What Is Captive Insurance Under Section 831(b)?
A captive insurance company is a wholly owned subsidiary formed to insure the legitimate business risks of its parent company. The parent pays insurance premiums to the captive, and those premiums are deductible as ordinary business expenses under IRC Section 162. Under IRC Section 831(b), captives receiving annual net written premiums of $2.8 million or less (2025, indexed for inflation) may elect to be taxed only on investment income, effectively exempting underwriting profits from federal income tax.
As discussed in "Billionaire Wealth Strategies" (Jim Dew, 2024), Chapter 9, captive insurance falls under the "A" (Arbitrage) component of the DEAPR framework, creating a rate arbitrage between the ordinary income deduction for premiums and the potentially lower tax treatment of captive investment returns.
How Does Captive Insurance Work?
The business forms an insurance subsidiary, typically domiciled in a captive-friendly jurisdiction such as Vermont, Delaware, South Carolina, or a U.S. territory. The captive must be licensed as an insurance company by the domicile state's insurance regulator and managed by a licensed captive management company.
The parent company pays premiums to the captive for coverage of legitimate business risks that are difficult or expensive to insure in the commercial market. Common covered risks include supply chain disruption, key person loss, regulatory compliance costs, cyber liability, and reputational harm. Under IRC Section 162, these premium payments are deductible by the parent as ordinary and necessary business expenses.
The captive invests the premiums and maintains reserves adequate to pay potential claims. Under the IRC Section 831(b) election, the captive pays federal income tax only on its investment income (dividends, interest, capital gains), not on the premium revenue received. Over time, the captive accumulates reserves that can be distributed to shareholders through dividend payments, which are taxed at qualified dividend rates of 0%, 15%, or 20%.
Captive ownership can be structured within irrevocable trusts for estate planning purposes, transferring wealth outside the owner's taxable estate while using the annual gift exclusion under IRC Section 2503(b) ($19,000 per recipient in 2025).
When Do Entrepreneurs Use Captive Insurance?
Businesses with insurable but hard-to-cover risks use captives when commercial insurers either refuse coverage or price premiums far above actuarially justified rates. The captive fills genuine coverage gaps while creating a tax-efficient risk management vehicle.
High-income business owners benefit from the premium deduction, which offsets ordinary income taxed at up to 37% (2025). The deduction is available only if the premiums reflect arm's-length pricing for the risks insured, as determined by a qualified actuary.
Estate planning integration allows captive ownership to be held in dynasty trusts or irrevocable life insurance trusts. Accumulated reserves grow outside the insured's taxable estate, subject to generation-skipping transfer tax (GST) considerations under IRC Section 2601.
How Does Dew Wealth Approach Captive Insurance?
Captive insurance has been subject to significant IRS scrutiny, particularly for arrangements that lack genuine risk transfer or economic substance. The IRS designated certain micro-captive transactions as "transactions of interest" under IRS Notice 2016-66, requiring disclosure on Form 8886. The Tax Court has disallowed deductions in multiple cases where captives lacked risk distribution, charged non-arm's-length premiums, or insured fabricated risks.
Dew Wealth advises that any captive must insure real business risks at arm's-length premium rates determined by a qualified actuary, be managed by a licensed captive management company, and maintain adequate loss reserves. The Fractional Family Office® coordinates between the captive manager, tax advisor, actuary, and business attorney to ensure every element satisfies the IRS economic substance doctrine.
The potential tax benefits are meaningful, but the compliance costs, regulatory filings, actuarial fees, and audit risk must be weighed against the savings. Captive insurance is not appropriate for every business, and premiums that exceed the IRC Section 831(b) threshold of $2.8 million (2025) subject the captive to taxation under IRC Section 831(a) on all underwriting income.