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Navigating Workers Compensation with Captive Insurance

The cost of workers compensation insurance can be a considerable burden for employers, particularly those whose employees are engaged in relatively hazardous activities. It is especially galling for an employer to see premiums set at levels that appear to bear no fair relationship to its own loss experience. A retro program, which gives the potential for some back-end savings may be preferable to a guaranteed cost policy but, for many, a high deductible plan with front-end savings will prove a better option.

When an employer opts for a high deductible workers compensation plan, it is with the aim of minimizing his overall cost of risk. Simply retaining the risk in the operating company should lower the premium paid to the commercial insurer but it won’t minimize the cost or maximize the benefit to the employer. However, establishing a captive insurance company to issue a deductible reimbursement policy can help achieve both.

Imagine an employer that makes a premium saving of $900,000 by amending its existing ‘first dollar coverage’ commercial insurance policy, to include a $400,000 deductible. The employer retains $400,000 of losses for a net saving of $500,000 (being premium saved of $900,000 less claims retained by the employer of $400,000). Let us assume that claims attributable to Year 1 of $400,000 are paid out over five years, with only $100,000 of the retained losses attributable to Year 1 being paid in Year 1. Without a captive, this translates into an initial $800,000 contribution to the operating company’s bottom line (being the premium saving of $900,000 less claims paid of $100,000) and income tax will be paid on that amount.

However, the operating company will now only be able to claim a tax deduction on the reduced premium, after the saving of $900,000, rather than on the full premium under the ‘first dollar coverage’ commercial policy. If, on the other hand, the $900,000 premium, which the commercial market priced as being the cost of insuring the first $400,000 of claims, is paid instead as premium to a captive for a deductible reimbursement policy to cover these first $400,000 of claims, the full premium amount is immediately tax-deductible by the operating company.

The captive is an insurance company and so has a different tax treatment. It will be able to either defer income recognition by deducting reserves or, at this premium level, may be exempt from income tax on underwriting profits, should it elect to be taxed as a small insurance company.
By hanging on to the pre-tax dollars rather than being left with only post-tax money, there is an opportunity for greater investment earnings on the full amount saved. The captive also has funds available to support a letter of credit, which will probably be required by the commercial insurer issuing the high deductible policy. Without a captive, the letter of credit would have to be supported by post-tax dollars held on the balance sheet of the operating company.

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For further information about workers compensation insurance, please contact Jeff Ellington.