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What is a captive insurance company?

A captive insurance company (CIC) is a corporation established either onshore or offshore to insure the risks of its parent company or a group of companies. While there are many benefits that can be derived from a CIC, the primary goal of any CIC is to reduce the parent company's overall cost of risk management.

CICs may allow insured companies to decrease their insurance and reinsurance costs, control premium costs, and increase profits and cash flow. They also may provide for coverage of unusual risks that are not customarily insured by commercial insurers, allow the insured direct access to reinsurance markets, improve risk management, and afford possible tax benefits.

There are many different types of CICs. The most common are pure captives--wholly owned by one parent and/or its affiliated companies; and group captives--owned by a number of similarly sized unaffiliated entities that are usually in the same line of business (e.g., doctors). Generally, CICs are run by a board of directors designated by the parent company.

CICs generally can insure risks ordinarily covered by commercial insurers, including malpractice coverage, automobile liability, workers' compensation, employee health-care costs, product liability, property damage, liability umbrella coverage, wrongful termination, and sexual harassment. Regardless of the type of risk, like most commercial insurance, the CIC typically will transfer some of its risk to another insurance company, referred to as reinsurance. This allows the CIC to control the amount of economic risk exposure it retains.

Generally, the parent company can deduct premiums paid to the CIC, so long as the IRS recognizes the captive as a true insurance arrangement. Also, if certain requirements are met, the premiums received by the CIC are tax free.

Establishing a CIC involves a high capitalization commitment, significant administrative costs, state or foreign domiciliary regulation, and the possibility of inadequate loss reserves to cover unexpected losses. But after careful analysis, a CIC may be a way to finance a company's risk at a reduced cost.