Captive insurance is offered by a corporation that owns the risk it insures. It protects against perils that traditional insurers find too small or too risky to handle. The captive insurance industry is growing globally. In 2017, about $1 trillion worth of captive insurance contracts were outstanding worldwide. By 2025, the global captive market is expected to reach $2.5 trillion.
Captive Insurance Company Definition
A captive insurance company is like a traditional insurance company but differs because it does not offer insurance products directly to consumers. Instead, captives are owned by insurance companies, businesses, and associations that use them to manage risk exposures. Captives are sometimes referred to as “capture vehicles” because they capture the risk exposure of the parent company.
Captives usually are subsidiaries of larger corporations that provide specific types of coverage. They are formed for financial benefit and to meet specific regulatory requirements, such as state laws regarding insurance. Some captives are explicitly established for tax reasons; others are set up primarily for cost-saving purposes. Captives are described as “insurers within insurers” because they are part of the corporate structure of a parent company.
Types of Captive Insurance Companies
Risk Retention Groups
Companies operating at a high-risk level should consider using a risk retention group (RRG). RRGs are companies that take responsibility for all the risks associated with their industry. They do so by pooling together the resources of many different companies to form a single large company. Typically, multiple companies own RRGs. Each company contributes money to the RRG based on how much risk it wants to bear; some refer to them as mutual funds.
An advantage of RRGs is that they offer greater flexibility than captive insurance companies. Because many organizations combine resources to form RRGs, they can provide services that no individual organization can afford. For example, RRGs may be able to purchase specialized equipment such as forklifts or cranes. Additionally, RRGs can negotiate better rates with vendors than individual companies can.
Another advantage of RRGs is their ability to spread risk across many different industries, allowing them to avoid overexposure to a single line of business. For example, if one of the members of the RRG experiences financial difficulties, the other members of the RRG can continue operating without interruption.
However, RRGs also have disadvantages. One disadvantage is that they require a significant amount of capital to start. In addition, RRGs must be very careful about which companies join them. If they choose poorly, they may have too little risk protection. Another disadvantage is that RRGs cannot insure against losses caused by natural disasters.
Self-Insured Retentions
With a self-insurance plan, a company insures losses it funds from its assets rather than paying premiums to an outside insurer. The main benefit of self-insuring is that the company saves money on premium payments. However, there are some drawbacks to this approach. First, the company has less control over the costs of insuring itself. Second, the company is responsible for all claims against it. Third, the company must pay for all of the benefits provided under the policy. Finally, the company must maintain sufficient reserves to cover potential liabilities.
Captive Insurance Companies
A captive insurance company is a company that takes full responsibility for insuring another company. A typical captive insurance company creation happens when two or more companies merge resources to create a new entity. Captive insurance companies differ from RRGs because they are not formed by combining the assets from several different companies. Instead, captive insurance companies create the operation by combining the resources of just one company.
Captive insurance companies are desirable when a company owner does not want to assume all the risks associated with insuring their company. For example, manufacturers might use a captive insurance company to protect their business from product defects liability claims.
Benefits of Captive Insurance Companies
Captives offer several benefits over traditional insurance policies, such as costing less because there are no overhead and administrative costs associated with running a business. In addition, captives do not pay dividends to shareholders as mutual funds do. Instead, profits go toward paying claims. Captives also present advantages with tax breaks specific to their structure.
The main benefit of captive insurance is that it allows businesses to purchase insurance without having to deal directly with insurers. Instead, they work with captive insurance brokers who act as middlemen between the insured company and the insurer. This routine ensures that the policy price is competitively priced while providing adequate coverage.
Captive insurance companies allow their owners to:
- Reduce insurance costs and control their risk exposure while diversifying their risk portfolio.
- Comply with regulatory requirements.
- Create a hedge against future liabilities.
Increase Control, Reduce Costs
Captive insurance companies represent a feasible option for small businesses looking to cut costs while increasing control over their risk management. Captive companies are typically formed to insure subsidiaries and affiliates. This setup allows captive insurers to provide coverage at lower rates and improve margins. In addition, captive insurance companies often offer better pricing because they don’t compete directly against each other. As a result, they can negotiate discounts based on volume and pool risks to obtain even better deals.
The Downside of Captive Insurance
Captive insurance companies are often marketed to limit risk exposure and lower taxes. But there also are downsides to owning a captive, including increased administrative costs and potential liability issues.
Captives are an alternative to traditional insurance products. And they tend to offer lower premiums because captive insurers don’t pay commissions to agents, which means they can share savings with customers. However, since captives typically lack access to large pools of capital, they must rely on investors to fund their operations. Consequently, captive insurance companies are often less stable than traditional carriers.
Tax Issues of Captive Insurance Companies
A captive insurance company operates within the framework of another organization, such as a holding company, mutual fund, trust, or partnership. This relationship gives rise to tax issues for the captive insurer. For example, if the captive insurer provides insurance coverage to third parties, it must file returns reporting income and expenses.
If the captive insurer engages in insurance activities, it must comply with state laws regarding insurance agents and brokers. In addition, the captive insurer must follow applicable federal regulations, including those governing the filing of financial statements.
The IRS treats captives differently than traditional insurance companies. As a rule, captives are treated as partnerships rather than corporations. As such, they cannot deduct losses against ordinary income. Therefore, they cannot claim deductions for interest payments, dividends, or salaries paid to officers. However, captives can take depreciation deductions for assets used in providing insurance. In addition, captives are subject to certain excise taxes. These include taxes imposed on life insurance premiums and surcharges on self-employment income.
What Types of Coverage Do Captives Provide?
Captive insurance usually covers standard casualty lines such as General Liability, Product Liability, Professional Liability, Workers’ Compensation, and others. These are the types of claims that captive insurance companies usually handle. However, captive insurance doesn’t protect clients against every risk imaginable but does include risks covered under standard commercial general liability policies.
Captive insurance is also available for specific industries such as law firms, accountants, architects, engineers, consultants, and public relations professionals. Other captive insurance companies focus on protecting manufacturers, distributors, wholesalers, retailers, and service providers.
Common Captive Insurance Products
These two types of insurance products are standard coverages that captives typically offer:
- General Liability Insurance – Protects against lawsuits arising from bodily injury, personal injury, and property damage.
- Workers’ Compensation Insurance – Provides benefits to employees who suffer injuries while at work.
What Are the Advantages of Captive Insurance?
Captive insurance offers several advantages over traditional insurance. First, captive insurance companies generally have lower costs. Second, because they aren’t paying commissions to agents, captive insurers can negotiate better rates from reinsurers and other sources of insurance. Third, lower costs mean captive insurers can charge lower premiums to consumers.
Additionally, captives are more flexible than traditional insurance companies because, unlike conventional insurance companies, they are not bound by contracts that limit their ability to change terms and conditions. On the other hand, captives that don’t face such restrictions can experience agile operations.
Also, captives provide more protection for policyholders. So, while traditional insurance companies may be reluctant to write new businesses because of uncertainty about future liabilities, captive insurers can offer broad coverage at competitive prices.
Finally, captives allow businesses to obtain insurance without having to establish an independent entity. Instead, they purchase insurance through organizations such as holding companies, trusts, partnerships, and mutual funds.
Additional Benefits of Captive Insurance
Captive insurance companies are often easier to administer than traditional insurance because one company handles the administration instead of multiple carriers. This feature makes tracking premiums and payments more manageable.
Several types of captive structures are available in today’s market ranging from agency captives to single parent, group or association captives, and protected cell captives. The array of options makes captives viable for many organizations.
Although captives operate differently, all offer similar benefits, including a lower insurance cost, comprehensive coverage, and lessened impact of industry market cycles. In addition, captives offer augmented risk management authority with more claims management controls and potentially substantial tax savings.
How Does a Captive Insurer Operate?
One or more parent entities own a captive insurance company. The parent entities own all the shares of stock in the captive insurer and control the board of directors. They hire the chief executive officer (CEO) and senior management team. In some cases, the CEO is appointed by the parent entities, while in other cases, the CEO works independently.
The parent entities retain ownership of the captive insurer’s assets, including cash, investments, real estate, equipment, vehicles, and other property. It also pays the captive insurer’s operating expenses which typically encompass payroll, office space, legal, accounting, marketing, and advertising. The captive insurer pays dividends to the parent entities from its profits. However, it won’t pay dividends if the captive insurer incurs losses.
Who Uses Captive Insurance?
Captives are often used to insure small-to-medium sized businesses. For example, many manufacturing companies use captive insurance to protect against product liability claims. And captive insurance is also popular with financial institutions. Many banks, credit unions, and savings and loan associations use captive insurance to protect themselves against potential losses from bad loans.
Captive insurance is a form of self-insurance. You take responsibility for insuring yourself and purchasing insurance policies from another source. Captive insurance isn’t appropriate for every type of business. Therefore, it’s essential to consider your needs before choosing a captive insurer.
Best Captive Insurance Programs
When you start a search for the best captive insurance program, we know it’s a difficult challenge to find reliable resources that will provide the solutions your clients need. It’s the same issue for nearly all specialty lines and program business needs. Recognizing the problem was our motivation to create the Program Business Market Directory—to serve the needs of both sides of the insurance distribution system for specialty programs.
Searching the Market Directory for “Captive Insurance” will find you Tangram Insurance Services. It is a Managing General Underwriter in the captive insurance program space. It will assist you in deciding whether a client is a good candidate for a captive solution. Tangram’s service includes conducting a feasibility study of the company’s risk profile to determine if the captive option is a route to insure and manage risk.
If the results look promising for your client, Tangram will work with you, your client, and the regulatory authority to complete all necessary documentation and submit all required information. It can also provide ongoing captive management services, including:
- Regulatory liaison and continuous compliance
- Corporate governance services
- Accounting and financial reporting
- Coordination of third-party service providers
- Maintenance of captive insurance policies & premiums