In today’s financially challenging healthcare environment, organizations are looking to reduce costs wherever possible. Insurance is one area that persistently experiences rising costs. One way to stabilize and possibly reduce the overall cost of insurance is by setting up a captive insurance company.
A captive is an insurance company that often is wholly owned and controlled by a health system or hospital and their employed or, in some jurisdictions, nonemployed physicians. With captive insurance, the insured party is most often the beneficiary of the captive’s underwriting profits. Captives represent an alternative to the traditional insurance market.
Some common areas of coverage written by captives include medical malpractice, property, workers’ compensation, professional indemnity, and automobile liability.
Benefits of Starting a Captive
There are five main benefits of starting a captive insurance company:
- A captive can reduce an organization’s overall insurance cost because the organization maintains underwriting profits.
- It enables an organization to customize its insurance program. Through a captive, an organization can insure any risk it chooses, as long as each choice is approved by regulators. This potentially can provide coverage even for risks that are not usually insurable through plans found on the commercial market.
- A captive insurance company can centralize an organization’s overall insurance program, which, in turn, can centralize the organization’s risk management function. In this sense, a captive can become an effective risk management tool.
- Over time, a captive insurance company may help an organization manage claims. A captive provides a platform through which the organization can better focus on prevention of losses and claims. For example, an organization’s doctors may come together and decide to establish a procedure for how to collectively minimize claims.
- Organizations that establish a captive have access to reinsurance markets, otherwise known as “insurance for insurance companies.” By accessing reinsurance markets, the organization can reduce the overall cost of insurance because it isn’t purchasing the insurance directly. This leads to lower costs for the organization.
Types of Captives
Once an organization has decided to form a captive, the next step is deciding which type of captive to form. There are two main structures for captives – single parent and group.
The single-parent captive, or pure captive, is the most common type of captive insurance company. A single-parent captive generally is owned by one parent company and is formed mainly to insure or reinsure the risks of the corporate parent and its business partners. This type of captive can be incorporated as either a stock or nonstock corporation. Most not-for-profit healthcare organizations form a nonstock corporation. Because a pure captive has a single owner, that one entity forms its own board of directors.
The second most common structure for captive insurance companies is the group, or association, captive. These captives are owned by many insured parties and are managed by the group captive’s owners and organizers. Group captives are formed primarily to lower the cost of insurance and share risk among those in the group. Common group captives seen within the healthcare industry are hospital group captives and physician group captives.
A group captive can be owned by an association. In some instances in this arrangement, the members (the insured parties) pay the association, and the association pays the premium to the captive on behalf of its members. In turn, the captive reimburses the association for any claims that have been set forth.
Foreign or Domestic Companies
Captive insurance companies can be set up as either foreign or domestic companies. Each structure has its own tax implications and laws.
Foreign captive insurance companies are organized in offshore domiciles such as the Cayman Islands or Bermuda. If structured properly, these are an attractive option because foreign insurance companies operating offshore generally are not subject to direct U.S. taxation.
With foreign captives, it’s important to keep in mind that all business related to the captive has to be conducted in the offshore domicile in which it resides. That includes everything from day-to-day decisions to board meetings.
Some organizations that qualify as an insurance company for federal income tax purposes can take an election under Section 953(d) of the Internal Revenue Code. A foreign insurer may be subject to direct U.S. tax if it is considered to be engaged in a U.S. business. The 953(d) tax election allows an organization to declare that it is doing business in the United States, which takes away concerns about not being in tax compliance.
Many organizations opt to form foreign captives because of favorable tax treatments. In recent years, however, there has been an increase in available U.S. domiciles. This has led to greater competition, making them an equally attractive option given the right facts and circumstances.
Proceed With Caution
While they can provide many financial benefits for an organization, captive insurance companies are a particularly complex area because they involve some of the most complicated tax laws, including insurance, foreign, and tax-exempt law. Be sure to contact a tax adviser for information about the tax implications of setting up a captive insurance company.