Captive Insurance Company: Understanding What It Means

What Is a Captive Insurance Company?

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 cannot find a suitable outside firm to insure it against particular business risks
• 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

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.

Understanding a 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, corporations that form captive insurance companies generally rely on traditional insurers to insure against some risks.

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 may locate the captive insurance company in a tax haven, such as Bermuda or the Cayman Islands, to avoid adverse tax implications. Today, several U.S. states allow the formation of captive companies. The protection from tax assessment is a sought-after benefit for the parent company.

Whether the parent company realizes a tax break from creating a captive insurance company depends on the classification of insurance that 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, 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.  

Pros and Cons of Captive Insurance

Captives can be an attractive option for companies looking for ways to manage and distribute risk, but there are advantages and disadvantages.

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 Guernsey, U.K.-based captive insurance company Jupiter Insurance, and 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 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.

According to a press release, the state’s Division of Claims and Risk expects the captive to help insure unique and difficult risks and reduce overall insurance costs. “The use of a captive will also allow the State to better evaluate and control the risks of Tennessee state government,” the release states.

The Bottom Line

Insurance is a significant expense for large companies. Captive insurance companies offer a way for companies to control costs, reap tax benefits, and cover risks that commercial insurance companies might be unable or unwilling to insure. While setting up a captive can be challenging, third-party captive professionals can help companies navigate the process and avoid costly mistakes.