Quick answer: A captive insurance company is a licensed insurance subsidiary created by a business to insure the business's own risks. The operating company pays premiums to the captive — a deductible business expense. The captive accumulates these reserves and pays claims when they occur. Under IRC Section 831(b), small captives with under $2.85M in premiums (2024) can elect to pay tax only on investment income — allowing premiums to accumulate largely tax-free if no claims are made.
How a Captive Works in Practice
A business owner establishes or participates in a captive insurance company (typically in Vermont, Nevada, or an offshore domicile like Cayman Islands). An actuary and insurance professional help identify legitimate, uninsured or underinsured business risks — contract liability, supply chain disruption, key customer loss, reputation risk, cyber. The captive issues policies and charges actuarially determined premiums. The operating company deducts the premiums; the captive collects them. If the captive is an 831(b) election, premium income is not taxed — only investment income is. In good years with few claims, reserves compound as a growing asset controlled by the business owner. In bad years, the captive pays legitimate claims.
Why Captives Are Attractive — and Heavily Scrutinized
Fortune 500 companies have used captives for decades — they're legitimate and widely used for legitimate risk management. For business owners, the appeal is compelling: deductible premiums fund an asset you own, premiums price risks that commercial insurers won't cover, reserves grow tax-efficiently, and the structure can facilitate estate planning and wealth transfer. However, the IRS has placed micro-captives (831(b) arrangements) on its "Dirty Dozen" list of tax scams when the arrangement lacks legitimate insurance characteristics — risks are not real, premiums are not arm's length, or the arrangement is primarily tax-motivated. The IRS has won major cases against abusive captives and requires disclosure of micro-captive arrangements on Form 8886.
Is a Captive Right for Your Business?
A captive is most appropriate for businesses with: annual revenues of $5M or more, legitimate uninsured or underinsured risks that cannot be addressed commercially, a long-term commitment to the structure (minimum 5–10 years), and strong legal and accounting support. Setup costs run $30,000–$100,000+ and annual administration adds $15,000–$50,000/year. The economics only make sense when the tax and risk management benefits outweigh these costs — typically at $300,000+ in annual premiums. If someone approaches you about a captive primarily as a tax strategy with a prepackaged set of fake risks, that's a red flag. Work with a qualified captive manager and tax attorney, not a promoter. The IRS distinguishes legitimate captives from abusive shelters, and the penalties for the latter are severe.
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