What is a 'Captive Insurance Company'

A captive insurance company is a company that provides risk-mitigation services for its parent company or for a group of related companies. A captive insurance company may be formed if the parent company is unable to find an outside firm to insure against a particular business risk if the parent company determines that the premiums it pays to the captive insurance company may create a tax savings or if the insurance the captive insurance company provides is more affordable or offers better coverage for the parent company's risks.

BREAKING DOWN 'Captive Insurance Company'

In essence, 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 also weigh the personnel cost of a captive insurance company. There are also complex compliance issues to be dealt with. As such, captive insurance companies are usually formed by larger corporations.

Tax Issues of Captive Insurance Companies

The tax concept behind a captive insurance company is relatively simple. 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. The captive insurance company is domiciled in a tax haven, such as Bermuda or the Cayman Islands, and therefore does not pay taxes on its income. This is an important benefit, in addition to the actual insurance of risk, for the parent company.

Whether the parent company will be able to see a tax break from the creation of a captive insurance company depends on the classification of insurance company transactions. In the United States, the Internal Revenue Service (IRS) requires risk distribution and risk shifting to be present in order for a transaction to be considered "insurance". Some types of risk that the captive company might insure against could result in larger expenses than the parent company can afford, and can lead to bankruptcy. Larger private insurers are less likely to be bankrupted by a single event because of a diversified pool of risk. The IRS has stated publicly that it feels there is abusive tax evasion in some captive insurance company schemes and that it will crack down on them.

Examples of Captive Insurance Companies

A famous example of a captive insurance company made the news in wake of the BP PLC (British Petroleum) 2010 oil spill in the Gulf of Mexico. It was then reported that BP was self-insured through a Guernsey-based captive insurance company called Jupiter Insurance and that it could receive as much as $700 million from it.

Many Fortune 500 companies have captive insurance subsidiaries.

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