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.
Similarly, there are two types of captives: Regular captives or 831(a) captives and 831(b) captives.
Regular captives pay taxes for federal income tax purposes. While 831(b) pay taxes based on just their investment income. Furthermore, when creating a captive insurance company, you need risk distribution and risk shifting. These two elements are what determines if your captive insurance company will be valid or not.
The captive insurance structure has a parent company that has 12 or more separate entities. In this article, we discuss what risk pools are, how they work, and we define the difference between risk distribution and risk shifting.
Definition of 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, its 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.
What is A Risk Pool?
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 all the time.
One option these companies have is 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. Without the law of large numbers, your captive insurance company won’t be valid, according to the IRS.
Also, to set up a captive insurance company, your clients are to contribute their premiums. This way, you get an even risk distribution. Middle and large market companies struggle to meet this requirement within their captive insurance companies, and they opt in for risk pooling as a result.
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 their losses.
Additionally, they assume an equivalent amount of risks from all the actuarial partners of the pool. The pool mitigates risk in commercial activities.
Furthermore, a captive insurance manager is the one who sets up a risk pool. The captive management is responsible for making sure that the pool is economically stable. Also, the captive management partners provide timely and accurate reporting to the actuarial partners.
In addition, they should have full underwriting control. It is also essential that they keep the pool financially strong. In risk pooling, no single member should take precedence over other members. Also, the risk pool must ensure even risk distribution. Adequate risk distribution is one of the advantages of strategic risk management.
Also, some captive insurance best practices are:
- Ensuring there are separate records for finances
- Being able to pay claims
- Handling real risks
Risk pooling is often a great idea especially when you’re unable to meet the IRS requirements alone. In this article, we give risk management advice, then discuss what risk pooling is and how it works. Hence, for those looking to form a captive insurance company, it’s definitely a great idea. It can help to mitigate risk and boost profit numbers.