A captive insurance business is a completely owned subsidiary insurer founded to provide risk management services for its parent firm or other linked entities. Captive insurance companies are also known as risk retention groups. Many different situations might lead to the formation of a company’s “captives,” including the following examples:
- The parent company has been unsuccessful in locating an appropriate outside provider to insure it against certain business risks.
- The tax benefits come from the premiums paid to the captive insurer.
- The premiums for the insurance that is offered are lower.
- It provides better coverage (or coverage at a lower cost) for the unique risks faced by the parent company.
- There is a distinction between a captive insurance business and a captive insurance agent, the latter of which can only sell the company’s own policy and not any other insurer.
How to Understand Captive Insurance?
To protect their assets, many large corporations use captive insurance companies. Although it may be advantageous for a company to spin off an insurance subsidiary, it must weigh this decision against the cost of hiring extra staff and covering other administrative expenses. Complying with regulations is another complicated factor. So, captive insurance businesses often use standard insurers to cover some risks for the parent companies.
What Are the Tax Concerns of Captive Insurance Companies?
The tax implications of having a captive insurance firm are not overly complicated. The parent company has its own captive insurance company and provides insurance premiums to that firm. The parent company then attempts to deduct these payments in its home nation, which is typically a high-tax state.
Suppose a parent business wants to protect its captive insurance company from unfavorable tax effects. In that case, it can establish itself in a tax haven like Bermuda or the Cayman Islands. Captive insurance firms can now be formed in several states across the United States. The parent firm values the benefit of being shielded from further tax assessment as much as possible.
The parent company may be eligible for a tax benefit depending on the type of insurance the captive insurance company deals with. To be classified as “insurance” by the Internal Revenue Service (IRS) in the United States, a transaction must involve risk transfer and payment for its assumption. Those captive insurance firms suspected of abusive tax avoidance have been notified that the IRS will be taking action.
The captive insurance firm may be forced to declare bankruptcy if it incurs high costs due to exposure to certain risks. A large private insurer’s diverse risk pool reduces the likelihood that a single incident will lead the insurer to go bankrupt.
Insurance is a substantial expense for large enterprises. Businesses can use captive insurance companies to keep expenses under control, take advantage of tax benefits, and protect themselves against hazards that commercial insurance providers may be unable or unwilling to insure. Although establishing a captive insurance company can be tough, competent captive managers from a third party can assist businesses in navigating the process and avoiding costly errors.