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Benefits of Captives: They Can Insure Against Pandemics

Boston Business Journal By Bernkopf Goodman on 07.30.2020
Posted In: Publications, COVID-19

This article was originally published on the Boston Business Journal’s website.  View the article here.

What do the overwhelming majority of Fortune 500 companies have in common? They are in the insurance business and have created wholly-owned insurance companies, referred to as “captives,” to insure risk. Many small and mid-size companies that have subsidiaries or affiliates, including real estate entities, also have the opportunity to take advantage of captives. A captive insurance company is a closely-held insurance company that does not write policies for the general public. A typical captive insurance company insures risks of the captive owner’s businesses that are otherwise unavailable in traditional insurance markets or that are extremely expensive to obtain.

The many pros to captives

If an insurance company with gross premium income of $2.2 million or less (known as a mini-captive) makes an election with the IRS, it avoids tax on its premium income; at the same time, the parent entity that paid the insurance premium to the captive gets a tax deduction for the expense. In addition, because the captive insurance company is a C corporation, it can issue more than one class of stock and can pay out “qualifying” dividends at preferential income tax rates.

Captives provide additional benefits. Captives create a pre-tax loss reserve to address future risks. While captives should not replace existing insurance programs, they may significantly reduce insurance costs while providing expanded coverage in a tax efficient manner.

In the last few months, many companies have unfortunately learned that their insurance companies are denying business interruption claims for losses resulting from the pandemic because there was no physical damage. A captive can insure against pandemics and other non-damage related business interruption events, such as loss of rental income and lost profits. Other typical coverages offered by a captive include owner/firm legal defense expenses, deductibles for third-party insurance, trade losses, customer bankruptcy, tenant loss, supply chain interruption, regulatory fines and cyber theft.

On an annual basis, the premiums paid to the captive in excess of its claims and operating expenses can be made available for investment or distribution to shareholders. An added benefit of captives is that there may also be opportunities for gift and estate tax savings to the shareholders of captives.

Candidates for captives

The use of a captive should be considered for entities that meet the following criteria.

  • Profitable business entities seeking substantial annual tax deductions.
  • Business owners with multiple entities or businesses that can create multiple operating subsidiaries or affiliates.
  • Businesses with $1,000,000 or more in annual profits.
  • Businesses with uninsured or underinsured risk.
  • Business owners interested in personal wealth accumulation and/or estate planning.
  • Determine if a captive insurance company is right for your business.

The formation and administration of a captive insurance company is a complex and involved process. It requires a team approach that includes experienced counsel, a captive insurance manager, a CPA and, in many instances, an actuary. The IRS has been concerned that some captives were and are abusing the captive election and never operated as a true insurance company that insured risks and paid claims. To address these concerns, companies need to make sure that a captive not only meets the necessary formation criteria but also operates in a similar manner to a traditional insurance company. If the rules are followed, captives will provide significant financial benefits and enhanced risk coverage.

Eric Allon and Allen Hankins are real estate and business law partners at Bernkopf Goodman, and Jonathan Korb is general counsel and managing director for Loring, Wolcott & Coolidge, a multi-family office and wealth management firm.