Captive insurance companies are primarily responsible for underwriting risks for their parent company. The sole purpose of creating captive insurance companies is to manage risks. However, there are other things the parent company stands to gain from the captive insurance company.
Similarly, there are two types of captive insurance: Regular captive insurance companies or 831(a) and 831(b) captive insurance companies.
Regular captive insurance companies pay taxes for federal income tax purposes. At the same time, 831(b) insurance companies pay taxes based on their investment income. Furthermore, you need risk distribution and risk shifting when creating a captive insurance company. These two elements determine whether or not your captive insurance company will be valid.
The captive insurance structure has a parent company with 12 or more separate entities. In this article, we discuss risk pools and how they work, and we define the difference between risk distribution and risk shifting.
Risk shifting, unlike risk distribution, is easy to achieve. For risk shifting, all you have to do is transfer the risk to another entity or party. It’s moving the risk from the balance sheet of the company to the captive insurance company. In risk shifting, you’re basically doing a risk transfer.
While for risk distribution, the basis is on the law of large numbers. IRS provides a safe harbor ruling 2002-89 for risk distribution. It considers whether or not the captive insurance company distributes risks adequately enough. Firstly, it considers if the captive insurance company insures 12 or more separate entities. Ensuring that these separate entities have no more than 15% of the risk and no less than 5%. Secondly, it considers if the captive insurance company has 50% independent or third-party risks. If the conditions are met, then the captive insurance company becomes valid by the IRS. However, if the captive insurance company doesn’t meet the condition, it can’t be valid. Captive insurance companies without 12 or more separate entities have to get their risk distribution from risk pools.
Due to the surge in premiums across different industries, many clients seek captive insurance companies. Most companies take this route because their insurance premiums skyrocket constantly.
These companies have one option: to set up their own captive insurance company. They do this in place of paying premiums within a traditional insurance market. The IRS requires risk distribution before you can set up your captive insurance company.
You must have enough independent risks that don’t relate to each other. Also, you should be able to pull these risks together to reach the law of large numbers. According to the IRS, your captive insurance company won’t be valid without the law of large numbers.
Also, to set up a captive insurance company, your clients must contribute their premiums. This ensures an even risk distribution. However, middle and large market companies struggle to meet this requirement within their captive insurance companies, and as a result, they opt for risk pooling.
So, what is risk pooling? Risk pooling is when a number of captive insurance companies combine to share their risks. Risk pools were uniquely designed solutions for enterprise risks. Risk pooling works with the partners paying a portion of their direct written premium to the pool.
The pool then uses its payment to get reinsurance placement for its losses.
Additionally, they assume an equivalent amount of risks from all the pool's actuarial partners. The pool mitigates risk in commercial activities. Furthermore, a captive insurance manager sets up a risk pool. The captive insurance management is responsible for ensuring that the pool is economically stable. The captive insurance management partners also provide timely and accurate reporting to the actuarial partners.
In addition, they should have full underwriting control and keep the pool financially strong. In risk pooling, no single member should take precedence over others. The pool must also ensure even risk distribution, one advantage of strategic risk management.
Also, some captive insurance best practices are:
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