At its most basic level a “pure” captive works like this: A corporation with one or more subsidiaries sets up a captive insurance company as a wholly owned subsidiary. The captive is capitalized and domiciled in a jurisdiction with captive-enabling legislation which allows the captive to operate as a licensed insurer. The parent identifies the risk of its subsidiaries that it wants the captive to underwrite. The captive evaluates the risks, writes policies, sets premium levels and accepts premium payments. The subsidiaries then pay the captive tax-deductible premium payments and the captive, like any insurer, invests the premium payments for future claim payouts.
At its core, a captive insurance company is a risk-financing tool. It places more risk-management control and financial control into the hands of the owner of the captive than exists in a typical commercial insurer-insured relationship. Unlike what occurs in the traditional insurance market, the risks that are underwritten by the captive are precisely the risks that the insured needs underwritten. The policy terms are designed to meet the specific needs of the insured and the rates are based on the specific loss profile/loss experience of the insured—not the average loss rate of the market.