Understanding The Taxation Of 831(a) Insurance Companies

Under the tax code law, business owners are permitted to create what is referred to as “captive” insurance companies to mitigate certain risks. Under the traditional captive insurance law, the insured business owner is allowed to claim deductions for any premiums paid on insurance policies. Those premiums are paid directly to said captive insurance company which is owned by the business owner and/or captive management partners. Captive insurance companies can be formed under various IRS codes. In this article, we’re going to focus specifically on code 831(a) and what it could mean for you and your business in terms of risk management.

What Is A Captive Insurance Company?

A captive insurance company is either a direct C-corporation or a business entity that is taxed as a C-corporation. The purpose behind this type of insurance company is to have the capacity to write property and casualty insurance to a smaller group of insureds. The basic captive insurance structure is as follows: A corporation that has one or more subsidiaries sets up a captive insurance company that groups all subsidiaries and defines them as one whole entity. Under this legal structure, the captive insurance company as a whole may operate as a licensed insurer, under which risks are identified and evaluated and policies and premiums are underwritten. From there, the subsidiaries pay the deductible tax premium payments set by the captive insurance actuarial partners. In turn, they invest those premium payouts into future claim payouts. As far as captive insurance best practices go, all risk transfer concepts are in the control of the captive insurance company's owner. In essence, the business owner has more control over their taxation with a captive insurance company than they would with a standard commercial insurance company.

831(a) Aka: Regular Captive Insurance Companies

The most common type of insurance captive insurance companies are referred to as “single-parent captive insurance companies”. These single-parent captive insurance companies typically insure the risks of the parent company, its subsidiaries, and employees. It can also be its own subsidiary company. As previously mentioned, there are various codes in which captive insurance companies can be formed. The one we’re discussing in this article is the 831(a) captive insurance, aka “regular captive insurance companies”.A regular captive insurance company is defined by the size of the premium and the taxation of the actual insurance company. The 831(a) captive insurance companies are best for larger corporations that can meet annual premiums of $2.3 million or more. Regular captive insurance companies function like any C-corporation or corresponding entity, only their taxation is based on the corporate level of their premium as well as their investment income. Despite being taxed on their premium income, they are allowed to deduct legitimate expenses. If these deductions are sufficient enough, they may be able to avoid premium income taxation altogether. This is especially beneficial since regular captive insurance companies being treated as a C-corporation are not taxed on capital gains.

Financial Benefits Associated With 831(a) Regular Captive Insurance Companies:

There are several benefits associated with being a regular captive insurance company including (but not limited to):

• Tax deductible loss reserves
• Increased income tax efficiencies
• Direct access to the reinsurance markets
• Coverage tailored to your specific needs
• Greater control over claims
• Improved cash flow and investment income to fund losses
• Flexibility in policy and underwriting
• Increased coverage and capacity
• Reduced operating costs
• Favorable taxation rates
• Asset protection
• Fewer government regulations and interference

Arguably, the greatest benefit of regular captive insurance is that you essentially are in the insurance business. Many business owners enter the “insurance business” for the sole purpose of controlling their overall insurance costs, only to discover the other benefits that come with underwriting their own profits.

How To Become A Captive Insurance Company

If you’re thinking about getting into the insurance business, the first thing you need to understand is that your actual tax benefits must be considered a qualifying insurance company on their own by the IRS. Those tax benefits include the amounts paid to the “captive insurance company” which are deductible as insurance premiums. To meet the qualifications of an “insurance business” there are two requirements: risk shifting and risk distribution.

Risk Shifting

Risk shifting involves risk transfer concepts such as transferring all financial consequences in terms of economic losses to another party. This way, the loss does not directly affect the insured, aka the business owner. Risk shifting is a much easier requirement to meet than risk distribution.

Risk Distribution

Risk distribution involves risk transfer concepts such as distributing any potential liabilities to multiple parties. This would involve the statistical concept referred to as the “law of large numbers”. This concept allows the captive insurer to minimize the chance of a single claim exceeding the amount of premiums they’re taking in. Captive insurance is a complex financial concept that will indeed benefit the right business owner. To learn more about Captive Insurance, be sure to read the following article that talks about 831(b) insurance companies.

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