By Melissa Johnson

In 1986 the US Congress adopted section 831(b) of the Internal Revenue Code of 1986 specifically to encourage small insurance company formation. They created significant tax breaks for forming these small captives. However, despite the tax election being almost 30 years old, most businesses have no knowledge of the potential benefits they can offer. So what exactly is an 831(b) captive?

Simply put, an 831(b) captive is a small version of a captive insurance company. The parent pays premiums to the captive and the captive provides insurance to the parent company. The premiums that the parent pays may be deductible for tax purposes, while the captive is exempt from tax on the underwriting income. The captive is only taxed on its investment earnings. The difference with an 831(b) captive is that the total annual premium must be below $1.2 million.

Based on how the tax section was designed the 831(b) captive provides little value to a large corporation and is aimed primarily at small to mid-sized companies. In general these captives often make sense for companies that meet the following requirements:


Long before the decision to form a captive is made, a feasibility study should be conducted. This study will analyse all areas of the company and will validate if a captive structure makes economic sense. In the event of an IRS audit they will request to see the company’s feasibility study which should demonstrate the captive was formed for reasons other than tax deductions.

  • Pay premiums to commercial carriers between $300,000 to $400,000 on an annual basis for property and
    casualty insurance;
  • Have a taxable income level of at least $1.5 million per year;
  • Have annual revenue of over $25 million.

The 831(b) captive must be set-up and run as an insurance company. Like any captive the coverage should be designed to meet the needs of the parent whether this is coverage they can’t find in the traditional market, deductibles or exclusions.

Shifting coverage to a captive can provide valuable benefits to the parent company that include items such as:

  • The ability to control the claims process;
  • Access to reinsurance markets;
  • Retention of underwriting profits;
  • Helps mitigate the soft and hard market cycles;
  • Potential tax benefits.


One major area where the abuse is seen is with the pricing of the risk insured within the captive. It is easy for several actuaries to come to different opinions on what an appropriate premium should be, even when basing their opinion on the same data. Common sense should always prevail. When looking to take deductions for tax purposes, the IRS will only allow a deduction for premiums that are reasonable.

An example would be when a captive provider suggests a premium of $250,000 for a $3,000,000 excess policy for professional liability; however, the client already has a $3,000,000 primary layer policy, which they paid $10,000 for. A small insurance company would need to charge a higher premium than a larger company, as they would typically have a smaller capital base, but not 250% more. Also, the premium for the excess layer is traditionally less than the premium for the primary layer, as the full $3,000,000 would need to be paid out prior to a claim being made to the excess layer.


A captive should not be insuring what can only be described as a long-shot risk. An example would be a terrorist attack in Kansas or hurricane insurance for a company in Montana. Yes, there is a chance that these events could happen, but it is a very slight chance, and the premiums should reflect this.

Other instances of unlikely risk would be when the coverage issued by the captive is already covered in the traditional market. For example, if someone already has a policy covering the first $3 million of a claim, why would they also purchase a policy from their captive covering the same layer?

In these instances there would never be a claim payment made from the captive and the captive is being set-up simply as a tax shelter.


Another area where problems can arise is with risk pools. Most small to midsize businesses do not have enough subsidiaries to pass the test for risk distribution, so many will take part in what are referred to as “risk pools” to meet the risk distribution requirements.

Basically a “risk pool” is an arrangement between several insurance companies to share certain risks. Most of these arrangements are set up and managed by captive managers to provide an option to meet the risk distribution guidelines as set out by the IRS. The problems begin when the risk pools are not run properly because either they share little risk, have operated for years without a single claim or have large premiums being paid.


Some domiciles will require capital as low as $10,000 to $15,000, which is why some captive owners/promoters will choose a domicile. The law may require a small capital requirement, but for tax purposes the reserves will be set by the actuaries, and should be significantly higher. The captive needs to have adequate capital to meet their potential liabilities and the minimum regulatory capital will not be sufficient.


“The establishment of an 831(b) captive is not the right solution for every business, however it can offer substantial non-tax and tax benefits for a business when it is done correctly.”

So far all this seems pretty simple: (1) pay in premiums less than $1,200,000; (2) take a tax deduction for the premiums; and (3) only pay capital gains tax when you remove the profit from the captive. However, it is not as simple as it may appear and aggressive captive promotion can be detrimental. While actuaries and regulatory approval can by themselves be used to justify the need for the captive, common sense risk management would not on its own justify the need for the captive.

Here are several pitfalls that 831(b) captives typically run into 1) Feasibility study, 2) Pricing, 3) Unrealistic risk, 4) Risk distribution and, 5) Capital requirements.

Business owners need to be aware that the planning formation and daily management of any captive is a complex financial structure that requires the input of an experienced industry professional. The establishment of an 831(b) captive is not the right solution for every business. However it can offer substantial non-tax and tax benefits for a business when it is done correctly.

Contract Surety Underwriter at