Small and medium businesses often encounter a set of unique risks due to their business nature, which are not covered by traditional insurance models. It is where micro captives, aka 831(b) captives, come in. According to Charles Spinelli, this is the reason an increasing number of SMEs collectively decide to form a micro captive – a type of self-insured entity to protect them against risks that could be otherwise too expensive or declined by the traditional market.
Unsurprisingly, micro captives are gaining increasing popularity among SMEs due to their flexibility, tax advantages, and a unique way to manage risk.
How Micro Captives Work?
A micro captive functions as a typical insurance firm, yet it operates within a significantly restricted domain. The small businesses collectively establish their captive insurance entity, and premiums are paid directly into it in the same manner as they would with an external insurance provider. Control and customization represent the fundamental difference because business owners enjoy the freedom to adjust coverage for specific operational risks.
Under Section 831(b) of the Internal Revenue Code, USA, a captive insurance generating premiums below $3 might be taxed primarily on its investment income rather than premium value.
Why Small Businesses Are Turning to the Micro Captive Option?
Typically, captive insurance is considered a brilliant risk management tool, with flexibility and enjoys ample tax benefits, in the opinion of Charles Spinelli. With the surge of business environments adding to more complex risks among small and medium businesses, micro-captive has emerged as a great risk management tool for them as well. Several benefits of micro captive include:
- Custom Coverage
Underwritten traditional policies often have exclusions for emerging and niche risks. A micro captive can provide coverage for:
- Cybersecurity breaches
- Supply chain interruptions
- Product recalls
- Regulatory changes
- Potential Cost Savings
If a small business starts to build reserves and become less reliant on third-party insurers, it may ultimately be able to save on the cost of insurance. If the business suffers little or no losses, the unused reserves stay with the business.
- Tax Efficiency
If a micro captive is structured and functions properly, the 831(b) tax benefits can be significant. For example, the premiums are typically deductible by the parent company, and the captive is only taxed on its investment income.
- Improved Risk Management
Owning an insurance company in the form of captive insurance encourages small businesses to stay proactive in risk assessment and mitigation. Businesses become more familiar with the operational risks and operate their business with greater diligence and efficiency.
The IRS has started examining Micro captives more closely because of the abuse of these as tax shelters when there was no actual risk transfer. The IRS has declared that certain structures will be treated as “listed transactions”, resulting in a stricter audit and reporting process for those transactions. Companies will need to demonstrate risk transfer, arm’s length pricing, and documentation, while avoiding the appearance of tax-driven formation
