Lea Uradu, J.D. is a Maryland State Registered Tax Preparer, State Certified Notary Public, Certified VITA Tax Preparer, IRS Annual Filing Season Program Participant, and Tax Writer.
Fact checked by Fact checked by Vikki VelasquezVikki Velasquez is a researcher and writer who has managed, coordinated, and directed various community and nonprofit organizations. She has conducted in-depth research on social and economic issues and has also revised and edited educational materials for the Greater Richmond area.
All businesses need to protect themselves against financial risk, and that's where insurance comes into the mix. But, businesses don't always have to purchase insurance from another company. With captive insurance, a business can provide its own coverage, offering better protection against the types of risks it may likely face as well as potential financial benefits for the business owners. Captive insurance is also sometimes promoted as a tax shelter, but using it that way has its hazards.
A captive insurance company is owned by the business or businesses it insures. Unlike mutual insurance companies, which are also owned by their policyholders (who may number in the many thousands), captive insurance companies are both owned and controlled by policyholders. In a nutshell, captive insurance is a form of self-insurance. However, a captive insurance company is subject to state regulations just like other insurance companies.
While policyholders own the captive insurer, their ownership interest is not an investment in the true sense of the word. Ownership ceases when insurance lapses, such as when the business owner no longer needs coverage and stops paying for it. The policyholder cannot sell, gift, or bequeath anything.
Captive insurance companies can be set up in a variety of ways:
For example, companies in a single industry might form a captive insurance company (a group captive) to meet their special risk needs.
Captive insurers are common in the U.S. and other jurisdictions worldwide. Each country has separate rules about capitalization and how much surplus these insurers must retain. According to the National Association of Insurance Commissioners (NAIC), there are more than 7,000 captive insurers worldwide and about 90% of Fortune 500 companies have captive subsidiaries.
Businesses risk their own capital when they decide to create their own captive insurance company.
Captive insurance can have legitimate tax benefits for business owners. Premiums paid to a captive insurer can be tax-deductible if the arrangement meets certain risk-distribution standards. Thus, the business gets a current year write-off even though losses may never occur.
The Internal Revenue Service (IRS) laid out the rules (in publications in Rev. Rul. 2002-89 and Rev. Rul. 2002-90) under which captive insurance constitutes insurance for federal income tax purposes so that premiums are deductible. There are two safe harbors under which captive insurance is viewed as real insurance (i.e., premiums are deductible):
The IRS may still challenge premium deductions where it believes stopgaps thwart risk distribution, such as reinsurance or tax-shelter-like arrangements.
In 2016, the IRS identified micro-captive insurance transactions as a potential risk for tax avoidance or evasion. Such arrangements are still singled out as abusive tax shelters on the IRS's "dirty dozen" list of tax scams and schemes for 2024. As the IRS explains:
"Abusive micro-captives involve schemes that lack many of the attributes of legitimate insurance. These structures often include implausible risks, failure to match genuine business needs, and in many cases, unnecessary duplication of the taxpayer’s commercial coverages."
Traditional insurance products may not meet a particular company's needs, at least not at an affordable price. Captive insurance can provide coverage that is better tailored than is available through existing products. For example, professional services businesses and construction companies may find captive insurance appealing.
Trade associations may also offer captive insurance for their members. For instance, the Coin Laundry Association used captive insurance for many years because its members could not obtain traditional coverage for their 24-hour businesses.
The extent of this special type of coverage can be limited. According to the International Risk Management Institute, the typical captive insurance limit is $250,000 per occurrence. Losses over and above that limit are not protected by the captive insurer, but companies with captive insurance can use reinsurance to cover losses that exceed the limit.
While the main reason for captive insurance is risk management, an ancillary benefit for businesses is that they stand to profit if the company's underwritings are sound. Captive insurers generally distribute dividends to owners.
One way to increase these returns is to reduce claims. This can be done by better business practices aimed at safety so that claims are minimized or avoided. Another way is to control operating expenses. Captive insurance companies can run leaner operations than commercial insurers and don't, for example, need the big advertising budgets that their commercial counterparts often have.
Like other types of insurance companies, captives are regulated primarily on the state, rather than federal, level. As the Insurance Information Institute notes, "A captive insurance firm must be licensed in each state in which it does business or must use a fronting insurer to do business across state lines. Most jurisdictions have established a specific regulatory framework based on the structure and operation of captives."
The III adds: "Captives that are owned by publicly held companies also must comply with all the regulatory compliance and governance requirements stipulated by the Sarbanes-Oxley Act, enacted in 2002 to increase the accountability of boards of publicly held companies to their shareholders."
Reinsurance is a means by which insurance companies spread their financial risk through contracts with other insurance companies. Spreading the risk to other insurers allows ceding insurance companies to remain solvent by reducing the net liability from large or multiple losses.
A major potential downside of captive insurance is that the owners are putting their own capital at risk. Another is that it represents a long-term commitment.
As a 2021 report from the Insurance Information Institute notes, "Companies must commit significant capital in order to comply with minimum capitalization requirements. While considerably less capital is required when joining a member-owned group captive versus a single parent captive, member companies are generally expected to make a long-term commitment when joining the captive and it likely would not make sense unless they planned to remain in for at least three to five years."
Captive insurance can meet risk-management needs for a small or large company while providing financial rewards for its owners. But this type of insurance is not for everyone. Typically, initial premiums can run into the hundreds of thousands of dollars or even millions. And there are considerable start-up costs—often more than a quarter of a million dollars, to create a captive insurance company and cover fees to actuaries, attorneys, and others.