What is a captive insurance company and how does it work?

A captive insurance company is a licensed insurer that exists mainly to insure the risks of its owners. The business pays premium to its own insurance company, the captive pays covered claims, and whatever is not used for losses and expenses stays with the owners instead of becoming a commercial carrier's profit. It is a way to retain risk in a regulated, funded and (when done properly) tax-recognized form, not a way to avoid insurance.

How the money moves

Start with the ordinary arrangement: you pay a commercial insurer a premium, the insurer pays claims, and the insurer keeps the difference. In a captive program the same three steps happen, but the insurer is yours.

1. The parent pays premium to the captive. The premium is set by an actuary using the parent's loss history and exposure data, normally priced the way a commercial carrier would price the same cover.
2. The captive pays claims within its layer. It usually takes a defined slice of the risk, such as the first $500,000 of each liability claim, and nothing above it.
3. The captive buys reinsurance for the rest. Losses above the captive's retention are ceded to reinsurance markets, so one bad claim cannot wipe out the captive's capital.
4. A fronting insurer often issues the policy. Contracts, lenders and state law frequently require coverage from a licensed carrier with an acceptable AM Best rating. A fronting carrier issues the policy and cedes the captive's share to it. See fronting arrangements and fronting carriers: how they work.
5. Underwriting profit and investment income accumulate in the captive. If losses run better than priced, the surplus builds. If they run worse, the captive's capital absorbs the difference, and the owners may need to add capital.

The captive also needs the rest of an insurer's machinery: a licensed captive manager, an actuary, an independent auditor, a claims administrator (often the same third-party administrator you already use) and a regulator in the state or country where it is domiciled. Captive managers are frequently units of the large brokers; the Vermont Department of Financial Regulation's list of captives licensed in the first half of 2026, for example, shows managers such as Aon, WTW and Brown & Brown among them.

The main kinds of captive

What makes it "insurance" to the IRS

A premium is deductible as an ordinary business expense only if the arrangement is insurance for federal tax purposes. Courts and the IRS have required both risk shifting and risk distribution since Helvering v. Le Gierse, 312 U.S. 531 (1941). Risk distribution is the hard part for a captive, because a subsidiary that insures only its parent is not pooling anyone else's risk.

The IRS published its framework in a group of revenue rulings:

• Rev. Rul. 2002-89: a parent that supplied 90% of its subsidiary's premium and risks did not have insurance. A parent that supplied less than 50% did.
• Rev. Rul. 2002-90: twelve operating subsidiaries insured by a sister insurer, each supplying between 5% and 15% of its risk, did have insurance.
• Rev. Rul. 2002-91: a group captive owned by unrelated businesses, with no member holding more than 15% of the ownership, votes or risk, was insurance and taxable as an insurance company.
• Rev. Rul. 2005-40: an insurer covering a single company, or twelve disregarded single-member LLCs of that company, was not providing insurance. The same arrangement with twelve LLCs taxed as separate associations was.

Those rulings are the source of the rules of thumb captive managers use. They are not safe harbors you can meet by arithmetic alone; the IRS looks at facts and circumstances, including whether premiums were priced at arm's length, whether the captive was capitalized, whether claims were paid, and whether money was loaned back to the owners. How the captive itself is taxed is covered in how captives are taxed: premiums, 831(b), excise tax and distributions.

What it costs to form and run

Costs are real and recurring, and they are why captives suit larger or more stable programs.

• Capital. Each domicile sets a minimum. Vermont's statute, 8 V.S.A. § 6004, requires at least $250,000 of capital and surplus for a pure captive, $500,000 for an association or industrial insured captive, $100,000 for a sponsored captive and $1,000,000 for a risk retention group. Regulators and fronting carriers often want more than the statutory floor.
• Premium tax. Vermont taxes direct captive premiums at 0.38% on the first $20 million, with lower rates on higher tiers and a minimum annual tax of $7,500 and maximum of $200,000 (8 V.S.A. § 6014). Other domiciles set their own schedules; see Captive domiciles compared: Vermont, Utah, Delaware and offshore.
• Service providers. Captive management, actuarial work, audit, legal, claims administration and the fronting fee.
• Collateral. A fronting carrier typically asks for a letter of credit or trust to secure the captive's share of losses.
• Reinsurance. The excess coverage above the captive's layer is a real premium.

The savings, when they exist, come from eliminating the commercial insurer's expense load and profit margin on the layer you can predict, from keeping investment income, and from access to reinsurance pricing. They do not come from the tax code alone.

A hypothetical example

Say a freight company pays commercial carriers $2 million a year for auto liability. Over five years, claims within the first $500,000 of any loss have averaged $900,000 a year, with the worst year at $1.8 million. These numbers are made up to show the mechanism, not market prices.

The company forms a captive that takes the first $500,000 of each claim. The captive charges the company $1.1 million, enough to cover expected losses of $900,000, the fronting fee, the manager, audit, actuary and premium tax, with a margin for volatility. The company buys excess cover above $500,000 per claim from the market.

In a good year, with $600,000 of losses and $250,000 of expenses, about $250,000 stays in the captive. In the worst of the five years, losses of $1.8 million exceed premium by $700,000 or more, and the captive's capital pays the difference. If that happens twice in three years, the owners have to decide whether to recapitalize. That swing is the price of keeping the underwriting result, and it is why risk transfer vs retention: avoid, reduce, transfer or retain starts with what the balance sheet can absorb.

Who uses captives

The NAIC's captive page, citing AM Best, puts the worldwide count at about 8,000, up from roughly 1,000 in 1980. Vermont, the largest U.S. domicile, reports in its 2025 aggregate report that 707 captives were licensed there at December 31, 2025 (677 active and 30 dormant), with $36.3 billion of gross premium written for the year. Of those licensed, 477 were pure captives, 82 were risk retention groups and 72 were sponsored captives. The figures come from unaudited annual statements. Vermont issued its first license in 1981 and had issued 1,428 licenses through June 30, 2026, which tells you that many captives are also closed or dissolved over time.

The coverages placed in captives are typically ones with steady, measurable loss experience: workers' compensation and auto and general liability, employee benefits such as medical stop-loss (see group captives for medical stop-loss: how employer health captives work), property deductibles, warranty and product-specific risks. Captives also appear where the commercial market is thin, such as some professional liability, environmental and cyber exposures.

Questions a feasibility study answers

Before a captive is licensed, a captive manager or consultant runs a feasibility study. The questions are the useful part, and you can ask them yourself first:

1. How much premium do we pay in the lines we would move, and over how many years do we have clean loss data?
2. Is the loss experience stable enough that an actuary can price a layer, or does one claim decide the year?
3. Can we afford the worst year, including collateral to the fronting carrier?
4. Does a real business reason exist apart from taxes, such as coverage we cannot buy or a commercial price that ignores our safety record?
5. Do we have the management time and discipline to run claims, safety and governance as an insurer would?

The longer version of this is in Is a captive right for your business? A feasibility checklist. Your broker can run the numbers, and your CPA and tax attorney should review the structure before you commit.

Key takeaways

• A captive is a licensed insurer owned by the policyholders it covers; premiums, claims and reinsurance work like any insurer's, but the underwriting result stays with the owners.
• The IRS treats premiums as deductible insurance only if there is genuine risk shifting and risk distribution; the 2002 and 2005 revenue rulings show where the line sits.
• Capital, premium tax, fronting, management, actuarial and audit costs are recurring, so captives fit programs with steady, predictable losses.
• Vermont reported 707 licensed captives and $36.3 billion of premium for 2025 (unaudited), but a domicile's size does not make a particular captive a good idea for you.
• Get the feasibility study, the CPA and the tax attorney before forming one, and decide what you would do after a bad year.