Captive for E-Commerce

By Gregory T. Bryant, CPA / Attorney at Law / Managing Partner

While conventional insurance can cover many types of business risks, e-commerce companies have many daily business risks that cannot be covered by conventional insurance. As a result, most e-commerce companies are absorbing liabilities on their balance sheets that they cannot see. Additionally, under most tax law principles, companies cannot deduct estimated reserves because they are not “liabilities in fact”. This is where captive insurance becomes the solution.

E-commerce companies have numerous business risks that are unique to the industry.  These include the following:

– Website cloning
– Product counterfeiting
– Credit card fraud
– Trademark infringement challenge
– FTC actions
– FDA actions
– Reputational Risks
– Better Business Bureau complaints
-Chargeback bombing
– Exchange control risk
– Supply chain disruptions
– Product quality liability risk
– Post-delivery inventory risk
– Cyber risk – mails
– Weather risk – agribusiness

Most of these risks are not covered by conventional insurance and are absorbed as they come.  The costs are legal fees and sometimes settlement payments. Captive insurance allows your company to pre-fund, deduct for tax and segregate assets to better manage these risks.

A captive insurance company is a separate company under common ownership.  It is a licensed insurance company and, because of that, it can deduct reserves for future claims where other companies cannot.  Additionally, there are special rules for “micro-captives”.   Micro-captives can set up reserves for 100% of their annual premium, up to $2.65m.[1]  This means a micro-captive only pays taxes on its investment income, which it earns on its cash reserves that are invested.  So, your operating e-commerce company pays a premium to your captive and deducts that premium payment on its tax return.  The captive has premium revenue but an offsetting “deduction for future claims”.  Your company has now segregated the assets by paying the captive insurance company and those assets are protected by law.

Because your operating company gets a tax deduction, but the captive does not have taxable income, the use of a captive insurance company can generate a large annual tax savings.  For example, if your company is a C corporation, its federal tax rate is 21% and the state, after federal deduction, is a rate of 4%, creating an effective tax rate of 25%.  If you paid a premium of $2.65m annually, it would generate an annual tax savings of $662,500.  For an S Corporation, which has a higher tax rate, the annual tax savings can be over $900,000. Additionally, you would be separating and protecting $2.65m of assets each year.  In the future, as claims arise, your operating company will present claims to the captive for the costs of legal defense, responding to Better Business Bureau letters, and possible settlement payments.

In addition to getting a great tax outcome and asset segregation, the captive insurance company allows your company to better manage risk in general.  As a licensed insurance company your captive can buy reinsurance, which is basically buying insurance at a wholesale price.  This further increases the savings of a captive.  It also allows your company to better fit traditional insurance to your business.

Set-up costs and operating costs can vary depending on the complexity of the structure.  Set-up costs are on average $50,000 and annual running cost is about 10% of the annual premium.  All operations are handled by an outside company that specializes in managing captive insurance, including making sure the annual premiums are properly documented and supported by underwriting.  The opportunity is significant but companies must adhere to the rules, which are technical.  Hiring a specialist is an important key to success.

[1] 26 USC § 831(b), as indexed as of 2023.