What Is Captive Insurance and How Does It Work?

Captive insurance is a financial strategy where an organization forms its own insurance company to cover its risks. This method allows businesses to manage their insurance needs directly, offering an alternative to traditional third-party insurers. This self-managed mechanism provides a unique way for businesses to control their risk financing.

What is Captive Insurance

A captive insurance company is a licensed entity wholly owned and controlled by its policyholders, established to insure the risks of its parent company or a group of related companies. This allows the owner to essentially self-insure, rather than purchasing coverage from a traditional commercial insurer. Instead of paying premiums to an external provider, a company directs these payments to its own captive. The core concept is that underwriting profits and investment income remain within the parent company’s group, rather than being disbursed to a third-party insurer.

Captives function as subsidiaries, providing insurance coverage to their owners. This arrangement contrasts with traditional insurance, where an independent insurer assumes risk and retains profits. By owning the insurer, the policyholder gains greater control over coverage terms and claims processes. Captives can cover a wide range of risks, encompassing nearly every type underwritten by commercial insurers.

How Captive Insurance Functions

Premiums are paid by the parent company or insured entities directly to the captive, which acts as the underwriter and issuer of policies. This keeps funds within the corporate group, allowing investment income to benefit the owner. The captive manages claims, paying out covered losses from its accumulated funds.

The captive builds reserves to cover future claims, ensuring financial stability. These reserves are invested, with investment income contributing to profitability. To manage large or catastrophic risks, captives utilize reinsurance, transferring a portion of their risk to external reinsurers. This protects the captive’s solvency and allows it to underwrite substantial exposures.

Captives often rely on external service providers for specialized functions, as they typically have few direct employees. These partners include captive managers who handle administrative, financial, and regulatory requirements; actuaries who assess risk and determine premium levels; and auditors who ensure compliance and financial integrity. This outsourcing model allows the captive to operate efficiently while adhering to regulatory standards.

Different Types of Captive Structures

Captive insurance companies can be structured in various ways, suited to different ownership models and risk profiles.

Single-Parent Captive

Also known as a Pure Captive, this type is owned by one non-insurance company to insure its own risks and those of its affiliates. This structure offers complete control over insurance programs and policy customization.

Group Captives

Owned by multiple, unrelated companies, Group Captives collectively insure their risks, often sharing similar industry characteristics. These captives allow participants to pool resources and manage risks jointly, sharing costs and benefits.

Association Captives

A specific form of group captive, typically sponsored by an industry association for its members’ benefit.

Protected Cell Companies (PCCs)

Also referred to as Segregated Portfolio Companies (SPCs), PCCs feature a single legal entity containing multiple, legally separated “cells” or “portfolios.” This structure permits individual participants to benefit from a captive arrangement without commingling assets and liabilities with other participants, balancing cost-sharing and individual financial segregation.

Risk Retention Groups (RRGs)

A specialized group captive formed under federal law, specifically the Liability Risk Retention Act of 1986. RRGs are authorized to insure liability risks for their members across multiple states with simplified regulatory requirements, provided they are licensed in one U.S. state. They cannot write workers’ compensation or property insurance.

Key Motivations for Using Captives

Organizations establish captive insurance companies to address challenges related to risk financing and insurance procurement.

Cost Control

One motivation is to gain greater control over insurance costs, allowing a business to manage expenses more directly rather than being subject to fluctuating commercial market rates. This leads to more predictable insurance expenditures.

Coverage for Unique Risks

Captives are formed to cover unique or hard-to-insure risks that traditional commercial insurers may be unwilling or unable to provide, or only at prohibitive costs. This includes emerging risks like cyber liability, which captives were among the first to cover. A company can tailor coverage to its specific exposures.

Improved Risk Management

Establishing a captive can lead to improved risk management practices within the parent organization. With a direct financial interest in the captive’s performance, companies are incentivized to adopt more disciplined approaches to identifying, assessing, and mitigating risks. This fosters a culture of heightened risk awareness and control.

Access to Reinsurance Markets

Another purpose for using a captive is to gain direct access to global reinsurance markets. This access is typically unavailable to individual corporations in the commercial insurance market, but captives, as licensed insurers, can tap into these wholesale markets. This allows for the transfer of significant risks, resulting in more favorable pricing and broader coverage.

Coverage Stability

Captives also serve to stabilize coverage, providing a more consistent and predictable source of insurance capacity. This is particularly valuable during “hard market” periods when commercial insurance becomes more expensive and difficult to obtain. This stability helps insulate businesses from market volatility and ensures continuous protection for operations.