Captive Insurance Company – Definition

Cite this article as:"Captive Insurance Company – Definition," in The Business Professor, updated March 14, 2019, last accessed October 22, 2020,


Captive Insurance Company Definition

A Captive Insurance Company is a subsidiary company formed and owned by a company for managing the financial risks of the parent company. A Captive Insurance company insures the risks of its owner. It is a vehicle for self-insurance which is cost-effective and tax-effective. Captive Insurance companies are formed to meet the risk management needs of its parent company. These companies are typically established as an alternative to commercial insurance, enabling the parent company to retain the money that would otherwise be spent on insurance premiums.

It is not only a way of managing financial risks more efficiently, but it also helps in accelerating the business objectives of the company. It provides stability in financial operations and decreases the volatility of cash flow of the parent company. Like any other commercial insurance company, Captive Insurance companies are also obliged to follow the state regulatory requirements.

A Little More on What is a Captive Insurance Company

Captive Insurance Companies serve their parent company in several ways. Besides serving the purpose of traditional insurance programs by covering All Risk and Civil Liability of the company they may also cover the credit insurance, cyber risk, extended warranties, employee health insurance, and other benefits. Currently, some companies are even thinking of covering risk against new disruptive technologies including Blockchain and Artificial Intelligence. If a company depends on the commercial insurance market, they may have to compromise their coverage policy but with a Captive Insurance company at their disposal, a company can strategize the most suitable coverage plan for itself.

However, a Captive Insurance company may prove to be disadvantageous for its parent company by creating volatility in their finance. This volatility may occur if the balance between the risk retained and the financial retention capacity of the company is disrupted. So, the market conditions, retention capacity, claims etc. are to be thoroughly analyzed before launching a Captive Insurance Company.

Although the mutual insurance companies are theoretically owned and run by its policyholders but this right of controlling the company is seldom used. Generally, policyholders are asked to vote on the issues that need their intervention. Even on such occasions they are presented with a proxy and guided by the board of the company about exercising their voting rights. The policyholder’s ownership gets over as soon as the insurance period ends. Policyholder’s assets are not invested in the company and they do not have an active role in running the company. On the other hand, a Captive Insurance Company is entirely owned and controlled by its insured.

Three main features of a Captive Insurance company are-

  •         The insured put their own capital at risk
  •         A Captive Insurance company functions outside the purview of the commercial insurance market
  •         The insured invests its capital to meet its risk financing objective.

A parent company needs to invest its own resources in the captive insurance company. They own the company and earns from its profitability. Whereas in a mutual insurance company the policyholders are technically the owners of the company and are entitled to earn benefits from its profitability but in practice, the companies accumulate their surplus instead of distributing them.

The captive insurance companies are considered to be a part of the alternative risk transfer market. They do not participate in the commercial marketplace and thus are not protected by the traditional regulatory environments. State guaranty funds do not provide any protection for the captive insureds and insurers often have much lesser capital than the commercial insurers. The insureds put their own capital at risk to take the advantages of captive insurance.

The commercial market may not always offer suitable products for a company’s risk financing needs. In such scenarios, a company may consider creating its own captive insurance company. The reasons behind establishing captive insurance companies are high pricing of commercial insurance plan, limited coverage, and unavailability of a suitable plan in the market.

There are mainly two types of captive insurers. When a captive insurer is completely owned, directly or indirectly, by its insureds it is called the Pure Captives. Sponsored captives are owned by parties unrelated to the insureds.

Pure Captives

Single-parent captives are owned by only one company whom they provide the insurance service and the group captives are owned by multiple companies. A group of individuals or companies set up one single captive insurance company to have insurance coverage.

Sometimes a group captive provides coverage to the insureds belonging to the same industry or having similar risks. Such group captives are known as Industrial insured group-owned captives. On the other hand, heterogeneous group captives are owned by the insureds from various industry groups. This type of groups captives may be a reinsurance pool. A reinsurance pool does not offer direct insurance, rather it reinsures the captives of its owner. It may also insure other insurers that agree to issue policies to the owners of the pool.

Sponsored captives have all the main features of a pure captive. The insured’s capital is put at risk and it functions outside the commercial marketplace. But it is not created by its insureds and it does not necessarily pool their risks. It may keep separate underwriting accounts for each one. This type of captives is also known and nonowned or nonaffiliated captives.

It may be created by someone related to the insurance industry for their client or by someone completely unrelated. The sponsor pays the statutory or core capital for the captive. Many sponsored captives do not acquire the capital from the insureds rather they take an access fee from them. These are known as rental captives.

In some domiciles, the underwriting accounts of the insureds are legally required to be separated and asset of one insured may not be used for paying the liabilities of other participants unless concerned entities are in agreement to do so. Such accounts are called cell account.

This is the main difference between pure group captives and sponsored captives. In pure group captive, one company’s asset is used for paying other’s liability as the risks are pooled but in sponsored captives, the accounts are separated.

Sponsored captives are generally used by those companies who cannot afford to set up their own captive insurance company. Eventually, after accumulating surplus they may move forward to create their own pure captive insurance company.

A Captive insurance company created by an association for the use of its members does not fall under the category of Sponsored captive. It is a pure captive, indirectly owned by the members of the association and they have the voting control. The association may finance the captive, but the association is owned by its members so in effect they are the owner of the captive.

References for Captive Insurance

Academic Research on  Captive Insurance

  • Captive insurance companies and manager-owner conflicts, Scordis, N. A., & Porat, M. M. (1998). Journal of Risk and Insurance, 289-302. The paper suggests the stature of managers of a company heightens by operating single-parent captive insurers. It examines the hypothesis that the companies with sharper manager-owner conflict are more likely to create a single-parent captive insurance company. The study used a time-series, cross-sectional sample of 4,212 observations and the result supported the hypothesis.
  • The Captive Insurance Phenomenon: A Cautionary Tale?, Kloman, H. F., & Rosenbaum, D. H. (1982). The Geneva Papers on Risk and Insurance-Issues and Practice, 7(2), 129-151. The paper studies the growth and development of captive insurance company movement dominated by the captives from the U.S. in the early 80s. The paper concludes the captive insurance companies are more efficient in providing some relief from the instability and unpredictability of the global economic scenario than the traditional insurance market. The paper expresses its concerns about the future of captive insurance as the Captive Insurances may face direct conflict with the established world market.     
  • • Financial management of insurance companies, John, J. (1993). The paper discusses the financial management of insurance companies. The discussion  delves into the following topics: Review of accounting, Statutory accounting, Gaap and statutory trial balances, Pro forma financial statements, Statement of cash flows, Financial solvency, Solvency measures, Profit planning for new insurance products, assessing risk in new insurance products, Forecasting losses, and Forecasting reserves and surplus.
  • Taxes, stock returns and captive insurance subsidiaries, Cross, M. L., Davidson, W. N., & Thornton, J. H. (1988). The Journal of Risk and Insurance, 55(2), 331-338. The paper analyzes the impact of Revenue Ruling 77-316 and the Carnation decision taken by the United States Tax Court, on firm value of the parent company of captives.
  • Risk response techniques employed currently for major projects, Baker, S., Ponniah, D., & Smith, S. (1999). Construction Management & Economics, 17(2), 205-213. This study focuses on the oil and gas industry’s choice and use of the most successful risk response techniques and compare their choice and use with that of the construction industry. Over one hundred companies within these two sectors were interviewed with an extensive questionnaire to reach a conclusion. The finding shows both two sectors most commonly used the risk reduction as a response to assessed risk, while the construction industry focuses almost exclusively on reducing financial risk. The paper recommends that the construction industry have points to learn from oil and gas industry to improve their management of technical risk and it assumes with the advent of private funding that is likely to become more predominant.
  • Steering Into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Tax Crackdown, Cantley, B. G. (2011). Hous. Bus. & Tax LJ, 12, 224. This article briefly discusses the advantages of an IRC § 831(b) Captive Insurance Company and its requirements and also the compliance issues surrounding it. The development of the IRS offshore crackdown is discussed in detail in the article along with an analysis of the rationales for opting an offshore jurisdiction for establishing Captive Insurance Companies. It also gives insight regarding the potential negative effect of the IRS crackdown on the choice of utilizing an offshore IRC § 831(b) CIC.  
  • The tax deductibility of captive insurance premiums: An assessment and alternative perspective, Lai, G. C., & Witt, R. C. (1995). Journal of Risk and Insurance, 230-252. This article provides an assessment and alternative perspective on the tax deductibility issue of captive insurers. The article suggests a concept of partial insurance for tax deductibility purposes. When the outside risks have higher variances than parent-specific risk, no tax deductibility could be allowed –the article rejects this statement and argues that in determining tax deductibility, the relative amount of business should be an important consideration and not the absolute number of unrelated risks. It further argues, in a group captive with unrelated risks, the degree of risk reduction can be shown to be higher for a parent than for single parent of a captive insure with a similar number of unrelated exposures, when all the other conditions are same.
  • Captive insurance tax policy: Resolving a global problem, Porat, M. M., & Powers, M. R. (1995). The Geneva Papers on Risk and Insurance-Issues and Practice, 20(2), 197-229. The article investigates the issues in the tax policy of Captive Insurance and proposes a unified resolution that allows for partial solutions in the spectrum from no tax-deductibility to full tax-deductibility. According to the authors, the solution is consistent with the federal policy of preferring conventional insurers and at the same time, it is fair to all the parties.
  • Federal Income Taxation and Captive Insurance, Barker, W. B. (1986). Va. Tax Rev., 6, 267. The article discusses the Federal Income Tax policy applied to the Captive Insurance Companies. The taxation policy is discussed in the light of the decision passed by the U.S. Claims Court, U.S. District Courts, U.S. Tax Court, and the Ninth and Tenth Circuits. The decision asserted that the insurance premiums paid by the corporations to its Captive Insurance Company are not tax-deductible under the federal tax system.

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