What is Captive Insurance?

Introduction and Overview

A captive is an alternative to traditional insurance in which a company – or group of companies – provide coverage for their own risks by forming their own licensed insurance company instead of buying insurance from a third-party.

This guide will explain how captives work, the benefits of captive insurance and explain how they are structured. It will also discuss how this alternative model could help you control insurance costs. If you’re interested in taking control of your risk in a way that saves your company time and money in the long run, continue reading.

History of Captives

The term “captive” originated in the 1950s, when an engineer turned insurance broker named Frederic Reiss founded the first captive insurance company in Bermuda in 1962. Responding to increasingly high premiums, he was interested in a method of retaining and sharing risk.

He based his newly formed captive insurance company in Bermuda, the first country to formally establish legislation and oversight procedures for captives. Today, Bermuda remains the world’s leading offshore captive domicile. However, captives are quickly rising in popularity – there are also 30 captive domiciles in the United States, according to the Insurance Information Institute, and in 2022, the state of Vermont overtook Bermuda as the world’s leading captive domicile.

Today, about 90% of Fortune 500 companies have their own captive subsidiaries, with this alternative form of risk management continuing to grow in popularity each year. But they’re not just for large companies – captives come in all shapes and sizes and span across many different industries, including non-profit groups.

What Exactly is a Captive?

As we mentioned earlier, a captive is a special type of licensed insurance company, controlled by its owners, that provides coverage for their own risks. This is still insurance, and most captive members still utilize traditional insurance markets to transfer certain risks, or to provide excess coverage. It is also common for an organization to place certain lines of insurance within a captive, with others covered by traditional insurance.

The general concept is that instead of buying insurance directly from a third party, members of a captive retain costs and certain risks by contributing premiums into a fund, usually at lower cost than within the traditional market, later covering their own losses.

If there are leftover funds after each organization’s claims have been paid out, each member could receive a share of the underwriting profits. And because much of the money in the captive is being invested, including your premium dollars, the return on these investments can be significant.

Other Advantages to Captive Membership

Other advantages include the many options for self-insuring risks, particularly standard casualty lines of insurance like general liability, product liability, professional liability, commercial auto and workers’ comp. Captives can sometimes provide coverage that is not available in the private market, while also offering cost savings and more control over claims decisions. There are opportunities to lower premiums, which in a captive structure are based on your actual loss history, and to receive significant dividends on funds invested within the captive.

In the current insurance market, many organizations are finding their premiums rising year after year, and are in need of a more consistent, cost-saving solution. Rates are increasing, and underwriting is becoming more difficult. This hardened market results in smaller coverage limits and higher premiums. Forming a captive, or joining an existing one, can be a way to insulate an organization from these market factors.

Types of Captive Insurance

There are many different types of captives; they truly come in all shapes and sizes.

Here’s a helpful way to think about the basic structure of captives:

Single-Parent or Group Captives

• A single-parent captive is owned entirely by one organization to insure risks of their parent company, subsidiaries and directly-affiliated businesses. We mentioned earlier that 90% of Fortune 500 companies have their own captives; the majority of these are single-parent captives. Some do provide coverage for other, non-related organizations; the term “pure captive” is used to describe single-parent captives that do not insure risks of other organizations.
• In a group captive, multiple, separate organizations join together to buy insurance as a group, sharing risk. These organizations could all be of similar size and operating within the same industry, but do not necessarily need to be. There are many types of group captives, some of which are explained in more depth in the next section. The members own the captive (member-owners).

To learn more about group captives, how they’re structured and what advantages they offer, take a look at our Group Captives blog.

Owned or Rented Captives

• An owned captive is entirely owned by any participating organizations, who serve as the exclusive policyholders. They are fully responsible for the administrative operations of the captive, including paying out claims. An owned captive could be a single-parent or group captive.
• A rented captive is a licensed insurer owned by on outside organization that provides many of the administrative functions of the captive. In this system, a captive allows members to enter into contractual agreements to pay a fee, share risks and “rent” the captive.

There are a variety of other structures and special purpose captives. Below are descriptions of a few important ones.

1. Protected Cell Captives – Also known as segregated-cell captives, these rental captives provide insurance to organizations but their assets and liabilities remain are legally separated, and members do not share risks (or claims). Each organization has a separate underwriting account.
2. Risk Retention Groups – an alternative risk transfer method created under the Liability Risk Retention Act in 1981. RRGs are domiciled in the United States, licensed to write liability insurance and regulated as a captive insurance company. They may operate nationwide, but must register in each U.S. state in which they will write insurance. They are treated as multi-state insurance companies. To learn more about RRGs, check out our Risk Retention Groups blog.
3. Industrial Insured Captives – a captive that provides coverage for multiple large companies, either as pure captives or group captives. (An industrial insured is a commercial insurance buyer which can negotiate contracts with insurers without the protection of insurance regulators.) The captive insures the risks of each organization, as well as any affiliated companies.
4. Micro Captives – a small captive insurance company with a small annual written premium. Premiums are placed in an investment account and as long as the captive stays under the premium threshold, they do not pay tax on their underwriting income.
5. Branch Captives – a unit of an existing offshore captive, licensed to operate in a U.S. state. This allows it to operate through a branch in the location where the insured risk is located, allowing companies to extend their coverage territories without establishing a separate captive in each legal jurisdiction, while also streamlining management.
6. Association Captives – a group captive sponsored by a specific trade association within a defined industry that predates the formation of the captive by at least one year. It insures risks of members, and of the association itself. There are notable advantages to participating in a captive with industry peers. Take a manufacturing captive, for example – you are paired with organizations that have similar risks and exposures. In addition to gaining the typical advantages of captive membership, you would be paired with other safety-minded organizations and have opportunities to share knowledge that can prevent future losses.
7. Employee Benefits Captives – in a benefits captive, employers can retain the risk of providing certain benefits for employees such as health insurance, life insurance, disability insurance and retirement plans. Instead of paying premium dollars to a traditional insurance carrier, they contribute money into a fund which is used to pay out claims. This often lowers costs, offers more flexibility in benefits offerings and offers access to risk management and decision-making tools that organizations otherwise may not have access to. To learn more about benefits captives, and to see how this differs from self-insuring, check out our blog on the subject.

Options for Captives

As you’ve just read, there are many types and structures of captives.

According to the Insurance Information Institute (Triple-I), in 2018 about 200,000 companies in the United States met the definition of a mid-sized company, with revenues between $10 million and $1 billion. These companies are best-suited to establishing a new group captive or joining an existing group captive.

Some member-owned group captives use a captive management company to manage the daily operations of the captive, but the members who serve as the captive’s board of directors are the true decision-makers. At board meetings, they vote on rules and regulations, and dictate the standards under which new members would be included in the captive.

How Captive Insurance Companies Are Formed and Regulated

You’ve just read about a variety of different captive structures, each of which may be the appropriate selection for an organization’s needs. While all have a few shared characteristics in common, the standards for forming a new captive, as well as the way they are regulated, depend on the type of captive as well as the location of its domicile.

Any captive would meet the following definitions:

• Risks are financed within a separately incorporated and managed entity
• There is a separation between the captive and its insureds, meaning the captive truly exists as its own insurance company
• The captive must have its own capital at risk, in addition to the capital of the participation organization(s)
• Those purchasing the insurance, or reinsurance, must have sufficient resources to buy an alternative risk financing program
• They must be capitalized and domiciled in a jurisdiction that legally allows them to operate as licensed insurers

Creating or joining a captive requires discussion and preparation from your leadership team. These are some of the considerations for an organization considering joining a group captive:

• Information gathering: an actuary will look at your claims history from the past five years, relative to your exposure such as payroll, sales and number of vehicles to calculate your premiums. Their job is simply to make sure the group will be able to finance every member’s claims.
• Financial review: most captives will have an independent consultant review your company’s audited financials. Since the captive is taking a risk with each new member, the established members want to make sure every company they admit will be able to pay premiums and weather the group’s financial requirements.
• Risk profile assessment: understanding the advantages and disadvantages of retaining risk – and sharing other member organizations’ risks – is very important. Prepare for questions about your organization’s safety and risk control efforts, which may be a large determining factor in whether you are accepted into the captive or not. Existing members will not want to include an organization that does not make risk management a priority, they want a partner who will mitigate risk and avoid a high frequency of claims.

This is a condensed list of the steps that would be involved in forming a new captive. This is a much more complicated process than joining a group captive and should be reserved for large organizations with the resources to operate their own insurance company, which will likely entail hiring professionals to fulfill the responsibilities usually performed by an existing insurance company.

• Assessing the varied insurance needs of each organization is vital. It is possible that the captive can address some, but not all risks and that traditional coverages will still be needed. If a captive cannot actually improve the members’ ability to control risk, it may not be the best solution. Keep in mind that even many single-parent captives retain the risks of their subsidiaries and affiliated companies.
• Feasibility study: the members assess the potential benefits and risks involved in forming the captive, namely the captive’s financial projections. This includes an actuarial analysis of each organization’s risk profile, loss history and past claims (which would also be a step for an organization planning to join an existing captive). This includes looking at models of various loss scenarios – including catastrophic ones – and how they would impact short-term and long-term costs. Can the captive adequately protect against these losses?
• Operations analysis: is it realistic to run your own insurance company? There’s a reason why many small and mid-size organizations rely on existing, sponsored captives or rent-a-captives. This alternative could be a better fit if the member organizations are not able to operate the captive themselves. Remember – you are essentially forming a new insurance company, which isn’t going to run itself.
• Domicile selection: depending on the type of captive being formed or joined, the location where the captive will be incorporated may vary. Factors that impact this decision would include:
  • Regulatory environment and legal standards
  • Solvency (capitalization) requirements
  • Tax laws and benefits
  • Investment restrictions
  • Underwriting requirements
  • Geography (accessibility of the location itself)Overseas domiciles may, for better or for worse, require travel to that location for board meetings. (Though, many could see why a trip to the Caymans for a board meeting or risk control workshop could be a positive!) According to Triple-I, offshore domiciles often have lower capitalization requirements, as well as more favorable regulatory requirements, though this depends on the domicile in question.
• Incorporation: the captive insurance company must be established as a legal entity, which requires filing establishing documentation with the authorities of the respective domicile. Quite literally, you are starting a new insurance company.
• Capitalization: the captive must meet minimum requirements, which vary depending on where the captive is domiciled. This requires those forming the captive to put up collateral to fund operation and its ability to pay out claims. Not only is this legally required, the success of the captive is dependent on this financing in order to pay out claims with certainty.

Key Differences Between Traditional Insurance and Captive Insurance

We’ve already gone over many of the advantages of starting or joining a captive, but here are some of the basic differences between a captive and traditional insurance.

More Benefits of Captive Insurance

There are several ways a group captive could lower your overall insurance costs.

• Premiums based on loss experience – premiums paid to the captive are based on your actual claims history and loss experience, meaning organizations that can control these factors stand to benefit.
• Insulation from market conditions – instead of being lumped in with organizations that don’t control their losses, in a group captive you are associating yourself with other risk-conscious organizations, as only good risks are accepted into the captive. Separating your organization from bad risks helps you avoid rising premiums in the traditional market, as well as the factors contributing to them, such as economic inflation, large jury awards and tort reform.
• Control over insurance policies – a captive provides greater control over their unique needs and concerns. A group captive offers more flexibility in program design and terms, and gives members a voice in the decision making process when it comes to coverage options, policy limits, deductibles and retentions.
• Saving on third-party costs – a captive can be more cost-efficient because you’re no longer paying for hidden costs in your premiums, such as a third-party insurer’s payroll, marketing and other expenses.
• Improved risk management – group captives provide direct access to risk control resources and services. An independent study by Captive Resources showed that across 15 mature group captives, members had 48% fewer fatalities and 22% fewer workers’ comp claims than the industry average.
• Return on underwriting profits and investment income – members are rewarded for avoiding claims because they receive dividends when they are able to reduce their losses, as well as investment returns on money paid into the captive (premiums, capitalization funds and collateral).
• Access to reinsurance markets – Because a captive is an insurance company, they can buy reinsurance coverage directly from reinsurers, essentially buying it wholesale and bypassing the traditional market. And because the price is directly related to the organization’s loss record, captives generally get more cost-effective rates for reinsurance due to their superior risk profiles.
• Employee benefit captives – Captive insurance for employee benefits can be another way to reduce costs, managing your benefits expenses more efficiently while gaining more control over your overall organizational risk management strategy. For more info on benefits captives, click here.
• Improved safety – Improving an organization’s overall safety is a common byproduct of entering a captive as most require every member to have their own safety committee. Also, since it’s their own money at stake, companies typically nominate someone internally to be their dedicated safety contact in addition to other roles.

Benefits of Improved Safety

Sound safety practices and claims management both protect the wellbeing of your employees and are good for your business. Research and industry experience suggest businesses that invest in health and safety programs realize a tangible return. These returns stem from:

• Decreased lost time – avoiding workplace accidents due to enhanced safety programs can help your organization decrease expenses related to medical care, PTO, litigation, LTD and disaster mitigation.
• Compliance with regulation, laws and standards – non-compliance can be disastrous to an organization, not just financially but also consider the reputational cost of legal fees and fines from OSHA.
• Increased efficiency – a focus on safety leads to higher productivity, which drives short-term revenue growth and supports long-term sustainability.
• Improved employee satisfaction – recruiting and retaining top talent is easier for organizations that provide safe, comfortable workplaces and who care for employee wellbeing and take steps to protect the environment.

In a group captive, you’ll have access to webinars and risk control workshops that help reduce your overall risk and lower your audit factor, which in turn will help lower your premiums. 

What Are The Costs of Captive Membership?

There are some cost factors involved in forming or joining a captive.

• Time – this is a big one. You are not buying traditional insurance, you are joining a captive, which is a long-term commitment and goes deeper than an insurance solution. It requires time for consideration, you will want to talk to other captive members about their experiences and you will need to consider the impact on your overall insurance and risk management program. However, you’ll find this investment of time is well worth it in the long run.
• Administration and overhead – remember that a captive is still an insurance company, and that there are costs involved in operating and maintaining this structure. However, these can be mitigated by the cost savings and benefits of being part of a captive. And joining a group captive can help, as you are sharing these costs with other organizations, creating economies of scale.
• Capitalization – the minimum capitalization requirements of a captive vary by size, risk profile and domicile, but they are important in order to fund the captive’s operations and ability to pay out claims. These costs are shared among the member companies, allowing for reduced individual financial burden and potential for cost savings in the long run. They tend to be lower in a group captive.
• Collateral – Before joining a captive, collateral money is put up in advance. Because members are retaining and sharing underwriting risk, this collateral serves to eliminate credit risk between members.

Customization and Flexibility

Captive insurance offers more control over insurance costs, with the flexibility to tailor risk management approaches to meet the needs of the group captive. That includes the lines of insurance the captive underwrites, how money is used and its investment strategy.

There are also opportunities for captive members to access loss control and risk management resources, which may otherwise be inaccessible due to cost or availability. Because the group captive model incentivizes reducing the frequency and severity of claims, this focus on reducing losses is a constant priority. All organizations stand to benefit from improving safety and reducing claims.

Common Misconceptions About Captives

Here are some of the common misconceptions we’ve heard about captives. If you’ve had these thoughts, you’re not alone, but here we’ll address some of these concerns and explain why they may not be barriers, after all.

My company is too small for a captive.

Group captives come in all sizes and span across different industries, so your insurance spend really shouldn’t be the deciding factor. Additionally, micro captives are a form of single-parent insurance company that provides smaller organizations with the opportunity to take advantage of the benefits a captive can offer.

Footnote: IRS code section 831(b) allows small, non-life insurance companies to elect to pay tax only on their investment income, not their underwriting income. However, this has allegedly been exploited to create tax shelters disguised as captive insurance companies. While this can be a legitimate structure for a captive, the IRS has pursued litigation against groups falsely claiming this classification. Only work with a broker you trust when identifying alternative risk options for your organization.

One catastrophic loss will bankrupt the captive.

In the group captive structure, the funding system separates and accounts for both the frequency and severity of losses. A loss forecast is developed by an independent actuary, generally using a member’s previous five years of loss history, with that forecast being split between the two layers. Losses are shared and absorbed through the captive’s funding, but reinsurance still protects the captive against catastrophic losses.

I’ll get stuck paying for everyone else’s claims.

While it’s true that you may share risks with other businesses, depending on the type of captive you’re in, that won’t necessarily cost you more. The beauty of a captive is that you’re paired with like-minded peers who are all trying their best to minimize their own risk and work their own claims as efficiently as possible. Every business has bad claims now and then, but in a group captive you can be confident sharing risk for the potential rewards.

I’m worried about regulations and compliance.

Remember that a captive is an insurance company, as as you can probably imagine, this does involve some complex legal and regulatory requirements. However, this isn’t a reason to avoid considering a captive. While familiarizing yourself with these regulations is important, in a group captive, day-to-day management including regulatory compliance, audit and tax prep is supported by captive management, leaving members free to focus on what they do best. In a single-parent captive, bringing in an expert to support this function would be necessary.

Joining a captive will be expensive, and they don’t seem accessible.

In the case of a group captive arrangement, companies considering joining may need to contribute capital to the captive to help cover the risks assumed by the group, and these initial costs can be significant. However, less capital is required in order to join a group captive, and keep in mind that if you do leave the captive in the future, collateral is returned when the last policy year the organization participated in is closed. A captive is a long-term approach to risk management, and should be thought of as a full commitment.

Is a Captive Right for My Business?

Here are some of the factors that would determine whether you may be the right fit for a captive.

• Best-in-class loss history, or close to it
• History of long-term financial stability
• Management team and organizational culture committed to safety
• Can think long-term, not near an ownership transition or financial restructuring
• Balance sheet can support collateral requirements

Additional considerations include:

Annual spend on premiums – There isn’t an exact formula to tell you whether or not you’ll be successful in a captive. However, we’ve found a good rule of thumb is that your company should be spending at least $100,000 annually on workers’ compensation, general liability and auto coverage for this type of insurance to be beneficial.

Capital commitment – Captives are built for the long haul. Typically, distributions don’t begin until 3-5 years after the end of a policy year for commercial insurance captives, though the return can be quicker for employee benefits captives. It’s unlikely that you will see an immediate return after joining a captive. This is a long-term strategy.

Risk of adverse underwriting results – It’s important for captive members to have a strong commitment to risk prevention. If loss control programs are not in place, the likelihood of claims increases and will negatively impact the captive as a whole, because you are retaining and sharing risks. And if risks are not accurately accounted for in underwriting, the captive may not be prepared to pay out claims. That’s why captive members are required to provide a detailed loss history before being accepted into the captive – a group arrangement will not accept poor risks.

Time commitment and related costs – While there is an investment of time and resources related to participating in a captive, if you’re thinking along those lines you are asking the wrong question. What you should be wondering is what benefits this investment will have for your organization. The answer is an increased focus on risk management and loss prevention, savings on lost time claims, fewer worksite accidents, and over time, lower overall insurance costs.

Tax treatment – This is NOT an investment or a way of receiving tax benefits. Captives are strictly an insurance product. Whether or not they offer tax benefits for your organization should be determined by a CPA or qualified tax attorney.

Captive Insurance Frequently Asked Questions

To recap what you’ve just read, here are some of the questions we get most often, answered in simplified terms.

How does captive insurance work?

A captive is an insurance company that provides insurance to, and is controlled by, its owners. There are many ways to structure captive insurance companies, and they come in all shapes and sizes. A captive insurance company retains the cost of risk through the captive that is usually transferred to traditional insurance companies.

What are the disadvantages of captive insurance?

Captive insurance is a long-term risk management strategy which is unlikely to provide financial benefits within the first 3-5 years. There are starting costs involved in capitalization, with collateral being required to start or join a captive. Some risks are a better fit for a captive arrangement than others.

What are the benefits of captive insurance?

Captive insurance can result in lower premiums, because they are based on a projection of future losses based on your five-year loss history, not on the variety of factors outside your control that impact traditional insurance premiums. Being part of a captive can provide more control over claims, access to risk management resources and more customization and flexibility than traditional insurance. You can also earn money on premiums and other funds which have been invested, whereas in a traditional arrangement you’ll never see those dollars again, no matter how well you can avoid claims.

What is the purpose of a captive insurance company?

A captive insurance company exists as an alternative to traditional insurance. Instead of transferring risks to an insurance company, in a captive, certain risks are retained by the captive. Premiums are calculated based on loss projections, using historical claims data to predict potential future losses, among other factors. Captives also provide opportunities to share retained risks with other captive members, so each member’s risk exposure and loss experience impacts the captive.

Why do companies form captives?

Captives allow companies to have more control over their risk management strategy and insurance costs, improved cash flow and greater flexibility in coverages. They can also directly benefit from having favorable loss experience, as their premiums are determined by their future loss projections, among other factors. With high premiums in the traditional market, and organizations feeling like they have little to no control over the market factors causing the rise in costs, a captive is a solution that provides protection, while also offering an opportunity for members to gain back premiums in the form of investment income.

What types of coverage do captives provide?

Captives exist to insure a wide variety of risks, most often for conventional coverages like general liability, product liability, professional liability, commercial auto and workers’ compensation.

Captives also can be used for specialty risks that are hard to find coverage for. Examples include:

• Cyber liability
• Credit risk
• Environmental liability
• Supply chain risk
• Political risk

Captives also exist to retain certain risks related to employee benefits, such as medical stop-loss, health claims and more.

Should I Consider a Captive?

Almost every time one of our clients gets into a captive, they tell us they wish they would have done it sooner because the captive’s structure actually makes them a better company from a lot of perspectives – not just from an insurance standpoint.

Think about it. If you’re with a group of like-minded peers and everybody’s trying to get better, you’re sharing all of these ideas and best practices that can help transform you into a better company. And that’s just one of many examples of how captives can help elevate your business. 

So certainly, you should consider it. Start having those internal discussions with your leadership team. And let us know when you’re ready to get started.

Learn More About Captives

Don’t miss the other entries in this series:

What is Group Captive Insurance?

Captives vs. Risk Retention Groups: What’s the Difference?

How Do Employee Benefits Captives Work?

This content is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel or an insurance professional for appropriate advice. Gregory & Appel is neither a law firm nor a tax advisor; information in all Gregory & Appel materials is meant to be informational and does not constitute legal or tax advice.