Although they’re becoming more common, captive insurance companies are still relatively rare. Unlike traditional commercial insurance, most businesses don’t have any direct experience with captives. As a result, the subject is often shrouded by myth, misconception, and misinformation.
So, we decided to set the record straight. In this guide, you’ll learn the benefits of captive insurance while uncovering some of the most common myths you might have heard—and the actual truth behind them.
Myth #1: Captives Are Only for Multinational Corporations
This is probably the most common misconception about captives.
Since it can take a substantial amount of capital to form a captive, many people assume that they only make sense for massive companies, global organizations, and businesses that make the Fortune 500 list.
While that may have been true in the past, captives have become far more accessible in recent years.
This is largely due to the different captive models available now. While the traditional single-parent model remains prohibitive for most companies, smaller businesses can team up to form group captives or take part in cell captives.
These alternative structures allow organizations to benefit from captives even if they don’t spend seven figures on annual insurance premiums. They can also form captives without any single organization needing to meet the total capital requirements.
Myth #2: Running a Captive Is Too Complicated
So, smaller companies are able to form captives or take part in them. But is it actually worth the trouble?
Since captives have been associated with major corporations, there’s a perception that they’re overly complicated. That yes, it might make sense for a huge organization to take control over its insurance. But for your average mid-sized company, it would simply be too much to handle.
Again, that might be true with a single-parent captive. However, taking part in a cell or group captive can drastically simplify things. These arrangements allow individual companies to share the burden of managing the captive. This results in lower overhead for each of the members and a streamlined administrative process.
Companies can also outsource compliance, accounting, and actuarial work to experienced managers. This allows them to benefit from the captive without having to handle all the day-to-day affairs.
Myth #3: Captives Are Just a Tax Evasion Scheme
This misconception arises when people learn about captive domiciles. Since captives are often registered in overseas jurisdictions, it’s easy to assume that they exist only to dodge taxes.
The truth is, captives are legitimate risk financing vehicles – not tax shelters. They’re not entities where companies park some of their earnings and assets to avoid being taxed on them.
While there can be tax benefits to forming a captive, they can’t exist solely for that purpose. Captives are insurance companies, which means they’re subject to rigorous oversight. There are consequences if the funds are used inappropriately.
For example, in the United States, regulatory scrutiny – especially for small 831(b) captives – has increased. The Internal Revenue Service (IRS) has flagged some abusive practices, such as overpricing coverage or insuring implausible risks. Compliance must be carefully maintained to avoid classification as an abusive tax shelter.
So no, forming a captive isn’t a way to avoid paying taxes. And even if it were, it would likely fail under regulatory scrutiny.
Myth #4: If You Have a Captive, You Don’t Need Commercial Insurance
There’s a grain of truth here – but only a grain.
Companies do, indeed, establish captives to have control over their own insurance. They can purchase policies directly from the captive instead of relying on third-party insurers. They also allow customized plans that wouldn’t be available from traditional insurance providers.
So, does that mean a captive can fully meet a company’s insurance needs?
Well, yes and no. Technically, a captive could cover its parent company’s entire risk profile. But doing so would be unwise – and potentially noncompliant.
Captives really exist to complement commercial insurance, not replace it. They’re often used to insure risks that traditional insurers would rather avoid. Companies that spend a lot on premiums might also rely on them to reduce their insurance costs.
However, most of those companies will make careful decisions about which risks the captive will cover. For certain exposures, it simply makes more sense, and it may be legally necessary, to rely on a traditional commercial policy.
Myth #5: Captives Only Cover Specific Types of Risk
We’ve just seen that some people assume captives cover every type of loss under the sun. On the flipside, some people assume captives only cover a narrow range of risks.
This misconception likely originates from one of the rationales behind forming a captive. One of the benefits of a captive is the ability to insure losses that would be excluded from most standard policies. This leads some people to believe that captive insurance only covers high-risk operations or very specific types of events.
In reality, captives are able to provide any type of coverage, including:
- Property
- Cyber liability
- Employee benefits
- Professional indemnity
- Supply chain risks
There are a few exceptions. For example, since the insured company owns the captive, issuing certain types of coverage, such as Directors & Officers (D&O) liability, would constitute a conflict of interest (specifically Side A coverage).
In most cases, however, the captive is simply an insurance company. And like any other insurance company, it can cover whichever risk it deems insurable.
Myth #6: Captives Tie Up Too Much Capital
To form a captive, the parent company must meet some rather hefty startup capital requirements.
This leads some people to believe that owning a captive would essentially freeze a substantial portion of their company’s assets. With captives requiring so much, there will be too little left for the parent company’s main operations.
It’s true that owning a captive reduces the parent company’s liquidity. But there are also ways to lessen its impact.
Some domiciles have lower capital requirements, which can free up more funds for the company’s operations.
Companies can also form group captives to spread the capital burden across multiple businesses. This allows each member to enjoy the benefits of a captive with a reduced impact on their cash flow.
There are also rent-a-captive arrangements. As the name implies, they involve far less commitment and lower contributions than a standard captive structure.
However, it’s worth noting that captive capital must remain dedicated to the captive’s claims-paying ability and solvency. It’s not money the parent company can freely reallocate.
Myth #7: Captives Are Offshore Operations, Which Makes Them Risky
When people hear about captives based in Bermuda or the Cayman Islands, they might get the idea that these are sketchy offshore operations.
Not only is this false, it’s false on two counts.
First, it’s simply not true that captives are offshore entities. Yes, some of them are. But plenty of captives operate domestically as well. States like Vermont, Utah, and Delaware are popular domiciles for captives, even those owned by American companies.
But there’s also no reason to be suspicious of those that are registered offshore.
Jurisdictions like Bermuda and the Cayman Islands don’t attract captives because they’re hush-hush and shady. They do so because they happen to have favorable regulations and achievable requirements. And they’re backed by robust regulatory frameworks – just like their onshore counterparts.
Moreover, many of these domiciles have solid credit ratings. Both Bermuda and the Cayman Islands, for instance, have been rated comparably or better than several developed nations.
Now, there are some risks to selecting a domicile. Political disruption, legal upheaval, and economic headwinds can all spell trouble for captives and their parent companies. But these unpredictable risks are present in any jurisdiction, no matter where they’re located.
Myth #8: Captives Are Inflexible and Difficult to Change
While a parent company forms the captive, it’s a somewhat hands-off relationship. A captive is a genuinely independent entity. While the parent might be its owner, it doesn’t micromanage the captive’s daily operations.
Captives are rather agile. They’re designed to be flexible so they can meet their parent company’s needs.
Among other things, companies can:
- Add or drop lines of coverage
- Adjust retentions
- Change domiciles
- Switch service providers
The majority of captives are also headed by boards made up of independent members (usually retired insurance executives and industry partners). These boards assist in managing the captive, ensuring that the operations aren’t set in stone but can be adjusted as needed.
There are certainly limits to what can be done with a captive. For instance, the parent company can’t use the captive to move funds around as it pleases. But it still affords a fair deal of convenience and flexibility.
Myth #9: Every Large Corporation Should Form a Captive
Captives are associated with large corporations, but that doesn’t mean every corporation should form one.
Whether a captive makes sense for a large company is really a case-by-case decision. Some will find it highly beneficial and go through the process of forming one. Others will deem it too much trouble with too little payoff.
That’s one of the reasons companies will conduct a feasibility study. This will help them determine not only whether they can form a captive, but if doing so would be beneficial.
In general, captives are ideal for companies with a robust approach to risk management, predictable loss patterns, and a focus on long-term strategy over short-term gains. Size helps, but it’s not the only factor that matters.
Myth #10: Captives Only Insure Corporate Risks
Again, this probably comes from the stereotypes surrounding captives. Captive are associated with large corporations, so it’s common to assume that they only cover corporate risks.
Captives, however, are not limited to covering internal risks. They can also insure third-party risks like:
- Warranties
- Customer service programs
- Extended guarantees
However, insuring third-party risks can change the regulatory status of a captive and may require the captive to meet additional licensing requirements. Companies should consider those implications carefully when structuring such coverage.
Get the Facts Straight
It’s no surprise that there are so many misconceptions about captives floating around.
Captives are often seen as this special entity. It’s a real insurer, but not a standard insurance company. It issues policies, but directly to its parent company. It’s owned by another entity, but domiciled in a separate jurisdiction.
All of that is bound to cause some confusion.
But the important thing to remember is that:
- Captives are legitimate insurance companies
- They can be structured in a number of different ways (including as group captives)
- They operate under strict regulatory oversight, even when based overseas
Knowing these three basic facts won’t tell you everything you need to know about captives and how they operate – but it will help you bust most of the myths that surround them.
