What a captive is for
A captive is an insurance company owned by the business it insures. Large organisations have used them for decades for sound reasons: coverage the commercial market prices poorly or declines to write, retention of underwriting profit on risks the business understands better than an outside carrier, and direct access to reinsurance.
Where the business genuinely bears the risks being insured and the arrangement operates as insurance, premiums are deductible by the operating company and the captive is taxed as an insurance company. That is ordinary and uncontroversial.
The election that created an industry
A small insurance company may elect to be taxed only on its investment income rather than its underwriting income, subject to a premium ceiling and other conditions.
Read together with the deduction at the operating company, the combination is striking: the payer deducts the premium, and the recipient does not include it. Where claims never materialise, the accumulated premium sits in a related entity, and the eventual extraction can be arranged at capital rates.
What insurance requires
There is no statutory definition. Courts have developed a test with four elements, and captive litigation has concentrated on two of them.
| Element | What it means | Where captives fail |
|---|---|---|
| Insurance risk | A real possibility of loss, not investment or business risk | Policies covering remote or commercially unavailable perils that no carrier would write |
| Risk shifting | The risk genuinely moves from the insured to the insurer | Thin capitalization, guarantees, or circular arrangements that leave the risk where it was |
| Risk distribution | Enough independent exposures that the law of large numbers can operate | The central battleground. Too few insureds, or pooling arrangements that on examination distributed nothing |
| Commonly accepted notions of insurance | It behaves like insurance in operation | No underwriting, unexplained pricing, claims never made or never paid, policies issued after the period began |
A line of Tax Court decisions has found against taxpayers on these grounds, frequently holding that pooling arrangements sold as providing risk distribution were circular and provided none, and that actuarial support for premiums was unreliable.
The examination posture
These arrangements have been designated transactions of interest and, in due course, subjected to listed transaction treatment, with disclosure obligations on participants, advisers and material advisers. Settlement initiatives have been offered on terms requiring concession of most of the benefit.
For a participant, the exposure is not limited to losing the deduction. It includes accuracy penalties, separate penalties for failure to disclose, interest running from the original due dates, and the cost of an examination that will not confine itself to the captive.
How to tell the two apart
Since the structure is legitimate and the abuse looks similar from a distance, the useful questions are operational.
- 01Would the business buy this coverage from an unrelated carrier at a comparable price. If the perils are ones no carrier writes and no prudent manager would insure, the arrangement is not answering a business need.
- 02Is the premium supported by an independent actuarial analysis that a third party would stand behind, and does it move with the underlying exposure from year to year.
- 03Have claims been made, adjusted and paid. A captive that has never paid a claim over many years is describing itself.
- 04Is the capital real and unencumbered, or is the captive dependent on guarantees or loans back to the operating business.
- 05Is there genuine risk distribution, from a sufficient number of independent exposures, without reliance on a pool whose mechanics nobody can explain.
- 06Is the arrangement administered as an insurance company, with proper governance, policies issued before the period, and regulatory compliance in its domicile.
General information only. This article describes law and practice as we understand them at the time of writing. It is not tax, legal, accounting, or investment advice, it does not consider your circumstances, and it does not create an advisor-client or attorney-client relationship. Odyssey Strategic Advisors LLC is not a law firm and is not a CPA firm. Confirm any position with your own tax professional before acting on it. See our disclosures.