premium.