Increase in Premium Limits Could Be Big Opportunity for Small Captives

Late in 2015, legislation was passed that changed the qualifications for small captive insurance companies to make a special tax election. IRS scrutiny of these small captive vehicles has been widely documented, and Congressional law changes looked to curb some of the perceived misuses and abuses by captive owners over the past several years. This new legislation, however, also provided some valuable positive aspects for current and future captive owners.  There were three primary impacts of the 2015 change in law, which became effective on January 1, 2017. Paraphrasing the legislation as we interpret it, the impacts were:

1. Captive ownership may not include a wealth transfer component (i.e., removing estate planning and trust mechanisms).  That is, ownership of the captive must sufficiently match ownership of the insured entity if heirs are involved.

2. The premium limit of US$1.2 million annually, which had been in place since the inception of the 831(b) election, increased to $2.2 million annually and will be adjusted for inflation thereafter. Effective January 1, 2018, the premium limit will increase to $2.3 million annually.

3. There will be some level of reporting requirements for captive owners. Congress has yet to clarify the requirements, but presumably it will include a means to comment on how captives are able to qualify for the 831(b) election and will include ownership information to help ensure compliance with the proscription against wealth transfer mechanisms in captives.

The clear loss for captive owners centered on ownership limitations. Many captive owners had used estate planning in captive ownership structures to reduce estate tax liabilities.  On the other hand, the premium limit increase allowed for some interesting opportunities as it related to coverages insured within captives.

Increase in Premium Limit May Be Biggest Opportunity for Small Captives

Many owners use small captives to fund corporate retained risk that is high severity and low frequency. Ideal coverages tend to focus on risks that are difficult or expensive to insure in the commercial markets.  For example, small captives often insure risks such as wind or quake deductibles that are commonly imposed upon clients by commercial insurers. Small captives are also increasingly used to insure arising risks such as supply chain contingent business interruption, cyber liability, and wage and hour, among others.

Because loss ratios for such risks, on average, tend to be low, the exposures can be efficiently funded within a small captive. But the premium limit of $1.2 million had required some companies to prioritize which risks to insure within a captive.  The limit increase to $2.2 million opened new doors for such policies as workers’ compensation deductible buydowns, property coverage on equipment, and medical stop-loss. These coverages may have greater loss activity, but with the increased premium capacity, parent company management can expand captive utilization to enhance the risk management function.

While we have seen some changes and challenges to the small captive laws surrounding the 831(b) election, we believe that the future is bright for our small captive clients. Relinquishing estate planning benefits was a small price to pay for the greater utilization that came with higher premium capacity.