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What is “Captive Insurance”?

by Douglas Lineberry on August 9, 2012

Captive Insurance

Lately a number of clients have expressed increasing interest in captive insurance programs.  Traditionally the domain of large corporations (over half of Fortune 500 companies are reported to have a captive), they are becoming more common in the medium and small size business world as well.  This very brief introductory article will outline a few basic concepts that will be expanded upon in other articles.

What is a captive insurance company?

No … it’s not your insurance agent in jail.  Simply put, a captive insurance company is an insurance company owned by another company as its subsidiary.  The captive exists to insure the parent company as well as other subsidiaries owned by the parent.  This type of arrangement is often termed a “single parent” or “pure” captive.

There are other captive insurance arrangements, such as group captives, association captives, risk retention groups, reciprocal insurers, rent-a-captives, sponsored captives, agency captives and branch captives.

What are the benefits of captive insurance?

There are numerous benefits to operating a captive insurance company.  One is that it allows a business to customize its coverage and obtain coverage for risks that might otherwise be self-insured.  For example, many business owners might have a single customer that represents a very large portion of gross revenue, but not have insurance to cover the loss of that revenue in the event the customer is lost.  Other businesses might rely on importing products or materials from a particular country but don’t have insurance to cover the loss in sales if political instability causes the flow of imports to stop.

Other risks include litigation defense, warranties, employment practices, environmental cleanup, mold, construction and product defect, business interruption, acts of nature, loss of computer data, pollution discharge, etc.

What’s the problem with self-insuring these risks? First, a business that self-insures by setting aside a fund to pay for risks like these does not get a current tax deduction. Second, the fund that is set aside is still the property of the business, exposing it to the risk of loss from some unrelated claim.

It is also possible to use a captive insurance program to make traditional insurance less expensive.  We all know that a higher deductible will make our insurance less expensive, but then of course we are exposed to the higher out of pocket cost related to a claim.  A captive can write a policy that will cover the higher deductible, thus allowing the business to obtain less expensive insurance and still set aside tax deductible funds (in the form of premium payments to the captive insurance company) to pay for deductibles when losses occur.

There are also significant estate, estate tax, business and executive compensation advantages to the captive insurance arrangement.  In later posts I will discuss these advantages, as well as how captive insurance companies are taxed, where they can be domiciled, how they are implemented and which businesses may be ideally suited for a captive insurance program.

 

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