Captive Insurance Basics

Editor's Note: The following article is provided by the Vermont Department of Financial Regulation, Captive Insurance Division.

Captive insurance refers to a subsidiary corporation established to provide insurance to the parent company and its affiliates. A captive insurance company represents an option for many organizations, from Fortune 500 companies to nonprofits, that want to take financial control and manage risks by underwriting their own insurance rather than paying premiums to third-party insurers.

What is a captive insurance company?

A captive insurance company is a licensed insurance company that is owned and controlled by its insureds and primarily insures the risks of its owners. A captive insurance company is governed by a board of directors whose membership consists of a majority of owner/insureds and who have oversight and direct involvement with the captive's operations, including underwriting, claims management, and investment policies. There are currently more than 6,600 active captives worldwide that service their parents' risk management and risk financing needs.

What types of insurance risks are written in captives?

In principle, virtually any risk can be covered through a captive structure. While the majority of captives are still insuring traditional property and casualty business, there are a growing number writing new and emerging risks as well. Captives offer unrivaled flexibility in financing risks, which is one of the reasons that more captive owners now use them to address new, complex, and emerging risks such as cyber, terrorism, employee benefits, and medical stop-loss. More companies than ever see captive utilization as being at the core of innovative risk management strategies.

How is captive insurance regulated?

Commercial insurance companies sell insurance to the general public and are licensed in all states in which they do business. By contrast, captive insurance companies insure only the risks of owners, who are sophisticated insurance buyers with the ability to manage and retain their own risk. Consequently, policyholder protection concerns are not the same, and the degree of regulatory oversight required for captives is less onerous than that which is required for commercial insurers. The captive is licensed in only one state and operates under the captive insurance laws of that domicile.

Why form a captive?

Establishing a captive insurance company often provides significant benefits to organizations and risk management professionals. The advantages of going captive include coverage tailored to meet an organization's needs, greater control over claims, reduced operating costs, control of cash flow, funding and underwriting flexibility, access to the reinsurance market, incentive for loss control, capture underwriting profit, pricing stability, potential tax benefits, investment income, potential additional profit center, and tremendous flexibility in managing risk.

How does captive insurance work?

Captive insurance works similarly to conventional insurance, except for a few key distinctions.

A business owner sets up a captive insurance company as a wholly owned subsidiary and identifies the risks that it wants the captive to underwrite. The captive is capitalized and domiciled in a jurisdiction with captive-enabling legislation that allows the captive to operate as a licensed insurer. In addition, the captive evaluates the risks, writes policies, and sets premium levels, and the business owner pays premiums to the captive insurance company.

After a given year, if there is an undistributed surplus in the captive with no claims for losses or less than expected claims for losses, these funds can be used as a secured loan back to the business as a dividend or used to support additional lines of coverage to be placed in the captive.