Captive Insurance Considerations

A captive insurance company is a licensed insurance subsidiary created and owned by a business to insure risks that the parent company faces. Rather than paying premiums to a commercial insurer, the business pays premiums to its own captive, which then covers specified losses. This structure has legitimate uses for risk management and can provide tax benefits when properly implemented. However, the IRS closely scrutinizes captive arrangements, and poorly structured captives face significant penalties.

What Is a Captive Insurance Company?

A captive is a formal, licensed insurance entity. It must be domiciled in a jurisdiction that permits captive formation, maintain required capital reserves, and operate like a genuine insurance company. The parent business becomes the captive's primary (or only) policyholder.

Common domiciles include Vermont (the largest U.S. captive domicile), Delaware, Utah, Nevada, and offshore locations like Bermuda and the Cayman Islands. Each jurisdiction has different regulatory requirements and minimum capital thresholds.

Types of captives:

• Single-parent captive: One company owns the captive and is its sole insured
• Group captive: Multiple unrelated businesses share ownership and pool risks
• Rent-a-captive: A business rents capacity from an existing captive facility
• Cell captive: A segregated cell within a larger captive structure

Most mid-sized businesses exploring captives consider single-parent structures.

Minimum Requirements and Feasibility

Captive insurance is not practical for every business. The economics typically require substantial premium volume to justify formation and operating costs.

General thresholds:

• Minimum annual premium volume: $1,000,000+ (some advisors suggest $250,000-$500,000 as the floor for small captives)
• Formation costs: $50,000-$150,000 (legal, actuarial, feasibility study)
• Annual operating costs: $30,000-$75,000 (management, audits, regulatory filings)
• Minimum capitalization: $150,000-$500,000 depending on domicile and risk profile

Risks typically insured through captives:

• Product liability
• Professional liability / errors and omissions
• Employment practices liability
• Cyber liability
• Business interruption
• Environmental liability
• Risks commercial insurers won't cover or price reasonably

If your business pays $200,000 annually in commercial insurance premiums for risks that could go through a captive, the $50,000+ annual operating costs consume a significant portion of potential savings. At $1 million+ in premiums, the economics become more favorable.

Tax Benefits of Captive Insurance

When structured properly, captive insurance provides several tax advantages:

Premium deductions: The parent company deducts insurance premiums paid to the captive as a business expense, just as it would deduct premiums to a commercial insurer.

Loss reserves: The captive can establish reserves for expected future claims. These reserves accumulate within the captive and are not immediately taxed to the parent.

Investment income: Premiums paid to the captive can be invested. Investment returns compound within the captive structure.

Small captive election (831(b)): Captives receiving less than $2.65 million in annual premiums (2024 threshold, indexed for inflation) can elect to be taxed only on investment income, not on underwriting profits. This provision has attracted significant IRS attention.

Example of tax treatment: A business pays $500,000 in premiums to its captive. The business deducts this as a business expense, reducing taxable income by $500,000. The captive, if it qualifies as an 831(b) small captive and has no investment income, may owe no federal tax on the premium. If the captive has a good claims year, surplus builds within the captive.

IRS Scrutiny and Compliance Requirements

The IRS has identified abusive captive arrangements as a significant compliance concern. In recent years, certain promoters have marketed captive structures primarily for tax avoidance rather than genuine risk transfer. The IRS has won multiple court cases against such arrangements.

Key requirements for a legitimate captive:

Economic substance: The captive must operate as a real insurance company. It must have adequate capitalization, formal policies, claims procedures, and actuarial support for premium pricing.

Risk distribution: Courts have held that insurance requires risk distribution—the pooling of risks across multiple insureds or exposures. A captive insuring only one policy from one company may fail this test. Many captives join risk pools or reinsurance arrangements to satisfy distribution requirements.

Risk shifting: Actual risk must transfer from the parent to the captive. If the parent would pay claims regardless of the captive's existence, no real risk shift has occurred.

Arm's length pricing: Premiums must be actuarially determined based on the risks insured. Premiums cannot be inflated to maximize deductions. The IRS compares captive premiums to what commercial insurers would charge for similar coverage.

Independent operation: The captive should have independent management, maintain separate books and records, and make genuine underwriting decisions.

Red flags the IRS investigates:

• Premiums that consistently equal the 831(b) threshold
• Coverage for implausible risks
• No claims ever filed despite years of coverage
• Premiums far exceeding commercial market rates
• Captive owned by family members rather than the operating business

Worked Example: $5M Revenue Business Exploring Captive for Liability

The Situation: Henderson Manufacturing generates $5 million in annual revenue and employs 45 people. The company manufactures industrial components and faces product liability exposure. Current insurance costs:

The owner is exploring whether a captive makes sense.

Feasibility Analysis:

Premium volume: $370,000 in total premiums. Not all would necessarily go through a captive—the company might retain commercial coverage for some risks and use the captive for others. Realistic captive premium: $150,000-$250,000 annually.

Formation and operating costs:

• Feasibility study: $15,000
• Formation (legal, actuarial, licensing): $75,000
• Annual management and compliance: $45,000
• Capitalization requirement: $250,000

Year 1 costs: $385,000 (formation + operating + capital contribution) Ongoing annual costs: $45,000

Economic analysis over 5 years:

Without captive: $370,000 × 5 = $1,850,000 in premiums to commercial insurers

With captive (insuring $200,000 of risk annually):

• Commercial premiums: $170,000 × 5 = $850,000
• Captive premiums: $200,000 × 5 = $1,000,000 (paid to owned entity)
• Formation costs: $90,000
• Operating costs: $45,000 × 5 = $225,000
• Capital contributed: $250,000 (remains in captive)

The captive premiums ($1,000,000) provide tax deductions to Henderson Manufacturing. If claims are lower than premiums, surplus accumulates in the captive. If the captive qualifies for 831(b) treatment, underwriting profit is not taxed at the captive level.

Potential benefits:

• Tax deduction of $200,000 annually shifts income to lower-taxed captive
• At 25% effective tax rate, annual tax savings: $50,000
• Five-year tax savings: $250,000
• Surplus accumulation if claims are favorable
• Coverage customization for hard-to-insure risks

Potential risks:

• IRS challenge if arrangement lacks substance
• Claims could exceed premiums, depleting captive capital
• Administrative burden of operating a licensed insurer
• Locked capital until captive is dissolved

Conclusion for Henderson: The premium volume ($200,000 to captive) is modest relative to operating costs ($45,000 annually). The arrangement might work but is near the lower threshold of feasibility. Henderson should ensure:

1. An independent actuary sets premiums
2. The captive participates in a risk pool for risk distribution
3. Claims procedures are genuinely followed
4. Coverage addresses real operational risks
5. Documentation supports business purpose beyond tax benefits

When Captive Insurance Makes Sense

Captive insurance is most appropriate when:

• Annual premium volume exceeds $500,000-$1,000,000
• The business faces risks commercial insurers won't cover adequately
• The business has a strong loss history and wants to retain underwriting profit
• Risk management sophistication exists to operate an insurance entity
• Long-term planning horizon justifies formation costs

Captive insurance is less appropriate when:

• Tax reduction is the primary motivation
• Premium volume is insufficient to justify operating costs
• The business lacks administrative capacity for compliance
• Short-term cash flow needs conflict with capital requirements

Captive Insurance Evaluation Checklist

Feasibility Assessment

• Calculate total annual insurance premiums currently paid
• Identify which risks could potentially be insured through a captive
• Estimate captive premium volume (minimum $250,000 recommended)
• Obtain formation cost estimates from captive managers
• Project ongoing operating costs (management, audit, actuarial, legal)
• Determine capitalization requirements for target domicile
• Model 5-year economics comparing captive vs. commercial insurance

Structure and Compliance

• Engage qualified captive manager with regulatory experience
• Hire independent actuary to determine arm's length premiums
• Select domicile based on regulatory environment and business needs
• Establish risk distribution through pool participation or unrelated business
• Document business purposes beyond tax benefits
• Create formal underwriting and claims procedures
• Maintain separate books, records, and governance

Ongoing Operations

• File required regulatory reports in domicile jurisdiction
• Conduct annual actuarial review of premium adequacy
• Process claims through formal procedures
• Maintain adequate reserves as determined by actuary
• Prepare for potential IRS examination with complete documentation
• Review captive performance annually against projections
• Consult tax advisor on any changes to 831(b) or related provisions