Captive insurance involves the formation of an insurance company that can directly insure business risk. A captive insurance company is essentially an insurance company in form and in fact. This brings all of the complexity of an insurance company that is licensed to issue policies directly to an insured business. These complexities include, for example, operating risk pools, building actuarial models, setting underwriting protocols, etc.

Creation of a captive insurance company is a complex and expensive undertaking. Formation of a captive insurance company involves the work of attorneys, actuaries, underwriters and other professionals. Large non-deductible capital contributions are also required. Furthermore, the captive must satisfy “insurance” requirements, including risk pooling or risk sharing, and must qualify as an insurer under the appropriate sponsoring legislation. This is an expensive solution when used in isolation. The expense of a captive insurer arises from its role as a direct insurer of risk. The captive takes on the role of the front-line insurance company. Nevertheless, the formation of a regular captive insurance company may be justified in some circumstances.

Reinsurance is distinct from captive insurance. A reinsurance company is reinsuring one or more risks already covered by a business casualty policy. This means that the work of quantifying risk, setting underwriting guidelines, paying claims, etc. is already being handled. The reinsurance company does not need to replicate these efforts. Establishing and operating a reinsurance company is much simpler and much less expensive than creating a captive insurance company.