How captive insurance works (in plain terms)
A captive insurance company is a legal entity—often a limited liability company or a small insurance company—established to insure the risks of its owner(s). Instead of buying every policy from a commercial insurer, a family business moves some of its coverages (or creates new ones) into the captive. The business pays premiums to the captive, the captive pays claims, and any underwriting profits or investment returns remain with the captive and ultimately the owners.
In practice this means a family business can:
- Write policies customized to exposures that the commercial market won’t cover or charges high premiums for.
- Control claims handling, retention limits, and loss-control programs.
- Capture underwriting profits and investment income within the group rather than paying them to third-party insurers.
In my practice advising family enterprises, captives most often emerge when conventional insurers either decline coverage, price risks unpredictably, or exclude important exposures. A captive isn’t a quick fix; it’s a disciplined insurance program that requires governance, capital, and ongoing regulatory compliance.
What types of captives should family businesses know about?
There are several captive structures; which fits a family business depends on size, risk profile, and goals:
- Single-Parent (Pure) Captive: Owned by one family business to insure only that business’ risks. Best when a single company has predictable, sizable exposures.
- Group Captive: Multiple unrelated businesses form or join a captive to spread risk. This can suit smaller family firms seeking scale.
- Sponsored or Rent-a-Captive: A family business ‘rents’ an existing captive structure to avoid the startup costs and long-term obligations.
- Protected Cell Captive (PCC): The captive holds separate cells for different owners; cells share the same domicile and manager but keep liabilities legally ring-fenced.
Each structure has tradeoffs in capital needs, control, and regulatory complexity.
Who benefits from a captive?
Good candidates generally: family businesses with steady revenues, measurable loss histories, and exposures that are frequent but manageable (e.g., workers’ comp, property, professional liability, or niche industry risks). Captives also appeal to businesses that want to centralize insurance programs across related family entities.
Captives are not limited to large firms. In my experience, mid-sized family companies that spend materially on insurance and can commit to multi-year programs often see the best return on effort.
Step-by-step overview of setting up a captive
- Feasibility study: Work with an actuary and a captive consultant to model expected premiums, losses, capital needs, tax implications, and projected returns.
- Choose domicile and structure: Domestic U.S. domiciles include Vermont, Delaware, and Utah; offshore options include Bermuda and Cayman. Each has different regulatory and tax frameworks—select based on your objectives and compliance preferences (NAIC and state regulator resources are useful here).
- Form the legal entity and obtain a license: File articles, bylaws, and an application with the captive regulator; submit business plans, actuarial reports, and financial projections.
- Capitalize the captive: Provide paid-in capital and surplus as required by the chosen domicile and the captive’s risk tolerance.
- Draft reinsurance program and service agreements: Determine reinsurance cover and contract with captive managers, third-party administrators, and auditors.
- Implement governance and risk controls: Establish a board, loss-control protocols, claims handling, and reporting systems.
- Ongoing compliance and audits: Maintain statutory filings, financial statements, and regulatory exams as required by the domicile.
Costs and capital: what to expect
Costs include setup fees (legal, actuarial, consulting), license fees, capital contributions, management fees, reinsurance premiums, and annual audit/regulatory costs. Capital requirements vary by domicile and captive type; expect a range from lower hundreds of thousands to several million dollars depending on the risks insured and the chosen jurisdiction.
Budget for multi-year costs: captives are long-term risk solutions, and payoffs are rarely immediate. Your feasibility study should show a realistic timeline for breakeven.
Tax and regulatory considerations (high-level)
Captives are heavily regulated and have drawn IRS scrutiny. Tax treatment depends on whether the captive qualifies as an insurance company under federal tax law and whether premiums are ordinary and necessary business expenses for the parent. Important points:
- The captive must operate as a bona fide insurer (risk distribution, risk shifting, and independent underwriting). Documentation, formal policies, and real economic risk are critical to support tax positions.
- Some small captives historically elected to be taxed under Section 831(b) for favorable treatment of underwriting income, but the availability and suitability of that election depend on current tax law and revenue thresholds—consult a tax specialist for up-to-date guidance (IRS).
- State and international domiciles impose solvency, reporting, and capital rules; NAIC and state insurance department guidance are primary regulatory references.
Because tax and regulatory rules change, involve a CPA and counsel experienced in captive taxation early in the feasibility phase.
Sources: IRS general guidance on insurance taxation; NAIC resources on captive regulation; Insurance Information Institute overviews on insurer regulation.
Governance, documentation, and best practices
A captive must be run like a real insurer. Best practices include:
- Written underwriting guidelines and reinsurance arrangements.
- Formal board meetings and minutes documenting decisions and arms-length transactions.
- Regular actuarial reviews and reserves analysis.
- Clear service agreements with third-party administrators, managers, and auditors.
- Independent audits and compliance reports for the domicile regulator.
Poor documentation or informal operations are the two most common reasons captives fail regulatory or tax scrutiny.
Common mistakes family businesses make
- Skipping a rigorous feasibility study.
- Underestimating the ongoing administrative and regulatory burden.
- Treating the captive as a tax avoidance vehicle rather than a legitimate risk-management tool.
- Putting all risks into the captive without an exit strategy or reinsurance program.
In my consulting work I’ve seen businesses that viewed a captive as a short-term cost saver. Successful captive programs treat the entity as a long-term investment in risk capacity and governance.
Practical strategies to get the most from a captive
- Start with readily measurable risks (workers’ comp, auto liability, property) before moving to more complex coverages.
- Pair the captive with a disciplined loss-control program; reduced claims drive underwriting returns.
- Use reinsurance strategically to cap catastrophic exposure while retaining profitable layers.
- Review and adapt the program annually; as family businesses grow or change, the captive should evolve.
Frequently asked questions (brief)
Q: How much capital do I need to start a captive?
A: Capital requirements vary by domicile and covered risks. Many captives begin with paid-in capital in the low six-figures, while others require larger surpluses. A feasibility study provides precise estimates for your situation.
Q: Can a captive insure related or unrelated third parties?
A: Rules depend on domicile and structure. Some captives can insure affiliates or related entities under specific arrangements; others are restricted to parent risks. Legal counsel will help design permissible programs.
Q: Are premiums to a captive tax-deductible?
A: Premiums are potentially deductible if they are ordinary and necessary business expenses and the captive operates as a real insurer. Tax treatment is complex—work with a tax pro to document risk shifting and distribution.
Interlinking resources on FinHelp
For related concepts that affect captive decisions, see FinHelp articles on Property and Casualty (P&C) Insurance and Key Person Insurance. Also review Understanding Exclusions and Riders in Insurance Policies when you build captive policy forms.
Decision checklist for family business owners
- Have you completed a third-party feasibility study?
- Can the business commit capital and multi-year funding?
- Are your owners prepared for statutory reporting, governance, and audits?
- Do you have tax and legal counsel with captive experience?
- Is there a clear business case (premium savings, retention, coverage expansion, or balance-sheet benefits)?
If you answer yes to these items, a captive may be worth exploring.
Final thoughts and next steps
Captive insurance can be a powerful tool for family businesses that need customized coverage, want to stabilize long-term insurance costs, and are willing to commit to disciplined governance. It is not a shortcut to tax savings or a remedy for poor risk control. Start with a feasibility study, involve experienced actuaries, captive managers, attorneys, and CPAs, and treat the captive as a regulated operating enterprise.
This article summarizes core topics and practical guidance but does not replace personalized financial, legal, or tax advice. Consult qualified professionals before forming or funding a captive.
Authoritative sources and further reading
- Internal Revenue Service (general information on insurance taxation): https://www.irs.gov
- National Association of Insurance Commissioners (NAIC) — captive insurance resources: https://www.naic.org
- Insurance Information Institute — insurer and captive overviews: https://www.iii.org
- Investopedia — Captive insurance primer: https://www.investopedia.com/terms/c/captive-insurance.asp
(For legal or tax planning, seek counsel licensed in your state. This article is educational and not individualized advice.)