Overview

Captive insurance is a formal self-insurance vehicle: a company creates a legally separate insurance company (the captive) to underwrite risks that the parent business would otherwise insure through commercial carriers. Captives can be domestic or domiciled in states or jurisdictions with captive-friendly rules. When executed correctly, they allow more control over policy terms, claims handling, and long-term cost of risk. However, captives carry setup, governance, and tax complexity that make them suitable only for certain businesses.

(See related: Insurance Captives for Small Business Owners: When They Make Sense and Risk Transfer Alternatives: Captive Insurance and Excess Policies.)

How captive insurance works — the mechanics

  • Formation: A parent company (single-parent or group) forms a licensed insurer under state or offshore law. This can be a stock company, mutual, or special-purpose insurer.
  • Premiums and funding: The parent pays premiums to the captive. Those premiums finance reserves, pay claims, and cover operating expenses.
  • Risk-retention and reinsurance: Captives typically retain a predictable layer of risk and purchase third-party reinsurance for catastrophes or large losses.
  • Governance and operations: The captive needs directors, officers, actuarial support, claims administration, and accounting—often outsourced to captive managers.

Captives are not informal. They must meet regulatory solvency and reporting rules in their domicile and operate like insurers. That includes actuarial analysis of premium adequacy, investment policies for reserves, and regular financial statements.

Pros: Why small businesses consider captives

  • Tailored coverage: Captives can insure gaps or niche exposures that commercial carriers exclude or price inefficiently.
  • Long-term cost control: Rather than paying changing market premiums, a company can smooth costs over time and retain investment income on reserves.
  • Better claims management and loss control incentives: When the owner pays claims indirectly, there’s a stronger focus on prevention and return-to-work programs.
  • Access to reinsurance markets (indirectly): Well-structured captives can place excess coverage more favorably than small buyers alone.
  • Employee benefits and captive solutions: Some captives can cover employee benefits or stop-loss policies, improving predictability for self-funded plans.

Cons and risks: Why captives aren’t for everyone

  • High upfront and fixed costs: Legal formation, feasibility studies, actuarial work, captive manager fees, and licensing can be substantial.
  • Ongoing compliance and administration: Annual audits, regulatory filings, captive management, and possibly state premium taxes add recurring expenses.
  • Capital and reserve requirements: Regulators require capital and surplus; inadequate capitalization risks regulatory action.
  • Tax and IRS scrutiny: Certain captive arrangements, especially micro-captives, face enforcement risks. Tax treatment is complex and should be reviewed by a specialized CPA or tax attorney (see IRS guidance and recent guidance on captive transactions).
  • Opportunity cost and liquidity: Funds in reserves are restricted; if your business needs cash, captive reserves are not easily redeployable.

Typical cost and scale considerations

There is no universal premium threshold, but practical feasibility usually starts where a business can justify the fixed costs—many advisers suggest a minimum of several hundred thousand dollars in annual insurable premium, and more conservative estimates favor $1 million+. The actual break-even depends on expected claims, investment yield, administrative fees, and tax treatment.

Feasibility studies (actuarial projections and multi-year cash-flow models) are standard. These studies quantify the time horizon for potential payback and sensitivity to loss volatility.

Domicile choice and governance

Captive domiciles vary by state and country. U.S. domestic domiciles like Vermont, South Carolina, and others offer regulated frameworks and local captive managers; offshore domiciles such as Bermuda or Guernsey can offer specialized reinsurance access and tax structures. Domicile selection should weigh regulatory reputation, solvency rules, taxation, service ecosystem, and travel/logistics for board meetings.

Good governance includes a clear captive business plan, independent directors or advisors, documented underwriting and claims processes, and regular actuarial reviews.

Tax and regulatory considerations (practical summary)

  • Federal tax: Captives are subject to U.S. federal tax rules. Some captives qualify as insurance companies and file the appropriate returns (e.g., forms for insurance companies). Small-cap (micro) captive elections under internal revenue code provisions have been used historically, but they invite IRS attention if the arrangement lacks bona fide insurance risk transfer and risk distribution.
  • State insurance regulation: Captives must comply with domicile laws—capital requirements, financial reporting, and sometimes premium taxes.
  • Professional advice required: Because tax outcomes turn on facts and documentation, involve a captive-specialized tax attorney and CPA early.

Authoritative resources: the National Association of Insurance Commissioners (NAIC) provides captive guidance and state resources, and the Internal Revenue Service publishes guidance on insurance taxation and audit positions (see NAIC captive resources and IRS pages on insurance company taxation).

When a captive makes sense for a small business

Consider a captive when several of these are true:

  • Your business pays consistent annual premiums large enough to absorb fixed costs (typically, multiple years of premium aggregation or a group captive structure can achieve scale).
  • You have unique or hard-to-place risks (e.g., specialized product liability, professional liability, or employee benefits exposures).
  • You want greater control of claims and loss-prevention programs and have the governance capacity to manage an insurance vehicle.
  • You can meet capital and reserve requirements and tolerate reduced liquidity of premium dollars.

If the fixed costs outweigh the potential savings, alternative risk-transfer options—like higher retentions, program captives, or pooled self-insurance—may be better. See our piece on Using Captive Insurance Concepts for Small Business Risk Control for lower-friction alternatives.

Real-world, anonymized example

A regional construction firm facing rising casualty premiums and limited carrier appetite used a feasibility study to model a group captive. The captive allowed the firm to:

  • Design policies that matched contract indemnity obligations,
  • Invest underwriting profits to smooth premium volatility,
  • Tie loss-control incentives to lower back-to-work costs.
    The captive required several years to realize net savings after setup and governance expenses, but the firm gained predictable capacity and better control over subcontractor coverage standards.

Common mistakes and red flags

  • Skipping a professional feasibility study: Don’t rely on anecdotal ROI claims—run an actuarial model.
  • Treating the captive as a tax shelter: The IRS scrutinizes arrangements lacking genuine risk transfer and distribution—document underwriting, claims, and independence.
  • Underfunding reserves: Regulators can step in if a captive appears insolvent.
  • Neglecting governance: Boards must act with insurer duties; treating the captive as a subsidiary slush fund invites legal issues.

Practical next steps checklist

  1. Order a feasibility study (actuarial + tax analysis).
  2. Talk to captive managers and compare domicile services and costs.
  3. Engage a captive-experienced CPA and insurance counsel.
  4. Pilot governance structures—board charters, claims protocols, and investment policies.
  5. Reassess annually: captive performance, loss trends, and tax/regulatory changes.

Brief FAQs

Q: Can small businesses join group captives?
A: Yes—group captives pool similarly situated businesses to reach scale and spread risk.

Q: Are captive premiums tax-deductible?
A: Premiums paid to a captive may be deductible if the captive qualifies as an insurer for tax purposes, but deductibility and timing depend on facts and should be verified by a tax advisor.

Professional disclaimer

This article is educational and does not constitute legal, tax, or investment advice. Captive setups involve complex tax and insurance rules; consult a licensed insurance professional, captive manager, and a CPA or tax attorney experienced in captive structures before proceeding.

Sources and further reading

For a tailored evaluation, bring your last 3–5 years of premium and claims data to a captive feasibility review. In my practice advising small and mid-size firms, a documented feasibility analysis is the single most reliable tool to decide whether a captive will deliver real value.