Captive Insurance: A Primer 

© 2003 Peter Joseph Loughlin, Esq., LL.M., J.D., B.A., CTEP, CAM, MFP, Mas, Fin. Prof..

Captive insurance companies have developed rapidly over the past twenty to thirty years and are now recognized throughout the world as an integral component of the insurance industry.  They are proclaimed by some to be everything from tax shelters to profit centers, but what are the real values of captives and are they necessary?  To answer these questions, and others, we need to get down to the basic premise behind all insurance concerns – let’s start at the beginning. 

What is Insurance?

The Supreme Court has held insurance to be “risk shifting and risk distributing”.[1]   Black’s Law Dictionary offers, perhaps, a more illustrative explanation: “[a]n agreement . . . to pay money or its equivalent . . . to [the] other party upon destruction, loss, or injury of something in which the other party has an interest”.[2]   Essentially, then, insurance is a means of shifting the risk of loss of one’s property, etc., to another.

Such concepts of risk distribution, while taken for granted in our modern commercial society, have actually been around since the dawn of time.  For instance, the ancient Babylonians encouraged traders to assume the risks of the caravan trade through loans that were repaid with interest—a practice that was ultimately incorporated within the Code of Hammurabi.[3]   The Romans developed an early form of life insurance with the advent of burial clubs, and the first recorded commercial maritime insurance contract dates back to c.1347 in Genoa.[4]   Even the insurance giant of the modern world, “Lloyd’s of London”, had its “ancient” beginnings as Lloyd’s Coffee House in 1688.[5]

The insurance industry has passed the test of time because it was a commercially practical idea from its inception. Without insurance to eliminate or mitigate the risk of loss, industrialists would never have taken the bold and mighty steps forward toward local, national, and international commerce and trade.  As such, the insurance industry remains an indispensable element of our modern American and global society wherein new commercial risks arise with stunning rapidity.  

Factors Leading to the Development of Captive Insurance Companies 

Although the growth of the insurance industry in the United States has generally kept pace with the ever-expanding development of commercial risks, gaps in liability coverage have occurred.  Some problems in the industry remained particularly resistant to legislative and market based cures.  Naturally, at any given moment, the risk of loss in a particular market may grow beyond actuarial predictions due to legislation, case law, and regional or marketing anomalies.  For example, floods or catastrophic weather conditions may occur causing claims against insurers to peak and seriously weaken the financial stability of the insurer.  Similarly, legislative changes and judicial decisions often have the effect of increasing the exposure of companies to losses that must be insured against or absorbed by companies in order to survive.

Traditional insurers have responded to these crises in one of two ways:

·                    Raise premiums[6]

·                    Eliminate the coverage[7]

Either approach can be devastating from the perspective of companies that require the elimination or mitigation of risk of certain losses as a prerequisite to remaining in business.  Such a condition arose in the 1970s wherein manufacturers and distributors found it difficult, if not impossible, to obtain product liability insurance at a reasonably affordable cost.  Landmark cases such as, Greenman v. Yuba Power[8] and its progeny began to sweep the nation from the early 1960s until the 1970s when the concept of strict products liability became completely and legally entrenched.  The Greenman decision and its legislative offspring meant that any commercial enterprise related to the manufacture and distribution of a defective product would be held strictly liable to consumer-users for their injuries.  American commercial insurance brokers sounded the retreat and those companies fortunate to find liability coverage were forced to pay an exorbitant price for it.

This dilemma precipitated immediate and widespread demand for product liability insurance – at any price -- and sparked a desperate search by American companies to  offshore financial centers in which the captive insurance industry was quietly awaiting its opportunity to seize a significant share of the market.   Fortuitous as this crisis was, the move to offshore captive insurance companies was not to be made in one fell swoop.  The Reagan administration stepped in with new legislation that would provide a partial solution to the inability of traditional insurance providers to meet the immediate demand for product liability insurance.[9] This legislation was the Product Liability Risk Retention Act of 1981 (hereinafter PLRRA).[10] This Act provided a temporary and groundbreaking solution that permitted US product manufacturers and distributors to set up risk sharing groups that would, in effect, spread the risk over an aggregate group of companies thus allocating the cost of claims while providing a level of protection that would be both actuarially sound and affordable. 

Notwithstanding the benefits this Act, America, in its quest for new options to the product liability catastrophe, glanced for a moment at the offshore captive industry and never quite looked back.  In fact, the PLRRA provided only partial relief and by the mid 1980s American firms were scrambling for liability coverage again.  This time in  healthcare, schools and law enforcement.[11]   Although the PLRRA was amended to meet these demands, companies were now securely on the fast track to forming captives to assure low-cost, long-term solutions and, perhaps, new opportunities for profit.

What Are Captive Insurance Companies and How Do They Work?

Captive insurance companies come in a variety of forms but basically conform with one of the following models:

·                    Pure Captive:  A parent company (not engaged in the insurance industry) forms an offshore (or onshore) “insurance” provider company for the purpose of decreasing the parents overall premium rates, avoid prohibitive regulation and/or turn a profit.

·                    Group Captive:  An association of members in a common industry or related interests form or participate in a captive insurance company in order to share the risk among its members and to obtain similar benefits as with single parent captives.

From these two primary categories other varieties of captives have evolved into a number of hybrids, however, the benefits derived are always about the same thing: Captives are   “ . . . all about alternative insurance—avoiding the pitfalls, peaks and valleys of insurance premiums dictated by commercial insurance brokers”.[12]   Captives are created primarily to insure against loss by the parent or group and a host of other secondary benefits – it’s just a matter of by whom, how, and to what degree those benefits are shared.  Owing to the extensive list of benefits associated with forming and utilizing a captive, a precise definition probably eludes description. Therefore, for illustrative purposes, the following is a list of the more common benefits of the captive insurance alternative:[13]

·                    To meet unique insurance needs;

·                    To provide a self-funding mechanism;

·                    To reduce the impact of the insurance industry’s underwriting price cycles;

·                    Direct or controlled claim management;

·                    Regulatory reductions;

·                    Profit.  Captives may be permitted to act as a primary insurer for other companies and may therefore participate in investment of premiums for profit;

·                    Tax planning.

As you can readily see, these advantages may be of great value to the parent/group, however, captive insurance is not for every company. 

According to Mark Shadwick, an insurance manager with International Management Services Ltd. in the Cayman Islands, “the minimum capital you’d need to justify setting up a captive is $120,000 [USD] – but that’s conservative. We would expect the captive to be able to generate at least $750,000 in annual premiums to justify establishment and operating costs”.[14]   This seems to be the minimum cost threshold.  This is why, inter alia, group captives are becoming more and more popular.

Because of the high start-up costs associated with captives, prospective companies should undertake a feasibility study before committing to the formation of a captive. Factors such as the level of capitalization required to launch the venture, the projected premium volume, and the availability of a qualified risk management team are all essential requirements of a successful captive insurance company.[15]

Additionally, whether a company produces hazardous products or is faced with market based anomalies that limit the availability of traditional insurance coverage, that company will face premium rates that are excessively high or, more devastatingly, coverage that is simply unavailable.  Setting up or participating in a captive insurance company will assure access to coverage at affordable rates. Often this means that the parent/group will, through the captive, directly participate in its own risk management and accumulate a reserve fund from which it may offset any future loss, thus providing a self-funding mechanism.  Further, parent/group companies may then gain access to the international reinsurance (wholesale insurance) market thus reducing costs while obtaining a decrease in the risk of loss that would, perhaps, be otherwise unavailable.

Traditional insurance companies face onerous regulatory restrictions with respect to capitalization, solvency margins and investment constraints.  Captives, however, face a much more relaxed regulatory environment.  This feature permits the captive (and the parent/group) to participate in investment gains that would otherwise be unavailable in the traditional insurer/insured relationship.  Furthermore, this opens up an opportunity for the captive to create a new profit center in the captive by underwriting the insurance risks of other unrelated companies.[16]   This opportunity should, however, be exploited with a great deal of caution by the captive as the associated loss of control and possibility of excessive claims by “outsiders” might not only eradicate any potential profits but could also lead to insolvency for itself and its parent/group.[17]

Tax Planning and Captives 

Tax planning is not generally considered a primary objective in setting-up a captive, notwithstanding, some tax advantages are possible to attain.[18]   Over the years, the Internal Revenue Service has been averse to recognize the independent status of the captives from the standpoint of qualifying for deduction allowances paid by a parent company to its captive.  Interestingly, “[I]nsurance premiums are deductible as an ordinary and necessary business expense under Reg. 1.162-1(a), but the IRS [does] not characterize payments as ‘insurance premiums.’  Furthermore, there is no definition of ‘insurance’ in the Code or Regulations, nor any indication of the proper treatment of payments to captive insurance companies.”[19]  

The absence of an Internal Revenue Code definition of “insurance” is particularly unusual in light of the Helvering decision rendered some sixty years ago.[20] Notwithstanding, some important decisions continue to shape the tax consequences of captive insurance companies.  For instance, in the Carnation[21] decision, the court found that the parent company was not allowed a business deduction because there was not sufficient evidence of shifting the risk from the parent to the captive.  The premiums paid were held to have merely established as a reserve for losses and thus were not deemed to be a valid deductible business expense.

While the Carnation decision effectively diminished the tax benefits of captives for American parent/group companies, the many remaining benefits were more than enough to assure a steady growth of the industry.  Additionally, recent decisions have made captives even more attractive for American companies, that is, from a tax planning perspective.  In Humana v. Commissioner[22] the Sixth Circuit Court of Appeals held that subsidiaries of U.S. parent/group companies paying premiums to the parent’s captive could deduct those payments as an ordinary business expense.  This provided American companies with a new tax planning strategy by structuring premium payments to be made by the subsidiary rather than by the parent.[23]   The Internal Revenue Service did not, however, initially make a complete retreat from its opposition toward the deductibility of premiums and only officially conceded the issue in November of 2000.[24]

The Current State of Captives  - Conclusion

Today, captives are a fundamental part of the American and international economy. Over 243 of the Fortune 500 companies utilize captives and over 79 own more than one captive.[25]   While the most popular jurisdictions for setting-up a captive are the usual offshore financial centers, Bermuda is by far the most popular with 4,600 more captives domiciled than anywhere in the world.[26]   Many U.S. states have also enacted laws favorable to the establishment of captive insurance companies “[The] [d]evelopment of domestic United States captive domiciles began with legislation first passed in Colorado in 1972.  Tennessee followed in 1978, Virginia in 1980 and Vermont in 1981 . . . many other states have since followed.”[27]   Vermont, however, has led the pack and is ranked as the number one U.S. captive domicile and ranks third in the word.[28]

Captives are therefore a valuable and viable option for companies wishing to avoid the difficulties and deficiencies of the traditional insurance industry.  They provide low cost solutions to risk management, claims control, and further offer a substantial opportunity for profit and tax planning. These advantages can no longer be dismissed as a passing fad. Captives are here to stay and are an absolute necessity for large companies to use as an effective and invaluable management and planning tool.

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About The Author

Mr. Loughlin Senior Partner with Goldman & Loughlin, PLLC  and former president and principal of, JurisConsults International Group, LLC. He is a member of the State Bar of California, Federal Bar Association, International Bar Association, the Royal Society of Fellows and a member of the AAFM Global Board of Academic Advisors and Professors.

Notice: United States Department of Treasury Regulation Circular 230 requires that we notify you that, with respect to any statements regarding tax matters made herein, including any attachments, (1) nothing herein was intended or written to be used, and cannot be used by you, to avoid tax penalties; and (2) nothing contained herein was intended or written to be used, and cannot be used, or referred to in any marketing or promotional materials. Further, to the extent any tax statement or tax advice is made herein, Peter J. Loughlin and Goldman & Loughlin, PLLC does not and will not impose any limitation on disclosure of the tax treatment or tax structure of any transactions to which such tax statement or tax advice relates. The Information provided here is for general information only and is not intended to nor does it constitute legal or tax advice to any person or entity. You should review your particular circumstances with your independent legal and tax advisors.

Endnotes