What Defense Contractors Most Commonly Get Wrong in CMMC Assessments
Manufacturers tend to think about insurance as a cost to be renewed each year. A captive changes that framework.
Instead of transferring every insurable risk to a commercial carrier, a business can form or participate in an insurance company designed around its own exposures.
For manufacturers with meaningful, predictable loss experience, the result can be more control over coverage, pricing, claims and long-term risk financing. The key is that a captive must operate as real insurance, not simply as a tax structure. Done correctly, it can turn part of an unpredictable expense into a disciplined risk-management program.
A captive insurance company is an insurer owned by the business or group whose risks it covers. The operating company pays premiums to the captive, and the captive issues policies, establishes reserves, pays covered claims and may purchase reinsurance for larger losses.
With commercial insurance, the manufacturer pays a third-party carrier to assume risk under the carrier’s pricing and policy terms. With captive insurance, the manufacturer has more influence over which risks are retained, how coverage is structured and how favorable underwriting results are used. The tradeoff is greater responsibility for capitalization, governance, underwriting, claims administration and regulatory compliance.
Manufacturers face risks that can be difficult to price through standardized commercial policies, including product liability, workers’ compensation, equipment breakdown, auto liability, property deductibles, supply-chain disruption, cyber events, environmental exposures and product recalls.
They can also face higher premiums, narrower coverage and larger retentions even when their own safety and claims records are strong. That makes manufacturers natural candidates for captive insurance risk management when losses are measurable. A captive can finance predictable layers of risk while commercial insurance or reinsurance remains in place for severe, less predictable events.
The tax treatment depends first on whether the arrangement qualifies as insurance for federal tax purposes. When it does, premiums paid by the operating company may generally be deductible as ordinary and necessary business expenses under Section 162.
If premiums exceed claims and operating expenses, those funds can remain in the captive as surplus and investment assets. That does not mean all captive profits are tax-free. A qualifying non-life insurance company that makes a Section 831(b) election can generally exclude qualifying underwriting income from taxable income and instead be taxed on its taxable investment income, provided it satisfies the applicable requirements. For 2026, the Section 831(b) premium limitation is $2.9 million.
The IRS has focused on abusive micro captive insurance arrangements because some were structured primarily to generate deductions and move income into related entities while lacking the economics of genuine insurance. The IRS has warned about abusive micro-captives for more than a decade. In January 2025, Treasury and the IRS finalized and made effective regulations identifying certain micro-captive arrangements as listed transactions and others as transactions of interest, with accompanying disclosure requirements.
A defensible captive needs genuine insurance risk, risk shifting and risk distribution, actuarially supportable premiums, valid policies and a credible claims process. Premiums should reflect risk, not a desired tax deduction.
A legitimate captive looks and behaves like an insurance company. It is formed in an appropriate domicile, adequately capitalized, governed separately and supported by documented underwriting and actuarial analysis. Policies are issued before losses occur, coverage terms are clear, premiums are commercially reasonable, reserves are maintained and valid claims are paid according to the contracts.
The IRS and courts also examine whether risk is genuinely shifted and distributed and whether the arrangement operates as insurance in the commonly accepted sense. The strongest captive insurance benefits come when the structure serves a real business purpose: financing predictable losses, filling coverage gaps and reducing exposure to commercial-market volatility.
For manufacturers, the most useful question is not whether a captive creates a tax advantage. It is whether the company has enough insurable risk, premium volume, loss data and operating discipline to run an insurance program economically.
Tax treatment matters, but it should follow a defensible risk-financing strategy. That is different from incentives such as R&D Tax Credits, where eligibility is tied to qualifying activities and expenditures. A captive is first an insurance company. If the economics, governance and claims practices would not make sense without the tax benefits, the structure deserves another look.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Charlsie Pritchett, partner in Bennett Thrasher’s Financial Reporting & Assurance practice, who has industry experience in manufacturing and captive insurance, or call us at 770.396.2200.
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