A captive insurer (or “captive”) is a special-purpose insurance company formed primarily to underwrite the risks of its parent or affiliated groups. It is quite similar to a traditional, commercial insurance company in that it is licensed as an insurance company, it sets insurance-premium rates for the risks it chooses to underwrite, writes policies for the risks it insures, collects premiums and pays out claims made against those policies.
The biggest difference between a captive insurer and a commercial insurance company is that a captive cannot sell insurance to the general public. It can only underwrite the risks of its parent organization or related entities. Another key difference is that the regulations governing captive insurance companies are typically less onerous than those regulations governing traditional commercial carriers.
At its most basic level a “pure” captive works like this: A corporation with one or more subsidiaries sets up a captive insurance company as a wholly owned subsidiary. The captive is capitalized and domiciled in a jurisdiction with captive-enabling legislation which allows the captive to operate as a licensed insurer. The parent identifies the risks of its subsidiaries that it wants the captive to underwrite. The captive evaluates the risks, writes policies, sets premium levels and accepts premium payments. The subsidiaries then pay the captive tax-deductible premium payments and the captive, like any insurer, invests the premium payments for future claim payouts.
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 predominately form 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 which is unaffordable. These sizable risk could lead to bankruptcy. Single events are less likely to bankrupt a large private insurer because of a diversified pool of risk they hold.