Captive InsurersWhat is a Captive Insurance CompanyTypes of CaptivesHistorical DevelopmentReasons for GrowthTaxation of CaptivesCaptive FunctionsRisk Retention Act of 1986Current Issues Regarding Captives

What is a Captive Insurance Company?

Established to insure the risks of the parent company

A form of self-insuranceUsed by large corporations with sophisticated risk

management programsUsed by companies with unusual or hard to insure

risksCaptive insurers are alternatives to buying

insurance from a traditional commercial insurer

Prime Locations for Captives

Bermuda

Cayman Islands

Vermont

Guernsey

Types of Captives

Pure Captives

Insure the risks only of its parent company and its affiliates

Association Captive

Established by a group of independent but similar companies to write coverage on those companies

Historical DevelopmentEarliest captives – 1800s

RailroadsNew England textile manufacturers (Factory Mutual)Formed to obtain coverage at reasonable prices

Later trend –1950sU. S. companies transforming to multinationals

Next expansion – 1960sProperty insurance availability problems

Growth in 1970s and 1980sMedical malpractice marketProduct liability market

Risk Retention Act of 1986

Reasons for Growth

Tax benefits

Insurance availability problems

Reduced cost of insurance

Improved cash flow

Profit center

International capital market movements

Taxation of Captives - 1Insurance companies can deduct losses when they occur

Non insurance corporations can only deduct losses when they are paid

Insurance premiums paid by corporations to commercial insurers are tax deductible

Income earned by U.S. corporations is taxed by the U.S.

Income earned by foreign corporations is taxed (or not) by that country

Taxation of Captives - 2

Ideal tax position:1. Parent company deducts premiums paid to

captive2. Captive insurer deducts losses when incurred3. Parent is not taxed on income of foreign captive

until profits “repatriated” (brought back to the U.S.)

Unfortunately for corporations, this ideal position is not allowed

Taxation of Captives - 3

Premiums paid to a captive are not deductible unless the captive is a true insurance company

A captive is not a true insurance companies unless it:• Writes substantial amounts of coverage with

unrelated entities (Sears – Allstate)• Is group ownedTaxation of Foreign Captive Income Tax Reform Act of 1986

Current taxation of income

Captive FunctionsFronting Company Arrangements

A licensed insurer writes the coverage and reinsures all or almost all of it with the captiveObligations of the fronting company

Captives as ReinsuresParent company’s riskUnrelated risks

Problems of mid-1980sRent-A-Captive

Current Issues Regarding Captives - 1

United Parcel ServiceUPS captive, Overseas Partners Ltd, held to be a tax dodgeUPS liable for $65 million in taxes for 1984 ($300 million including interest and penalties)Class action lawsuit for $14 billion for insurance fraud relating to captiveClaims that UPS overcharged shippers for insurance from captive

Current Issues Regarding Captives - 2

Gold Medal InsuranceCaptive of General MillsRefused to pay a claim for $169 million for pesticide contaminated grainGeneral Mills sued Gold MedalVerdict for General Mills