Captive Insurance Company Definition
A captive insurance company is a wholly owned subsidiary insurer formed to provide risk mitigation services for its parent company or related entities.
Companies form “captives” for various reasons, such as when:
- The parent company can’t find suitable external insurance.
- The premiums paid to the captive insurer create tax savings.
- The insurance provided is more affordable.
- It offers better (or more affordable) coverage for the parent company’s specific risks.
Potential benefits include lower costs and greater control over coverage. Disadvantages include overhead expenses and compliance issues.
Captive insurance companies are not the same as captive insurance agents.
Key Takeaways
- A captive insurance company is a wholly owned subsidiary that provides risk mitigation for its parent company or related entities.
- Captive insurance can offer potential cost savings, tax benefits, and greater control over coverage and claims.
- Companies form captives to address coverage gaps when commercial insurers can’t or won’t cover certain risks.
- Drawbacks include potential high overhead costs, compliance issues, and the risk of being underinsured.
- Most Fortune 500 companies have captive insurance subsidiaries to better manage their unique risks.
How Captive Insurance Companies Function
A captive insurance company is a form of corporate self-insurance. While there are financial benefits to creating a separate entity to provide insurance services, parent companies must consider the associated administrative and overhead costs, such as additional personnel and startup costs. Companies must also navigate complex compliance issues. As a result, corporations that form captive insurance companies generally rely on traditional insurers to insure against some risks. Reinsurance companies help distribute risks that the parent company would otherwise take on.
Fast Fact
Captive insurance companies are often formed to supplement commercial insurance, allowing the parent company to keep the money it would otherwise spend on additional insurance premiums.
A captive insurance company should not be confused with a captive insurance agent, who is an insurance agent who only works for one insurance company and is restricted from selling competitors’ products.
Tax Considerations for Captive Insurance Companies
The tax concept for captive insurance companies is straightforward. The parent company pays insurance premiums to its captive insurance company and seeks to deduct these premiums in its home country, often a high-tax jurisdiction. Today, several U.S. states allow the formation of captive companies. Protection from tax assessment is a sought-after benefit for the parent company.
The tax break a company receives depends on the type of insurance it handles. In the United States, the Internal Revenue Service (IRS) requires risk distribution and risk shifting to be present for a transaction to fall into the category of insurance. The IRS has publicly declared it would take action against captive insurance companies suspected of abusive tax evasion.
Some risks could result in substantial expenses for the captive insurance company, potentially leading to bankruptcy. Single events are less likely to bankrupt a large private insurer because of the diversified pool of risk that they hold.
Advantages and Disadvantages of Captive Insurance
Captives can be a good option for managing risk, but they have pros and cons.
Pros and Cons of Captives
Cons
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Company’s capital is at risk
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Potential to be underinsured
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Overhead expenses and startup costs
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Potential compliance issues
Real-World Examples of Captive Insurance Companies
A captive insurer gained attention after the 2010 BP oil spill in the Gulf of Mexico. At that time, reports circulated that BP was self-insured by Guernsey, U.K.-based captive insurance company Jupiter Insurance, and that BP could receive as much as $700 million in coverage from losses. British Petroleum is not alone in this practice—indeed, most Fortune 500 companies today have captive insurance subsidiaries.
In a more recent example, the state of Tennessee launched its own captive insurance company in 2022 to cover state-owned buildings and contents, including Tennessee’s public college campuses, as well as general liability. The captive insures property valued at $31.4 billion as of July 2022.
The state expects its captive to cover unique risks and cut insurance costs. “The use of a captive will also allow the State to better evaluate and control the risks of Tennessee state government,” a press release from the state’s Division of Claims and Risk stated.
There are numerous types of captive insurance companies, including pure captives (which only cover the parent company and affiliates) and group captives (insuring several members of a specific group). Micro captives are smaller entities with annual written premiums up to $1.2 million.
Who Owns a Captive Insurance Company?
Is Captive Insurance a Good Idea?
Captive insurance is essentially a type of self-insurance that allows a company to meet its unique risk management needs. Captives can be a good idea because they might offer lower costs, significant tax advantages, underwriting profits, and greater control over coverage and claims decisions. They are also helpful if the commercial insurance market can’t provide coverage for certain risks. However, there are disadvantages to consider, including the potential to be underinsured or have a poorly drafted policy.
Which Types of Coverage Do Captives Provide?
Captives aren’t intended to protect against all risks. Companies that use them generally rely on conventional commercial insurers to protect against certain risks. While captives permit companies to manage risks that traditional insurers don’t (or won’t) cover, captive insurance is often used for standard casualty lines like general liability, product liability, professional liability, and workers’ compensation.
How Do Captives Differ from Mutual Insurance Companies?
The primary difference is that captives are formed and owned by a parent company to insure only its risks and those of its affiliates, while a mutual insurance company sells protection products to policyholders amongst the general public. A captive is owned by its parent, while a mutual is owned by its policyholders.
The Bottom Line
Captive insurance companies are an avenue for self-insurance, allowing enterprises to manage risks efficiently when traditional insurance options fall short.
Key advantages of captive insurance are cost control, tax benefits, and customized coverage for unique risks. Potential downsides include initial costs, compliance complexities, and risk of being underinsured.
While captive insurance setup can be complex and costly, engaging third-party captive professionals can ease the establishment and management process.
Businesses should evaluate the suitability of a captive insurance company based on their specific risk management needs and financial circumstances. Most Fortune 500 companies have successfully implemented captive insurance, which signifies its effectiveness and reliability.
