What You Need to Know: 831(b)
Commercial Insurance: Captives and Tax Elections
Chances are, if you’ve been involved in any captive discussions recently you’ve heard the term 831(b) or “micro captive.” If you’re not familiar with this increasingly popular captive structure, you may have done what I typically do in that type of situation: smile, nod and hope no one asks you a direct question.
What Is It?
831(b) is an IRS tax election for small insurance companies with less than $1.2 million in premium. With this election, the insurance company – or captive – is allowed to collect up to $1.2 million in premiums, receiving the normal deduction for this expense, while paying no tax on any underwriting profit. Tax is only paid on investment income.
- Forming your own captive insurance company to reap this financial benefit sounds like a no-brainer, but it’s vital that you keep in mind the following characteristics that must be met in order to conform to the definition of “insurance company:”
- Business purpose must be legitimate: your captive’s primary activity must be insurance, and it needs to be operated like an insurance company.
- Premiums and policies must be market-comparable and risk-based.
- Initial capitalization must be adequate: typically a 4:1 premium to capital ratio.
It must meet the requirements to be considered an insurance transaction, which means two very important features must be present:
- Risk transfer – the shifting of risk from one party to another. There must involve a significant chance of loss to meet this requirement.
- Risk distribution – risk must be spread amongst seven or more entities; typically we recommend a minimum of 12 with each bearing 5-15% of risk and premium.
Any risk that’s currently covered by commercial insurance – property, general liability, product recall, etc. – as well as many others:
- Deductible layers
- Cyber risk
- Directors & Officers
- Intellectual property