The IRS recognizes the legitimate business concern of creating a small and closely-held insurance company in order to cover some of the risk associated with various business entities. If the company is defined as a small one, the insurer does not have to pay any tax on underwriting income. Usually the definition of small means no more than $1.2 million in net written premium across a year. 

The originating company in this situation would receive a tax deferral due to the deduction of premium paid, while the insurer does not have to pay underwriting tax, either. The key to all of this is that the captive has to be structured as a legitimate insurer providing coverage at a reasonable cost. Possible risks could arise if the company were used to generate implausible coverage with extremely high fees or high premiums.

The structure of such a captive, and the management of it, should be done with care. This is to ensure the highest level of protection offered by such a structure. The use of captive insurance companies is something that has become increasingly popular, but it should always be done properly in order to maximize benefits.