What Is a Captive Insurance Company?

Captive insurance is an unusual but beneficial way for businesses to approach insurance. Instead of paying a third party for coverage against business losses, the company forms its own insurance company — often at a significant discount.

But captive insurance companies are beneficial in another way: they offer better tax benefits than other forms of insurance. Here’s how they work.

What Is Captive Insurance?

Captive insurance is a form of self-insurance. In a traditional self-insurance setup, a company will set aside funds to cover business losses and they will draw down those funds as needed. All payments are made out of pocket.

Captive insurance is a bit different. Captive insurance is when a business forms its own small insurance company. The business will pay premiums to its captive company based on its own specific risk factors. To protect against exceptionally large losses, the captive can purchase “reinsurance.” Reinsurance can be thought of as an insurance policy for insurance companies. If the business has an especially large loss, the captive can file a claim on its reinsurance policy to pay for the company’s losses.

How Do You Form a Captive Insurance Company?

Even though captive insurance companies take out their own insurance policies, they are still considered a form of self-insurance because they are owned by the people or companies they insure. But captive insurance companies can insure more than one business at a time. Single-parent captives are owned by only one company while group captives are owned by more than one company. In group captives, companies with similar risk profiles — often those in the same industry — collectively form an insurance company and operate it as co-owners.

Captives that only insure their owners are called pure captives. Captives that insure unaffiliated parties (i.e., nonowners) are called sponsored captives. The largest tax benefits tend to go to owners of pure captives.

What Are the Tax Benefits of Captive Insurance Companies?

The most basic tax benefit available to nearly all captive insurance companies is that the premiums a business pays to its captive are deductible if the captive meets certain risk standards. This effectively allows the company to deduct funds today that are held in reserve for losses they expect to claim tomorrow.

The IRS states in Rev. Rul. 2002-89 and Rev. Rul. 2002-90 that if either of the following safe harbors are true, captive insurance premiums are deductible:

• The captive receives at least 50% of its premiums from nonowners
• The captive insures at least 12 subsidiaries owned by the same parent, each holding no more than 15% of the total risk

In both scenarios, the IRS believes there is significant risk distribution for the captive to be considered a true insurance company and therefore allows the business to deduct insurance premiums.

But keep in mind that these are just safe harbors. The IRS may allow businesses to deduct premiums paid to captive insurance companies that don’t meet one of the above requirements. The IRS may ask some of the following questions to determine if the captive is a true insurance company:

• Is the captive licensed as an insurance company?
• Does the captive conduct business as an insurance company?
• Are the insurance policies binding?
• Does the captive have adequate capital to cover claims?
• Does the captive loan money back to its owners?
• Are premiums reasonable for the risks being covered?
• Has there been a true shifting of risk from the business to the captive?

What Are Micro-Captive Insurance Companies?

Micro-captives are a subset of captive insurance companies that:

(1) have no more than $2.2 million of net written premiums each year, and

(2) make an election under Sec. 831 of the tax code.

Micro-captives have even greater tax benefits than traditional captive insurance companies.

Micro-captive insurance companies are not taxed on premiums. Micro-captives are not taxed on premiums paid by their owners; they are only taxed on investment earnings. Their owners and other insureds can continue to deduct premiums they pay to the captive.

Micro-captive earnings accumulate tax free. Micro-captives that have net underwriting profits can retain those profits within the company. This wealth can accumulate tax free for years before it is paid out to the captive’s owners.

Micro-captive distributions are taxed as dividends. When the captive’s earnings are paid out to its owners as dividends, they are taxed at preferential rates.

Micro-captives can help reduce estate and gift tax. Depending on how the captive is set up, a micro-captive may help remove earnings or business assets from the owner’s estate, and captive earnings can accumulate for the benefit of the business owner’s heirs.

Micro-captives aren’t fool proof, though.The IRS has listed micro-captive insurance companies on their “dirty dozen” tax scams list multiple times (including 2021), informing businesses that abusive micro-captives are at high risk of being audited. Businesses that establish micro-captives should do so only with collaboration from legal, business and tax advisors to ensure their micro-captive would stand up to an IRS audit.

Why Should You Form a Captive Insurance Company?

Captive insurance companies can be tax beneficial to businesses and their owners, but there are non-tax (and non-financial) reasons to establish a captive insurance company.

Captive insurance companies have lower costs. Captive insurance companies can cost less than purchasing commercial insurance policies. When businesses establish their own insurance companies, they can reduce (and potentially remove) marketing costs, overhead costs, sales commissions, agency fees, etc. The business will need to hire qualified workers to operate the captive, but this can be done at much lower cost.

Captive insurance companies insure risks that are uninsurable. Captive insurance companies can protect against risks that aren’t covered by other insurance policies. That risk must be diversified and the premiums must be adequate, but businesses have the ability to cover more of their business hazards with captive insurance than with commercial insurance.

Captive insurance policies are more flexible. Captive insurance companies offer customized coverage. In fact, captives can write individual policies for each type of risk. This allows businesses to boost coverage in areas they deem to be especially risky. Remember: businesses know their risk profile better than any insurance company. By building their own insurance policy, they can address all the risks that threaten the business.

What Businesses Do Best With Captive Insurance Policies?

Not all businesses will thrive operating and maintaining a captive insurance company. The business owner must be prepared to pay for feasibility studies, build financial projections, assess risks, hire experts like insurance managers and actuaries, maintain licenses, prepare applications, track earnings, make tax elections and so much more.

And the type of business matters, too. Though the tax benefits may be enticing, the greatest benefit is the mitigation of risk. Businesses that are either uninsured or underinsured will benefit most from captive insurance policies, and they will be the ones most willing to put in the effort to establish and maintain a captive.