TUCSON, Ariz.—Some small and midsize captive insurance companies can produce the same benefits for their parent companies as larger captives and add particular benefits that only small companies can provide.

At the same time, however, smaller captives can face some special challenges, and it's essential that they are structured appropriately and for the right reasons, said a panel of experts speaking about small and midsize captives at the Captive Insurance Cos. Assn.'s 2011 International Conference this month in Tucson, Ariz.

Among factors that prospective parents of smaller captives must consider are their companies' size, expected captive premium vs. risk, and their risk appetites and exposures, said Robert Vogel, vp at Pro Group Captive Management Services in Carson City, Nev.

While the final decision on forming a captive is subjective, a captive feasibility analysis helps an organization arrive at the right answer, Mr. Vogel said.

As a smaller organization explores forming a captive, “The first key is to obtain management's unbiased support of the feasibility process,” said Robert Davidson, senior vp at Arthur J. Gallagher Risk Management Services Inc. in Brentwood, Tenn. “Management has to be behind this 100%.”

While organizations' goals for their captives might differ, and publicly held companies' goals often will differ from privately held firms, it's still “good to have those goals written down and documented,” Mr. Davidson said.

Tax considerations are a factor but shouldn't the primary reason for forming a captive, said Nicola Neilon, a partner at accounting and advisory firm Casey, Neilon & Associates L.L.C. in Carson City. “Captives are a great tool for a business, but they have to be run properly to stand up to the scrutiny of a regulator or the IRS,” she said.

Risk shifting and risk distribution are essential if the captive is to be considered an insurance company by the IRS, Ms. Neilon said. “If you don't have those criteria filled, you don't have an insurance company for tax purposes and that can cause some problems.”

In considering a captive, it's critical that the insurance company is being formed for real business purposes, Ms. Neilon said. “If you list tax considerations as a top reason for forming a captive, you've potentially shot yourself in the foot if there's an IRS audit,” she said.

She also cautioned parents of new small or midsize captives to be careful in making tax elections, such as nonprofit or a small insurance company 831(b) election. “You have to be very careful in making your elections and making sure you've got your rationale documented and making sure you qualify,” Ms. Neilon said.

An 831(b) election, under which insurance companies with less than $1.2 million in annual premiums can elect to be taxed by the federal government only on investment income, can be “a great strategy if you meet all the criteria,” Ms. Neilon said.

“It's a phenomenal advantage to be able to use the captive to transfer wealth for some of these closely held companies,” she said. And, if they are structured so that their ownership is properly diversified, it's possible for a company to set up multiple 831(b) captives, Ms. Neilon said.

Mr. Davidson noted that small and midsize captives often face certain common problems, including financing and governance issues. In the latter area, problems can arise if the captive is perceived as a low priority by organization leaders who are focused on the primary business, or if those leaders are more focused on the captive's return on investment and cash flow than on risk management.

The risk management focus is essential in forming the captive, he said. “It's so important that the captive have that business purpose of providing that coverage.”

“The people who come in and just want to knock out a captive because they think they can save some money aren't necessarily the best prospects for a captive,” added Ms. Neilon.