What Is a Captive Insurance Company?

A captive insurance company is a wholly-owned subsidiary company that provides risk-mitigation services for its parent company or a group of related companies. A captive insurance company may form if the parent company cannot find an outside firm to insure them against particular business risks, if the premiums paid to the captive insurer create tax savings, or if the insurance provided is more affordable or offers better coverage for the parent company's risks.

Understanding the Captive Insurance Company

A captive insurance company is a form of corporate "self-insurance." While there are financial benefits of creating a separate entity to provide insurance services, parent companies must consider the associated administrative and overhead costs, such as additional personnel. There are also complex compliance issues to consider. As a result, larger corporations predominantly form captive insurance companies.

Tax Issues of Captive Insurance Companies

The tax concept of 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. A parent company will locate the captive insurance company in tax havens, such as Bermuda and the Cayman Islands, to avoid adverse tax implications. Today, several states in the US allow the formation of captive companies. The protection from tax assessment is a sought-after benefit for the parent company.

If the parent company realizes a tax break from the creation of a captive insurance company will depend on the classification of insurance, the company transacts. 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 publicly declared that 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 that are unaffordable. These sizable risks could lead to bankruptcy. Single events are less likely to bankrupt a large private insurer because of a diversified pool of risk they hold.  

Examples of Captive Insurance Companies

A well-known captive insurance company made headlines in the wake of the 2010 British Petroleum oil spill in the Gulf of Mexico. At that time, reports circulated that BP was self-insured by a Guernsey-based captive insurance company called Jupiter Insurance and that it could receive as much as $700 million from it. British Petroleum is not alone in this practice, as many Fortune 500 companies have captive insurance subsidiaries.