As a corporation grows it often changes its casualty insurance program from guaranteed cost coverage to self-insurance to a captive subsidiary program. In deciding whether to move from self-insurance to a captive program, a corporation will want to know, "How much is it worth?". One aspect of answering this question involves quantifying the potential tax benefit of a captive. Assuming that premiums paid to a captive are deductible, we estimate annual tax savings of approximately 2% to 3% of self-insured losses, as shown below.

Casualty losses incurred in a given "accident year" are paid out over several calendar years. Under a self-insurance program, a corporation deducts these losses as they are paid. However, a captive insurer may be able to accelerate these deductions, because an insurance company deducts not only paid losses, but also the present value of its loss reserves, which are provisions for future payments on incurred losses.

We will illustrate the potential tax benefit by constructing a cash flow model for a corporation with $10 million in annual accident year losses, which pay out over ten calendar years. These losses arise from the corporation's self-insured workers compensation, auto liability, and general liability exposures.

Table 1 compares tax deductions under the two alternatives (self-insurance versus a captive) and the corresponding economic benefit.

The captive program allows a larger tax deduction in the first year, which is offset by smaller deductions in subsequent years. Column (4) calculates the tax savings using an estimated marginal tax rate of 35%. Column (5) takes the timing differences into account by calculating the present value of column (4), using an estimated after-tax interest rate of 5%.

Ultimately, the same dollars of loss are paid out (and therefore the same tax deductions apply) under a self-insurance or a captive program. However, because of differences in the timing of the deductions for losses, a captive program may allow the corporation to hold onto funds that otherwise would be paid out in taxes. Even if the corporation currently takes credit on their financial statements for the timing difference by establishing a deferred asset, the ability to actually "collect" this asset produces economic value. Another way of looking at this is to think of column (4) as a loan of $2.3 million which can be paid back over nine years without interest!

The tax savings become even more significant as additional years roll into the captive program. For this example, we estimated the present value of the tax benefit for nine accident years to be $2.2 million. The tax benefit will be even larger if the loss volume grows each year.

In order to realize the potential tax benefit, a corporation will incur the cost of setting up and operating the captive insurance subsidiary. Annual fees for service providers (captive management, audit, legal, actuarial, etc.) can range from $50,000 to $100,000 or more. Also, the captive will need capital (often arranged using letters of credit), pay premium taxes, and incur other expenses (e.g., an annual Board of Directors meeting in the captive's domicile).

There are also some "hidden" costs to consider, such as internal management time. And the deductibility of premiums paid to a captive is open to challenge from the IRS. Further, the latest federal budget plan includes a provision that would prohibit a captive owner from deducting premiums paid to the captive unless 50% or more of the captive's total premiums were from third-party (unrelated) risks. Because of the uncertainty surrounding this issue, each corporation, in consultation with its legal, tax and accounting counsel, must make its own decisions regarding its tax and accounting treatment of losses, premiums, investment income, etc.

Using $100,000 of annual captive costs ($65,000 after tax) and a $300,000 tax benefit, the net savings are $235,000, or 2.35% of the $10 million in self-insured losses. For a corporation with more than $10 million in self-insured losses, the percentage savings will probably be higher, since most of the captive costs are fixed.