Should Your Dealership Form a Captive Insurance Company?

Are you interested in tailoring risk management services to better meet your dealership needs? Are you concerned that your dealership may be overpaying for your current insurance coverage? More dealerships are forming their own (captive) insurance companies to self- insure selected risks. Learn the basics, and pros and cons of establishing a captive insurance company for your dealership.

The What

A captive insurance company is a licensed insurance company formed to insure and reinsure the risks of related or affiliated businesses. A captive usually insures the exposures and risk of the parent company and/or affiliates or a number of similar companies, and can be domiciled on- or off-shore. Examples of typical policies issued by automotive dealership-related captives include:

Directors & OfficersGap InsurancePhysical DamageEarthquake & FloodLegal DefenseWarranty InsuranceEmployment PracticesService ContractsBusiness InterruptionEmissions TestsCyber/Elec. Data LossDrive TrainIntellectual PropertyAuto InsuranceGeneral LiabilityRepo Costs

Captives generally fall into one of two basic categories: small and large captives. Small captives are captive insurance companies that make an election under IRC Section 831(b) and can write up to $1.2 million of premiums per year that are not included as taxable income. Large captives write annual premiums in excess of the $1.2 million cap and are fully taxable.

The Why

If your dealership doesn't currently own an 831 (b) captive insurance company, perhaps you should consider establishing one. The recurring theme with captives is that they offer businesses significant benefits by controlling risk, controlling premium costs and creating an off-balance sheet rainy day fund.

Dealerships can be selective in managing what risks to retain with the commercial insurance providers vs. what to self-insure or reinsure inside the captive. Commercial providers often times have exclusions and gaps, or unaffordable premiums on coverage, leaving the operating business at risk. The captive can insure against those commercially unavailable or unaffordable risks, and provide coverage that extends or fills voids in existing commercial coverage.

Commercial providers have substantial overhead costs built into their policies for compensating agents, marketing & advertising costs, executive compensation, etc. that get passed down to the insured through higher premium costs. Captives avoid these costs and also retain the underwriting profits that would ordinarily be lost to the commercial carrier. In addition, insuring risks inside a captive can create opportunities to reduce overall insurance costs through raising deductibles, lowering coverage limits or increasing exclusions of the policies that are retained with the commercial provider. Even the mere existence of a captive can cause the commercial providers to significantly reduce premium costs in fear of losing policies to the captive.

Although a captive insurance company is primarily designed for risk management and controlling insurance costs, it can also provide significant tax advantages and cost benefits to help dealerships maximize their financial return. The insured entities deduct from taxable income the premiums paid to the captive. These amounts would otherwise be taxed at personal or corporate ordinary tax rates. Under the small captive tax structure the premium income received is not taxable. This creates a tax arbitrage that permits the owner to accumulate investment assets at an accelerated rate, giving rise to numerous opportunities, including that of a rainy day fund.

Other advantages for forming captives include, but are not limited to, estate & succession planning, retention of key employees and asset protection.

Here are a few considerations that can maximize the return to you and your dealership from your 831 (b) captive insurance company.

• Deducting premiums at the dealership level at the 35% or 39.6% rate.
• Returning captive profits to the captive owner in the form of dividends taxed at the capital gains rate.
• Considering additional risks that could be self-insured to increase annual premiums to the maximum allowable $1.2 million.
• Covering large deductible risks in the captive adding to underwriting profits.
• Providing for the opportunity to accumulate investment income and defer tax on the appreciation.

The Why Not

Although captives offer a wide array of advantages, there are numerous drawbacks to be wary of.

• Captives can be expensive to form and maintain due to the initial feasibility study, formation costs, capitalization of the company reserve & working capital, and annual audit & tax filings.
• During cycles of soft commercial markets, it is possible that policies obtained through the captive could become more expensive than the outside rate.
• If reserves needed to cover losses/claims are underestimated, it can result in unexpected large cash outflows.
• This is a real insurance company with real regulatory requirements. Once the captive is formed there is little opportunity to get too cute.

The Way

If properly executed and diligently managed, a captive insurance company can be an efficient risk management vehicle for your dealership and an ongoing source of profit for years to come. However, there are many other considerations and structures to evaluate and understand before entering into the captive insurance market.

To learn more about establishing a captive insurance company for your dealership, please contact us.

Branden A. Wilson, CPA / bwilson@hhmcpas.com / 423.702.8151