What Are Captive Insurance Companies?
So, what is a “captive insurance company” (or a “captive”)? Generally speaking, a captive is an insurance company owned by a corporate affiliate or subsidiary that insures the risks of its parent and/or related entities. Except for risk retention groups, which are enabled under the Liability Risk Retention Act of 1981, captives are defined by, and largely regulated at, the state level, and the quality of that regulation varies from state to state.
Each state that permits captives to operate within its borders defines them in its own way and then identifies what types of captives are permitted in the jurisdiction. States vary, but captives usually may be used to (1) insure against most commercial property and casualty risks (i.e., business interruption, professional liability, product liability, cyber risk, directors and officers, errors and omissions, environmental losses, reputational repair losses, loss of key contracts, loss of key persons, workplace violence, crop loss, etc.); (2) provide medical stop loss for employer-backed health benefit programs; and (3) reinsure against workers’ compensation and commercial auto liability losses. Captives, however, cannot be used for personal property lines like personal auto and homeowners liability. They are not licensed to sell insurance to the general public. The rationale is simple: captives are intended to help businesses only, but they can be used by nonprofit organizations and state agencies.
Many types of captives exist to meet the insurance needs of their various insureds. The primary types of captives are briefly described below.
- Agency: An agency captive is a company that is owned or controlled by an insurance agency, brokerage or reinsurance intermediary, or affiliate thereof, or under common ownership or control with such agency or brokerage or reinsurance intermediary, and that only reinsures the risks of insurance or annuity contracts placed by or through such agency or brokerage or reinsurance intermediary.
- Association: An association captive is a company that is owned by an industry or trade association that insures the risks of the association’s members, and that may also insure the risks of affiliated companies of the member organizations and the risks of the association itself.
- Branch: A branch captive is a division of a captive insurer domiciled in another state. It is registered to do business in the state where the branch is approved.
- Group: A group captive consists of entities or persons in the same industry that come together to collectively own a captive to insure their various risks.
- Industrial: An industrial captive insures the risks of “industrial insureds,” which, depending on state law, must meet certain net revenue or worth thresholds and employ a minimum number of employees; such captives typically are intended to protect only large organizations and state agencies. Industrial captives generally require that the insured employ a person to internally develop the insurance program for the benefit of the industrial insured.
- Protected (or segregated) cell: Depending on state regulations, protected cell captives are a form of sponsor captives where a parent or core cell is created (which may or may not take on risk itself) to serve as the “house” under which individual cells established are attached and operate. Structurally, think of the core as the condominium building (typically owned by the captive manager) and the individual cells as the condo units that are capitalized and operated by unrelated entities. The cells’ and the core’s obligations to and among each other are established through a participation agreement. Protected cells are increasingly used by middle-market businesses to access the captive insurance market. Cells can be incorporated or unincorporated, but each cell’s assets and liabilities are separately accounted for.
- Pure: A pure captive insures the risks of its parent and affiliated companies or controlled unaffiliated businesses. Some states, like New York, only allow pure captives to insure industrial insureds.
- Series LLC: Operationally, series LLCs are similar to protected cell captives and are creatures of state law. The primary difference is that series LLCs must be organized as distinct entities, whereas a protected cell need not be. Like protected cells, series LLCs are increasingly used by middle-market businesses to access the captive insurance market. As with protected cells, a series LLC’s assets and liabilities are separately accounted for.
- Special purpose financial: Generally speaking, special purpose financial captives are used to insure the risks of securities and securities offerings.
- Sponsor: A sponsor captive is a single-owner or group-owned core captive that serves as the hub, core, or parent for protected cells or series LLCs.
While prevalent among large publicly traded corporations, when it comes to small- or middle-market businesses (privately held entities with minimum gross revenues of $10 million plus and/or less than 500 employees), captives are some of the most underutilized risk management tools available, even in today’s toughening insurance market. Surprisingly, the four largest states in the U.S. based on population—California, Florida, New York, and Texas—have some of the most restrictive or nonexistent captive legislation, unnecessarily depriving countless organizations within those states of a critical risk management tool that would help insure them against fortuitous losses.
The Golden State has no active captive regulatory program in place, but its regulatory authorities will impose a retaliatory tax (3% of gross written premium) on captives located outside of California that provide captive insurance coverage to businesses located within its borders (which are also charged a nonadmitted premium tax, a.k.a. “self-procurement” tax). The lack of an active captive insurance regulatory program in California really is unfortunate, as the University of California had to go out of state to procure its own captive in Washington, D.C., in order to adequately insure the risks at its 10 campuses (including a satellite campus in D.C.).
Not much better, however, are Florida, New York, and Texas, in which the captive legislation is so restrictive that it makes domiciling a captive in those states impractical to most of their domestic enterprises. The current regulatory environment in New York and Texas makes captives only really accessible to large organizations ($100 million plus net revenue). Relatedly, Florida, with its traditionally low-tax, business-friendly climate, has an unnecessarily long and tedious application (70+ pages) and higher premium tax rates and capitalization requirements as compared to the well-established U.S. captive domiciles like Vermont, D.C., Delaware, Tennessee, Utah, North Carolina, Hawaii, and Arizona. In fact, Florida’s captive program is so uncompetitive that it is not even in the annual list of the top 30 captive domiciles released every year by the National Association of Insurance Commissioners (NAIC).
Captives Provide Several Important Benefits
Why does this matter? Why should states ensure they have modernized captive statutes and engaged regulatory bureaus? It matters because middle-market organizations employ nearly 50% of Americans, and those employers need as much insurance protection as they can afford in today’s highly complex, interconnected, ever-changing world that is full of underinsured risks. It matters because a properly run captive insurer can provide several congressionally intended, state-supported benefits, including but not limited to the following:
- they can plug in the gaps created by the commercial insurance market where coverage is either unavailable or simply too expensive;
- the claims process can be more transparent and streamlined;
- they can provide premium rate stability so that CFOs have an easier time setting the insurance budgets each year;
- they can directly access the reinsurance market, providing further protection to organizations;
- premiums paid to a captive, as with a commercial carrier, are deductible as an ordinary business expense (and the insured business is paying those premiums to an insurance company that it owns);
- captives that comply with the requirements of, and make the election under, § 831(b) of the Internal Revenue Code do not pay ordinary corporate income on their premium income but rather are taxed on their investment income; and
- when risks are managed well, underwriting profits in a mature captive can accumulate and be invested in a variety of ways, pursuant to state regulations, bolstering the corporate bottom line and creating a new profit center for the larger organization.
During the past few years (particularly during the pandemic), publications such as Forbes, the New York Times, and the Wall Street Journal praised the benefits of captive ownership as “nearly all Fortune 500 companies” have a captive and approximately “90% of Fortune 1000 companies” have one. The NAIC estimated that captives earned approximately $45 billion in premiums in 2022, with a mean premium income of $10.7 million. In late 2023, ratings agency AM Best noted that “with the continued growth in captive surplus and dividends, captives have saved their organisations an estimated US$9.4 billion over the past five years in comparison to the traditional [insurance] market.”
Federal and State Regulation of Captives
For federal income tax purposes, captives are taxed under either § 831(a) or § 831(b) of the Internal Revenue Code. Whether a captive is taxed under § 831(a) or § 831(b) depends on its annual premium income. Large captives, which can earn an unlimited amount of direct written premiums, are taxed under § 831(a). Fortune 1000 companies typically own these large captives.
Small captives or “microcaptives” are taxed under § 831(b). In 2024, these small captives cannot earn more than $2.8 million in direct written premiums if they wish to make the election under § 831(b), which provides an added congressional incentive to encourage middle-market businesses to use these types of captives to insure their businesses. That additional incentive is that § 831(b) captives do not pay ordinary corporate income tax on their premium income but instead are taxed only on their investment income, which is usually at the long-term capital gains rate. This incentive has been abused by some as a tax avoidance scheme, which is why the microcaptive segment of the captive industry has come under scrutiny by the Internal Revenue Service (IRS) during the past decade.
How a captive is taxed at the federal level impacts certain elements of how it is managed on a daily basis. Notwithstanding that, captives and risk retention groups—which can write insurance in every state—are largely regulated at the state level. However, not all states have passed legislation that permits captives to operate within their borders, and states that have antiquated, restrictive captive laws do a great disservice to businesses domiciled in those states, as they may be compelled to directly procure captive protections in other jurisdictions (thereby also depriving that state of its ability to generate premium taxes).
As referenced earlier, the top states in descending order for captive formation within the U.S. are Vermont, Utah, Delaware, North Carolina, Hawaii, South Carolina, Arizona, Nevada, Tennessee, and D.C. These states lead the pack because:
- Each has sophisticated, educated, and engaged regulators who are empowered by their state’s executive and legislative branches to grow and recruit captive businesses to their states within the parameters of well-developed captive legislation that meets the needs of complex business environments.
- Their captive legislation affords many different types of captives, which enable business owners and their advisers to select from the structure that best suits the needs and capabilities of the business(es) needing coverage.
- They offer competitive premium tax rates that are typically less than 0.5% of gross written premium (in contrast, the premium tax rate for captives domiciled in Florida is 1.75% of the captive’s annual premium) and reinsurance premium tax rates that are even lower.
- Their application processes and annual reporting obligations are transparent and not overly burdensome, while still ensuring that the captive is created and operated with the appropriate capitalization, liquidity, and protocols so that the fundamental purpose of those captives is achieved—i.e., that each captive can pay the valid claims of the insureds as they become due.
Having an engaged, sophisticated regulatory body that actively enforces compliance is critical to a captive’s legitimacy. Taxpayers who domicile their captives in jurisdictions with lackadaisical regulators, irrespective of whether they are offshore or domestic, can be used by the IRS as indicia that the taxpayer intended to use the captive as a tax shelter rather than as a risk management tool. Active and engaged regulators are a good thing and should not be feared by captive owners.
On the flip side, however, regulations that impose standards on captives similar to the heavier burdens that are borne by commercial carriers can suffocate captive growth because the vast majority of captives will never have the same reserves and resources as commercial carriers; and they are not intended to do so because they focus on insuring the risks of their related insureds, not the general public. As noted above, captives are prohibited by state law from selling their policies to the public. Their policies are “procured” solely by the related insured that sets up the captive in the first place. In contrast, setting up a commercial carrier that sells policies to the public at large requires more initial capitalization (e.g., $100,000 vs. $1.5–$5 million plus for property and casualty carriers, depending on the state) and more regulatory scrutiny because of the increased need for greater consumer protection.
Those captive jurisdictions that are growing understand that, while captives must still operate like traditional insurance carriers in many ways (with appropriate underwriting, actuarial, and claims protocols), captives are intended to be accessible to, and utilized by, small businesses as defined by the Small Business Administration (businesses that employ less than 500 people). The more captives can be utilized to plug the gaps that the commercial marketplace cannot fill, the more commerce is protected, and that is good for everybody. Given the need to make captive ownership accessible, advanced captive domiciles, recognizing the importance of providing businesses with access to this critical risk management tool, specifically exclude captive insurers from the bulk of insurance regulations governing commercial carriers.
When managed properly, a captive insurer is just like any other insurance company in the business of earning premiums in exchange for indemnifying its insureds against fortuitous loss. While captives are not subject to the same regulations as commercial carriers, they still must abide by various capitalization, filing requirements, and certain insurance industry standards. Thus, because of this IRS scrutiny of captives, for a business to seriously consider establishing a captive, it must be prepared to abide by the insurance industry operational norms and appreciate that the captive is a regulated entity and not a personal piggy bank.
IRS Scrutiny of Captives
One of the IRS’s recurrent attacks on captives is that they do not provide “real insurance.” To be considered “real insurance,” the U.S. Supreme Court mandates that (1) the risk must be transferred to another entity (to the captive) and off the books of the insured, and (2) that risk must also be distributed and diversified among a sufficiently large number of unrelated, independent risks. This is the law of large numbers. Diversification and distribution of the risk mitigates an insurer’s solvency concerns so that no one loss would jeopardize all the premiums paid to the captive to cover such losses.
Achieving adequate risk diversification and distribution can be the most challenging hurdle for any captive owner to overcome. Whether the risk is distributed enough, and how it is evaluated, depends, in part, on whether the captive is taxed under Internal Revenue Code § 831(a) or § 831(b).
In the world of captives, risk distribution does not occur if a captive insures only one or a few small policyholders containing very few risk points, or if a captive insurer (which is wholly owned by a parent) insures various disregarded entities owned by that same parent. Fortunately, within the past several years, Congress, the IRS, and federal courts have provided guidance on how to achieve this important threshold.
Requisite Risk Diversification for Section 831(b) Captives
On January 1, 2017, the Protecting Americans from Tax Hikes (PATH) Act of 2015 went into effect, establishing two bright-line tests for risk distribution for § 831(b) captives:
- The “80/20” test, which mandates that no single captive can accept more than 20% of its risk and associated net written premium (or, if greater, direct written premium) from any single policyholder, wherein a “policyholder” applies to affiliated companies that share 50% or greater common family ownership.
- The “ownership” or “specified holder” test, which requires that ownership of the insured businesses and assets must mirror (within a 2% de minimis margin) ownership of the captive. A “specified holder” is a person “who holds (directly or indirectly) an interest in such insurance company and who . . . is a [spouse or] lineal descendant (including by adoption) of an individual who holds an interest (directly or indirectly) in the specified assets with respect to such insurance company.” “Specified assets” are defined as the “trades or businesses, rights, or assets with respect to which the net written premiums (or direct written premiums) of such insurance company are paid.”
To meet the 80/20 test, a captive must receive no less than 80% of its risk and associated premiums from unrelated policyholders (which the captive manager oversees). If the captive cannot meet the 80/20 test, it may still be able to make the election under § 831(b) if it can meet the specified holder test, which essentially requires that ownership of the captive must match ownership of the insured business. This latter test prevents captives from being misused as tax avoidance tools in the wealth transfer aspects of estate planning. However, even if the specified holder test is met, the captive may still need to have its risks diversified among a sufficiently large enough number of unrelated policyholders to achieve risk diversity. To ensure these numbers are met, the captive owner needs to look at how the IRS and federal courts have treated § 831(a) captives.
Requisite Risk Diversification for Section 831(a) Captives
Large captives must adhere to the safe harbors found in various IRS revenue rulings and federal court cases. One notable precedent is Harper Group v. Commissioner, where the Tax Court held that an insured parent that paid premiums to its subsidiary captive achieved minimum risk distribution because 30% of the captive’s premiums were paid from unrelated businesses. Ten years later, the IRS determined in Revenue Ruling 2002-89 that a captive that received 50% of its income from unrelated nonparent premiums achieved adequate risk diversification and the premiums were deductible as an ordinary business expense. Likewise, in Revenue Ruling 2002-90, the IRS stated that premiums paid by 12 subsidiaries owned by the same parent were also deductible, as their captive insurer achieved adequate risk distribution because no single subsidiary, each of which respected various corporate formalities and conducted itself as a distinct entity, paid more than 15% of the captive’s gross written premiums. Similarly, in a group captive setting (where multiple unrelated businesses in the same industry co-own a captive to insure homogenous risks), the IRS declared in Revenue Ruling 2002-91 that 31 unrelated insured entities, each with less than 15% of the total risk insured (and associated premiums), met the requisite risk diversity standards.
In addition to risk transfer and risk distribution, the captive—irrespective of its size—must also follow certain insurance industry standards. These standards include: (1) adherence to corporate formalities (i.e., annual meetings, corporate binders, bank accounts, etc.); (2) sufficient capitalization, which is established by state statute and feasibility studies prepared by an actuary; (3) whether the captive operates like a traditional insurance company inclusive of insurance applications, underwriting processes, and timely issuance of real insurance policies; and (4) adherence to claims protocols and the ability to promptly pay valid claims.
Notwithstanding the IRS scrutiny, whether a captive conducts itself pursuant to industry standards is determined by state regulatory authority because Congress “has delegated to the states the exclusive authority (subject to exception) to regulate the business of insurance.” With this in mind, business owners seeking to establish a captive would be well-advised to select a domicile that has an active and engaged captive regulatory commission. If the business to be insured is located within a progressive captive regulatory commission, the business could establish its captive in the same state. If not, ultimately, under the precedent established in State Board of Insurance v. Todd Shipyards Corp., businesses can establish an out-of-state captive, use a “fronting carrier” (i.e., a carrier already admitted in that particular state) to provide the direct insurance (if such fronting is required based on the lines of coverage issued in that particular state) and then use their captives to indemnify the risks of the fronting carrier. Businesses could also use their captives to directly underwrite the standard liability risks without the need for a front, but such relationship would still have to be reported and likely subject to a state’s retaliatory and direct procurement taxes.
Ultimately, irrespective of where domiciled, captives that fail to meet basic corporate operational standards will likely fall under examination by the IRS, which can lead to not only the disallowance of the deductibility of the insurance premiums but also late fees and tax penalties incurred by both the insured and the captive. In fact, the IRS has recently won several notable cases where captives and/or the policies themselves were deemed illegitimate. Important factors outlined in those rulings that were held against the taxpayers included: (1) a circular flow of funds among related insureds, such as the captive being used to “loan” funds back to the insureds; (2) cookie-cutter premium allocation within a risk pool where the same money out was the same money in; (3) lack of minimum risk distribution and diversification among unrelated policyholders; (4) paying a premium that was 5, 10, or up to 1,500 times more expensive than the commercial market for less coverage (i.e., not commercially reasonable); (5) inadequate capitalization (which is, perhaps, indicative of a failure of regulatory and managerial oversight); (6) not having a real insurable risk (e.g., insuring hurricanes in the Dakotas, another potential failure of regulatory and managerial oversight); (7) the issuance of policies late in the policy year or even after the policy had expired; and (8) failure to abide by objective and independent claims protocols.
Practical Implementation of Captives
So how does a business owner inexperienced in the world of insurance operations actually form and operate a captive? Unless the business has the bandwidth to hire its own back-office support to include actuaries, underwriters, and claims specialists, it will need to hire an experienced, reputable captive manager who stresses the importance of the captive being used for risk management, not tax avoidance. Risk management needs must always be the motivating factor behind establishing a captive. With captive insurance, one can never put the cart before the horse—the risk management and insurance needs must pull the captive forward if it hopes to enjoy any of the congressionally intended benefits.
In almost every state that has an active captive marketplace, regulators maintain and/or publish a list of captive managers approved to manage captives in that state. Lawyers can do a real service to their clients by participating in the interview process of these captive managers. Further, regulators also typically maintain and publish lists of approved CPAs and actuaries, know who the knowledgeable attorneys are, and have relationships with the financial advisers experienced in managing captive investments (because there are some restrictions, particularly early in the life of the captive, where maintaining liquidity is vitally important). No captive will be issued a certificate of authority to operate until it has a regulator-approved manager, actuary, and CPA under contract and listed on the application.
Captive managers will typically either (1) charge one-time setup fees during the first year and earn an annual management fee based on a percentage of the captive’s annual premium income or (2) charge a flat annual rate. Approved captive managers will have personnel who will identify insurable risks and ensure that the premiums are commercially reasonable and determined through an arm’s-length analysis. The captive manager will also have claims specialists in place to ensure the timely, consistent, and objective processing of any claims. Managers will work closely with the state regulators to ensure annual filing compliance. Managers also will work with experienced accountants and other professionals to have the captive’s tax returns prepared and audited annually; and they will, critically, help each captive achieve the risk distribution that is needed. Managers do this by either managing a risk pool (which is regularly used in the commercial insurance world) where each captive has the requisite minimum risk distributed to unrelated captives via reinsurance or by way of a direct, written subscription consortium akin to how international insurance syndicates underwrite their risks.
The initial capitalization requirements for establishing a captive may make owning a captive unattainable for certain small businesses that lack a minimum level of gross revenues. Depending on the captive manager’s comfort level based on an analysis of the organization’s cash flow and risks, the underlying business should have minimum gross revenues between $10 and $20 million. Nevertheless, small businesses that may not be able to establish their own captive by themselves may still find it worthwhile to speak with a reputable captive manager or other knowledgeable adviser who can discuss participation in an association or group captive where some of the setup costs are shared, deferred, assumed by the trade association that owns the captive, and/or otherwise baked into the annual operating expenses.
Given that captive insurers provide tailored insurance programs unique to each business, and they can be used in virtually every industry, including nonprofits and state bodies, every business lawyer who develops a basic knowledge of how they can work could provide a valuable solution to their clients struggling to protect themselves against losses. States that have inactive or nonexistent captive programs should consider modernizing their statutes to help businesses located in their states.
Conclusion
Business lawyers throughout the U.S. should identify their clients’ underinsured or uninsured risks and recommend establishing a captive to insure against those risks where commercial insurance is hard to come by. Reputable captive managers will work with a client’s legal, tax, and financial advisers, along with the regulators, to determine whether a captive insurance company is appropriate and the best way to structure it. In due course, considering Congress’s long-standing efforts to encourage the use of captives and the majority of states seeking to capitalize on their inherent value, business lawyers could help their clients enormously by evaluating whether captive insurance could provide their overexposed, middle-market, or institutional clients with the same kind of protection that the largest, publicly traded corporations already enjoy.
An earlier version of this article focused on Florida captive laws was previously published in the March/April 2024 issue of the Florida Bar Journal.
