Captive insurance is a device used by some small businesses in Ohio to provide a form of self-insurance. The "captive" insurance company is a captive of the entity it insures. For instance, a factory or manufacturing plant may create a captive insurer to protect it from certain types of risk that may be more expensive in the traditional insurance market or altogether unavailable.
These are "real" insurance companies, and are subject to all of the regulatory rules that any other insurer must follow, including capital, reserve and tax requirements. The advantage to the parent entity is that it controls much of what the captive does and how it invests the premiums of the parent. As the value of the captive increases, the amount of protection it can offer to the parent also increases.
However, some features of a captive insurer can be attractive from the perspective of estate planning and minimization of taxes. This has resulted in captive insurance landing on the IRS's Dirty Dozen issues of abusive tax scams.
The Service has recently issued new regulations related to Section 831(b) of the Internal Revenue Code. The regulations are designed to prevent excessive premiums from being paid for protection from unlikely risks. The premiums may be structured to offset the income of the business, resulting in no income tax, while promoters earn significant fees and may provide defective underwriting support for the coverage.
The newly issued regulations do not resolve all questions related to this matter and there is a pending case in the U.S. Supreme Court that could prompt further changes on this issue.