When set up correctly, captive insurance gives businesses a powerful tool for controlling risk and reducing insurance costs. But despite the potential, some captives fail—often because businesses and their advisors overlook steps in planning, funding, and managing the program.
For independent agents, it’s essential to understand these pitfalls. When captives fail, it’s usually due to preventable issues, like inadequate capitalization or a lack of explicit risk management. Captive Coalition has brought advice from William Paul White, Captive Insurance Expert with Acuity Strategic Consulting, and Scott Barry, Director of Underwriting with Captive Coalition, to bring you expert knowledge on what causes captives to fail.
This article will cover the top reasons captive insurers fail and provide practical advice to help agents support their clients in building effective captives.
One: Purpose-driven Planning Is Essential
One of the biggest reasons a captive fails often starts on day one. Many captives falter because they lack a clear purpose beyond a vague desire to “save on premiums” or “gain control.” For a captive to work, it needs a purpose-driven, strategic objective—better managing a specific risk, stabilizing insurance costs, or building up reserves for particular types of claims.
Without these goals, a captive can quickly lose focus or be set up for the wrong reasons, leading to operational issues down the line.
Agent Tip: Ensure your client sets up the captive with well-defined objectives. Captives created solely to capture tax advantages or cut expenses without strategic planning are more likely to fail. Help your clients determine what they hope to achieve, like steadying their insurance costs or improving risk management, and make sure the captive’s purpose aligns with their goals.
Two: Knowing the Difference: Captive Management vs. Captive Manager
One misunderstanding is the difference between “captive management” (a business owner’s responsibility) and the “captive manager” (the external professional managing the captive’s day-to-day). When clients assume the captive manager handles everything, they may neglect their oversight role, leading to regulatory issues or underperformance. Captive managers take care of compliance and reporting, but they don’t bear ultimate responsibility for the captive’s success—this falls on the owners.
Agent Tip: Educate your clients on the difference. While captive managers are experts in regulatory and operational tasks, the owner must stay engaged in strategy, financial planning, and risk assessments. Make it clear the owners cannot hand over the wheel entirely.
Three: Sticking to the Business Plan Is Non-Negotiable
Each captive is formed with a business plan approved by a regulatory body. When captives deviate from their original plan—especially in ways that prioritize tax savings over risk management—they increase their chances of failing.
For example, the IRS scrutinizes captives that misuse the 831(b) tax election, which can lead to penalties and possibly force the captive to shut down. A well-run captive should be regularly evaluated to ensure it stays aligned with its original goals and compliance requirements.
Agent Tip: Encourage clients to review their captive’s business plan annually and adjust as needed without sacrificing its primary purpose. Captives that shift focus or overreach without updating their plans can lose regulatory approval and even incur penalties.
Four: Regulatory Compliance and the IRS
Compliance isn’t optional. Captive insurance companies are subject to state and federal regulations and must strictly adhere to requirements like financial reporting, reserve maintenance, and business plan updates.
The IRS keeps a close eye on captives, particularly those that use the 831(b) tax election, which exempts underwriting profits from federal income tax. Captives that misuse 831(b) can face hefty fines and potential closure, as they have been included in the IRS’s “Dirty Dozen” tax scams list.
Agent Tip: Make compliance a priority in every client conversation. Explain the importance of regular audits and prompt filing of all necessary reports. Help clients understand that while captives have tax advantages, those benefits should be secondary to their primary insurance purpose.
Five: Risk Management and Adequate Reserving
Captives fail when they don’t have enough reserves to pay claims. Some business owners see reserves as money sitting idle and might be tempted to “reclaim” them if no claims arise early on.
However, that money serves as a buffer for the unexpected—and in insurance, it’s only a matter of time before unforeseen costs arise. Reserving is especially important for long-tail liabilities, where claims may take years to emerge.
Agent Tip: Encourage your clients to reserve conservatively. Captive owners need to set aside funds to cover potential claims and avoid the temptation to “repurpose” those funds for unrelated business needs.
Six: Economic Factors: COVID-19 and More
The pandemic showed us that external forces, like economic downturns or supply chain disruptions, can impact captives. For instance, some captives were forced into dormancy during COVID-19, when businesses couldn’t maintain their cash flow or fulfill their premium obligations. Economic hardships like recessions can also push captives to halt or close operations.
Agent Tip: Prepare your clients for the unexpected. By helping them set realistic financial expectations and revisit their coverage needs annually, you can safeguard captives against significant economic swings.
Seven: Misaligned Intentions: The Need For Long-Term Commitment
A captive isn’t a quick fix or a temporary measure; it’s a commitment to a long-term risk management strategy. Clients who think they can “test out” a captive often end up disappointed. Captive setups come with upfront costs and require time to see the financial benefits. For a captive to succeed, owners need a long-term mindset.
Agent Tip: Help clients understand that a captive is an investment, not a cost-cutting gimmick. When clients enter a captive with realistic expectations about time, effort, and expenses, they’re more likely to benefit over the years.
Eight: The Role of Reinsurance and Proper Claims Handling
Reinsurance is critical for captives, especially businesses with volatile claims histories or high-risk exposure. Without reinsurance, a captive may be vulnerable to significant losses exceeding its financial capacity. Proper claims management is also incredibly important—mistakes can add unnecessary costs and create regulatory problems.
Agent Tip: Encourage clients to explore reinsurance options as part of their captive’s setup. Reinsurance can provide the necessary support to help captives weather larger-than-expected losses, while effective claims management makes it so losses are processed smoothly and fairly.
Warning Signs a Captive May Be at Risk
Captives rarely fail without warning. As an agent, you can help clients by identifying red flags before they escalate. Warning signs might include:
- Frequent business plan changes without clear strategic purpose.
- Reserve levels decline significantly or become insufficient for potential claims.
- Rapid turnover of captive managers or service providers can indicate mismanagement.
- Shifts in financial statements that suggest dwindling resources or rising expenses.
Agent Tip: Make it a point to monitor these indicators in regular client discussions. You can help clients avoid costly missteps and maintain their captive’s health by catching issues early.
Support Your Clients for Captive Insurance Success
Captive insurance can provide benefits for businesses, though it’s not without risks. As an agent, you can help your clients by clarifying the purpose of the captive and emphasizing financial stability. Each step taken with your client reinforces their captive’s success. The best captives are purpose-driven, well-managed, and continually assessed.
Next, read our Captive Insurance Prequalification Checklist to see how your best clients can successfully create or join a captive insurer.
At Captive Coalition, our sole purpose is to educate independent agents and their clients on all things captive insurance, including why captive insurers fail. This way, you will know how to avoid these failures and relay this information to your best clients.
You might be wondering if your best clients are even qualified to join a captive. Use this captive assessment tool to see if your clients qualify.
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