Overview

Captive insurance is a deliberate risk financing strategy: instead of buying all coverage from a commercial carrier, a company creates a licensed insurance entity (the captive) that writes policies for its owner(s). Captives let businesses customize coverage, control claims handling, and potentially capture underwriting and investment gains. They are not a one-size-fits-all solution — captives add regulatory, tax, and administrative responsibilities that must be managed carefully.

How captive insurance works (step-by-step)

  1. Formation: A parent company or group selects a domicile (a U.S. state or offshore jurisdiction) and forms a licensed insurer. Popular U.S. domiciles include Vermont, Delaware, and South Carolina; Vermont is the largest U.S. captive domicile and publishes guidance for captives (see NAIC and state resources).
  2. Capitalization: The captive is capitalized with paid-in capital and surplus to satisfy state minimums and actuarial requirements.
  3. Premiums and policies: The parent(s) buy policies from the captive and pay premiums. Properly set premiums are actuarially defensible and reflect expected losses plus loading for expenses.
  4. Claims and risk control: The captive handles claims or hires a third-party administrator. Captives often invest in loss control programs to reduce frequency and severity.
  5. Investments: Premiums retained by the captive can be invested to earn income, improving cash flow and funding future claims.
  6. Surplus and dividends: If underwriting is profitable, the captive builds surplus that can be used for future losses or returned as dividends to owners (subject to tax and regulatory rules).

(For foundational guidance from regulators, see the National Association of Insurance Commissioners (NAIC) captive insurance page: https://www.naic.org/captive_insurance.htm.)

Common types of captives

  • Single-parent (pure) captive: Owned by one company and covers its risks. Best for firms with predictable losses and sufficient capital.
  • Group captive: Owned by several unrelated companies (often industry peers) pooling similar risks to gain scale and reduce volatility.
  • Association captive: A type of group captive formed by trade associations to serve members.
  • Rent-a-captive / protected cell company (PCC): A rented cell within a licensed captive structure; lower setup cost and faster entry but with different legal and accounting trade-offs.
  • Micro-captive: Small captives that historically used IRC Section 831(b) to elect tax treatment. Micro-captives have been under increased IRS scrutiny; specialized advice is essential.

Benefits — why companies choose captives

  • Cost control: Potentially lower long-term insurance costs by eliminating commercial insurer profit margins and reducing premium volatility.
  • Custom coverage: Tailor policy terms to risks that commercial markets will not insure or will charge steeply for.
  • Cash flow and investment income: Premiums paid are available for investment by the captive until claims occur.
  • Improved risk management: Financial incentive for loss control programs and better claims handling.
  • Access to reinsurance markets: Captives can purchase reinsurance to protect against large losses and stabilize results.

Costs, capital, and ongoing obligations

Captives are not “cheap.” Costs include incorporation, actuarial studies, licensing, audits, captive management fees, compliance, legal and tax advice, and claims administration. Capital and surplus requirements vary by domicile; common practical thresholds for small captives often exceed $250,000 in combined capital and surplus, though larger captives need substantially more. Ongoing operating expenses and regulatory filings are recurring commitments.

Tax considerations and IRS scrutiny

Captive insurance can provide tax advantages when structured and operated as a bona fide insurance company. However, the IRS closely examines captive arrangements, especially micro-captives and related-party transactions, to ensure they meet the economic substance and risk-distribution requirements of insurance law. Important references:

  • IRS Notice 2016-66 and related guidance addressing transactions involving micro-captive insurance (see https://www.irs.gov/pub/irs-drop/n-16-66.pdf).
  • General IRS guidance on the tax treatment of insurance companies and premium deductibility. Work with a tax attorney or CPA experienced in captives before relying on tax outcomes.

In practice, premiums must be actuarially justifiable, claims and underwriting must be real and documented, and the captive must operate with adequate corporate governance to reduce the chance of adverse tax challenges.

Regulatory and governance matters

Captives are licensed insurers and must follow the domicile’s insurance code, maintain required reserves, file financial statements, and submit to periodic examinations. Strong governance includes an independent board (or appropriate governance for group structures), written policies for underwriting and claims, annual actuarial opinions, and documented loss control efforts.

Regulatory compliance is not optional: poor filings or undercapitalized captives can be shut down or forced into rehabilitation by regulators. Domicile selection affects costs, regulatory approach, and operational practicality.

Is a captive right for your business? A practical suitability checklist

Use this checklist to evaluate candidacy before spending on feasibility studies:

  • Predictable loss history: Do you have 3–5 years of stable loss data that an actuary can use?
  • Sufficient scale or group support: Can you meet capitalization and fixed cost requirements? Group captives lower the threshold.
  • Risk appetite: Are you willing to retain more loss in exchange for potential savings?
  • Cash flow and investment ability: Do you have capital to fund initial losses and pay start-up costs?
  • Management bandwidth or access to experienced captive managers and advisors.
  • Long-term time horizon: Captives often take several years to deliver net financial benefits after start-up costs.
  • Willingness to comply with jurisdictional regulation and reporting requirements.

If you answered “yes” to most items, a captive feasibility study is the logical next step.

Steps to evaluate and form a captive

  1. Run a feasibility study: An independent actuary and captive consultant model costs, capital needs, and expected outcomes.
  2. Choose a domicile: Consider regulatory environment, cost, available services (third-party administrators, captive managers), and reputation.
  3. Form the captive: File license applications, secure capital, adopt bylaws, and appoint officers and service providers.
  4. Purchase reinsurance (if needed): Reinsurance can protect against catastrophic losses.
  5. Operate and document: Maintain underwriting discipline, claims records, and governance. Perform annual actuarial reviews.
  6. Monitor and adjust: Regularly review premium rates, retentions, and reinsurance structure.

Common mistakes and red flags

  • Skipping an independent feasibility study or actuarial review.
  • Using the captive primarily for tax sheltering rather than legitimate risk transfer and risk distribution.
  • Underestimating ongoing administration and regulatory costs.
  • Poor documentation of underwriting and claims — a primary IRS and regulator trigger.
  • Choosing a domicile based solely on low upfront fees rather than regulatory fit and service availability.

Short case example (illustrative)

A mid-sized manufacturer faced rising general liability costs. After a feasibility study and reinsurance placement, the firm created a single-parent captive. Over five years the captive produced underwriting profits, lowered overall insurance expense by about 20–30% relative to the market (after factoring in captive operating costs and reinsurance), and created a reserve to stabilize future premium fluctuations. The success drivers were a stable loss history, committed management, and professional captive management.

Related FinHelp resources

Frequently asked questions

Q: How much capital do I need to start a captive?
A: Requirements vary by domicile and risk profile. Practical starting capital often ranges from several hundred thousand dollars to multi-million levels for larger or higher-risk captives. A feasibility study provides specific numbers.

Q: Will my premiums be tax-deductible?
A: Premiums are deductible by the payer only if the arrangement qualifies as insurance for tax purposes and is not disguised profit-sharing. Tax treatment is fact-specific; consult a tax adviser.

Q: Can a small business form a captive?
A: Yes, but small firms usually use group captives, rent-a-captive structures, or pooled arrangements to reach scale. See our guide on small-business captives linked above.

Next steps and professional advice

If captive insurance might fit your business, engage a multi-disciplinary team: a captive manager, an actuary, insurance counsel, and a tax advisor with captive experience. Start with a feasibility study before making commitments.

Sources and further reading

Professional disclaimer

This article is educational and not individualized legal, tax, or investment advice. In my practice helping business owners evaluate risk-transfer strategies, I find captives can be powerful when used for the right reasons and managed correctly. Consult a licensed insurance professional, a CPA or tax attorney, and captive counsel before forming or funding any captive.