What is Captive Insurance?

Captive insurance is a sophisticated risk management strategy where a company establishes its own insurance subsidiary to provide tailored coverage for its specific risks. This approach offers potential cost savings and greater control over insurance policies and claims.

History and Growth of Captive Insurance

The concept of captive insurance has existed since the 1950s, when the first captive insurance company was formed. Since then, the captive insurance market has experienced significant growth both domestically and offshore, with Bermuda being the largest single jurisdiction, followed by the Cayman Islands. In the United States, Vermont leads in catering to Fortune 500 companies, while states like Utah, Delaware, and North Carolina have emerged as viable options for mid-market companies.

Defining Captive Insurance Companies

A captive insurance company, also known as a "captive" or "captive insurer," is a subsidiary or separate legal entity established, fully owned, and controlled by its parent entity (the "insured"). The primary objective of a captive is to insure and mitigate the risks of its owners. Captives can be created to augment or replace existing insurance coverages, finance various risk exposures, or provide coverage for unique risks that may be challenging to insure in traditional markets.

Key features of captive insurance companies include:

1. Full ownership and direct control by the insured
2. Capital at risk from the owners
3. Financial rewards obtained from direct control of the captive

To be recognized by the IRS, a captive should be established as a C-Corporation or any other legal entity taxed as such. It must be licensed and domiciled as an insurance company through a state or foreign jurisdiction that allows captives to operate.

Establishing and Operating a Captive

The process of establishing and operating a captive insurance company involves:

1. Analyzing existing coverage, exclusions, premiums, and insured losses
2. Identifying potential insurable risks
3. Assessing risks and writing policies accordingly
4. Determining premium amounts with third-party actuarial support
5. Investing premium payments for future claim disbursements

IRS Requirements for Legitimate Captives

For a captive to be considered legitimate from an IRS standpoint and allow premiums to be tax-deductible, it must meet certain requirements:

• Risk Transfer: The insured risk must be transferred from the parent company to the captive insurer, which must have sufficient capital to guarantee effective risk transfer.
• Risk Distribution: The captive must provide coverage for a substantial number of identifiable independent risks, incorporating the law of large numbers to reduce the chance of a single claim exceeding the premiums collected.
• Insurance Risk: The captive must manage only risks of losses arising from underwritten insurance coverage, not other business risks like investment losses.
• Common Nuances of Insurance: The captive must operate according to conventional insurance company protocols, including writing risk-based premiums, financing risks, and creating reserves.

The Appeal of Captive Insurance in Challenging Markets

As traditional insurance markets face challenges and premiums continue to rise, many business owners turn to captive insurance as a flexible and cost-effective means of self-insurance. Captives offer a 'calm port in the storm' during hard markets with increased premiums and stricter coverage terms.

Working with Specialized Firms

For businesses considering this option, it's essential to work with specialized firms that can assist in developing, creating, and managing captive insurance companies. These experts can help determine if a captive insurance company is the right solution for a particular business and guide them through the complex process of establishment and operation.

Strategic Benefits of Captive Insurance

Captive insurance represents a strategic approach to risk management that can provide significant benefits for companies seeking greater control over their insurance coverage and costs. As the business landscape evolves, captive insurance will likely remain attractive for organizations looking to optimize their risk management strategies.

At Risk Management Advisors, we specialize in assisting companies in developing, creating, and ultimately managing their own captive insurance companies. Discover if a captive insurance company is right for your business.