Companies in highly competitive industries like construction are continually looking to enhance their businesses in ways that will have substantial, enduring impacts on their bottom lines. Increasingly, construction businesses are looking to cut one of their biggest expenses by establishing or joining a captive insurance company. As an alternative to traditional insurance, captives can provide multiple ongoing benefits, including premium savings, improved risk management, and substantial long-term returns on invested capital.

Captives are licensed insurance companies owned by the companies they insure. They are particularly appealing to businesses that want to reduce their risk exposure and the related losses. Once limited to large corporations, middle-market and even small companies are now participating in captives to cover a range of insurances, but most popularly workers’ compensation, and auto and general liability.

Group captives tend to be the most common form of captives for mid-market construction companies. In a group captive, a business becomes a single shareholder owner of an insurance company by pooling its premiums together with other parties. In a homogeneous group captive, such as a captive consisting of like-minded construction firms, participating members can address common industry-related insurance problems and target those issues.

Good group captives require businesses to demonstrate superior risk management strategies to be accepted into the group. As such, participating members can expect to pay for fewer severe claims than they would be exposed to in the general market.

Good and Bad Captives

So-called “micro” or “B” captives are under attack by the IRS as “abusive,” essentially for deducting insurance premiums to cover events that will never happen. In these type of captives, a company claims a tax-deductible “insurance expense,” the funds are invested, and when there are no claims they look to collect large returns on the invested capital.

According to an April 2021 IRS memo, the IRS has “ratcheted up its efforts to combat abusive micro-captive insurance arrangements. … The IRS will disallow tax benefits from transactions that are determined to be abusive … and continue to assert penalties, as appropriate, including the strict liability penalty that applies to transactions that lack economic substance.”

On the other hand, group captives seek to help members reduce insurance costs by improving their risk ratings. Well-operated group captives accept members who can prove good health and safety records. They meet regularly to discuss ways to improve members’ internal risk management. The resulting benefits can include dramatic reductions in insurance premiums, a return on their investment in annual dividends, and most importantly, becoming a stronger organization in terms of risk management and health and safety.

How Group Captives Work

In a member-owned group captive, all the insured members are owners. The business is operated with a committee structure, with each member with one vote, and participation is required. In the past, most captives were domiciled overseas due to the tax advantages—think Cayman Islands—and those semi-annual committee meetings must be conducted where they are registered. Today the tax advantages of being overseas are not as significant, and legislation in more than 30 states now allows for the formation of good captive insurance options here in the U.S. Many homogeneous as well as heterogeneous captives are now managed in the U.S. by captive management firms.

The captive grows with the addition of other like-minded companies, and businesses with loss histories better than average for their industry, a history of long-term financial strength and stability, and a management team committed to the health and safety of their workers. Actuarial studies, policy reviews, loss run reviews, financial statements and tax return reviews, and interviews with key personnel, all done up front, protect the membership from admitting companies that don’t belong. Risk assessments and even character endorsements of owners are typically required to protect captives from admitting the wrong members

The savings captives produce for members are rooted in lower premiums based on loss experience insulated from the overall market. Operating expenses are lower than the costs included in premiums from traditional insurance companies. Moreover, the captives’ emphasis on enhanced loss control and claims management reduces loss expenses, which also serves to reduce premiums. Captives also control expenditures through reinsurance, which is designed to cover losses due to a major claim event. And captives can pay dividends, though those dividends are taxed as ordinary income.

Good captives reward members for their good risk management and claims experience. Each company’s premiums are based on its actual losses. Examples of enhanced controls include how companies with fleets use software to ensure drivers aren’t using their cell phones while driving, how they choose their routes to avoid higher-risk situations, or simply decide what to do in the middle of the week instead of first thing on the Monday morning following Superbowl Sunday.

Actuarial studies indicate that companies can expect to start taking dividends by about the third year of a captive. However, construction companies can expect significant decreases in vehicle fleet rates and workers' compensation rates right out of the gate.

Captives support participating members by sharing best practices and the collaboration that follows, which helps them improve their risk management. In turn, better risk management generates multiple benefits, from premium savings and dividends to reduced losses due to accidents and illness, which not only saves money but enhances their reputation. This is also a valuable recruiting and retention tool, as people want to work for companies that are truly concerned about their safety and well-being while they are at work.

About the Author(s)

Michael is a Principal in the King of Prussia, PA office of HBK CPAs & Consultants. He is the Mid-Atlantic Regional Director of HBK Construction Solutions, a team of specialists focused on contractors and their unique business needs.

About HBK Construction Solutions Group

At HBK, our Construction Solutions is comprised of dedicated team members devoted to keeping pace with industry changes impacting your business and in turn providing you and your company with strategies and solutions customized to fit your unique needs.

Our specialized group serves a broad range of clients throughout the region who include general contractors, heavy construction, home builders, bridge painters and other specialty trades.

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