A New York Times article examining the benefits of captive insurance opened with this admission:

“Every so often I come across a financial strategy that sounds too good to be true. That was how I felt when I heard about the increased use of captive insurance companies by entrepreneurs and small-business owners.”

A Fair Question

It is easy to see why a business owner – or in this case a business reporter – might feel that way. Establishing a captive insurance subsidiary just makes sense for so many businesses that deal with risk, yet so many business people have never heard of it.

For many businesses, captive insurance is a no-brainer. In the right situations, it can reduce costs, insulate against insurance premium hikes, boost revenue, provide broader coverage and more efficiently finance risk.

It really does sound too good to be true.

In fact, the first time I was approached to establish one for a client, I advised them to pass. I felt exactly the same way the business reporter did.

The client persisted, so I did some research. I discovered that this was a rare case when something that sounded too good to be true actually lived up to the billing.

Why Is It I Haven’t Heard of It?

Captive insurance is not new. The first captive insurance company was founded in 1955 in Ohio. By 1980 there were still only about 1,000 captive insurance companies in the U.S., most of them headquartered overseas.

In 2002, the floodgates opened when the IRS issued guidance on how to set up captives to comply with the U.S. tax code. Today, 90% of Fortune 1000 companies and large hospitals own captives to minimize costs. Nonetheless, many more organizations would benefit by taking advantage of owning their own insurance company.

How Does a Captive Work?

This is captive insurance in a nutshell:

An organization that has a substantial amount of insurable risk establishes a captive insurance company to insure the risks of its owner. The company pays insurance premiums to the captive rather than to an external insurance company. If premiums exceed claims, the company can recapture the excess – that is, the profit.

In addition, the premiums paid to a captive insurance company are deductible, just as any other insurance expense. For companies with large insurance premiums, that can create substantial savings compared to simply self-insuring. The premiums collected by the captive are tax-free up to $2.2 million annually, and indexed for inflation.

In order to qualify as insurance there must also be risk diversification, to accomplish this, many captive insurance companies buy reinsurance or participate in a reinsurance pool. In essence, they lay off the biggest risks on other providers or in the case of a pool, can “smooth” large risks among the many participants. That protects the company insuring itself through its own insurance company from facing extinction because of a mammoth claim or series of claims.

Captive Insurance is Not for Every Business

That’s all a simplification, but you can see why captive insurance seems like it can be a panacea. It offers the same security and diversification of risk as with ordinary insurance, but it can cost less, reduce operating expenses, and offer the possibility to profit from effectively managing risk.

No company should enter the captive insurance market without first understanding the risks and benefits for their particular situation. I have certainly advised potential clients that captive insurance was not the right solution for them.

For those who might benefit, it can be a very profitable risk financing option. I walk readers through every step of the captive establishment and management process in my new book, The Business Owner’s Definitive Guide to Captive Insurance Companies, so they too can obtain the benefits realized by those Fortune 1000 companies.