The world of captive insurance can be new for independent agents, even those who have been working in insurance for decades. This can initially make explaining captive models and certain tax elections intimidating to clients. The same goes for micro captives, which are often misunderstood in the insurance world.
Our sole purpose at Captive Coalition is to help educate independent agents about captive insurance. After all, it is our area of expertise. While we don’t work with micro captives, we understand them very well, knowing how they operate and the common challenges independent agents face when explaining them to clients.
In this article, you’ll learn what a micro captive is, how it works, its risks and benefits, and how to explain it to clients.
What Is a Micro Captive?
A micro-captive is a form of captive insurance that allows businesses to self-insure their risks while taking advantage of certain tax benefits. Under the 831(b) tax code, companies with annual premiums under $2.4 million can create a captive insurance company and only pay taxes on investment income rather than underwriting profits.
This means the IRS will look at you under a microscope as long as the 831(b) tax election is there. (This will be said multiple times throughout this article.)
The primary difference between a micro captive and other types of captives is its size, determined by the tax election, not the structure itself.
How Micro Captives Work
Micro captives operate like any other captive insurance model, but the distinction is that businesses using a micro captive can take advantage of tax breaks on premiums under the $2.4 million threshold. Here’s how it works:
- Formation: A business establishes a captive insurance company to cover certain risks that are typically uninsured or difficult to insure in the traditional market.
- Premium Collection: The business pays premiums into its own captive, which are used to cover claims. If no claims occur, the underwriting profit remains within the company.
- Tax Benefits: Under 831(b), the company only pays taxes on investment income rather than the full premium amount, potentially allowing the business to lower its overall tax burden.
Again, to really emphasize, the IRS will be on your butt with the 831(b) election. Bad actors used it in the past. Captive insurers should primarily be used to insure a business, not for tax benefits. If you hear anyone talking about captives for the tax benefits, run away and as far as you can.
Benefits of Micro Captives
For the right client, a micro captive offers several distinct advantages over traditional insurance:
- Control: Businesses gain greater control over their insurance programs. They decide what risks to cover and have more flexibility in claims handling.
- Profit Retention: When claims are lower than anticipated, the business retains underwriting profits instead of handing them to a traditional insurer.
- Tax Efficiency: The 831(b) tax election provides tax savings by allowing businesses to defer tax on premiums up to $2.4 million annually, paying tax only on investment income.
Risks and Challenges of Micro Captives
While the benefits to micro captives can be appealing, it’s very, very important to understand the associated risks:
- IRS Scrutiny: Micro captives are under intense scrutiny by the IRS due to abuses of the tax benefits. Your clients would have to ensure that their captive serves a genuine insurance purpose rather than just a tax shelter.
- Compliance: Businesses must meet strict compliance requirements, which include proving the captive is insuring legitimate risks. This involves providing adequate actuarial data and ensuring the risks covered are real, not fabricated (e.g., earthquake insurance for a business in a low-risk area like Florida).
- Cost of Administration: Running a captive involves management costs and administrative burdens that businesses must be prepared to handle. These costs can be a barrier for smaller businesses, even those nearing the $2.4 million premium threshold.
Who Should Consider a Micro Captive?
Micro captives aren’t the right fit for every business. A micro captive could make sense as an option for those spending significant amounts on insurance premiums (close to $2.4 million annually). However, the IRS would rather have the 831(b) election go away if it had the chance. It depends on how much your client wants to be friends with the IRS.
How to Explain Micro Captives to Clients
When discussing micro captives with clients, independent agents should focus on these points:
- Clarify the Purpose: Emphasize that a micro captive is an insurance company, not a tax shelter. Its purpose is to cover real risks that aren’t easily insured in the traditional market.
- Highlight the Benefits: Explain the control, profit retention, and potential tax benefits that come with micro captives. And use concrete examples to show how it might benefit their business.
- Address the Risks: Be upfront about the risks, including the IRS scrutiny and the need for strict compliance. Clients should fully understand that this is not a “set it and forget it” insurance model—it requires active management. And the IRS will be breathing down their neck with the 831(b) tax election.
Are Your Clients Ready for Captive Insurers?
Micro captives can be a tantalizing alternative for businesses that want control over their insurance programs and seeking financial advantages. However, in the opinion of Captive Coalition, the risks outweigh the benefits, which is why we don’t work with micro captives.
Next, read our article on conversations to have with clients about captive insurance. That way, your best clients can feel reassured when considering captives.
If you have any other questions or want to schedule a consultation, click the button below to speak with one of Captive Coalition’s captive consultants.
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