Oksana Kuzmina /
4 August 2014Law & regulation

Small, but growing

The 831b tax election is proving an extremely popular option among mid-market captives. Here we address the growth and benefits of such captive entities in a burgeoning part of the US captive market.

Enterprise risk, or 831b election, captives are currently taking the US market by storm, with some estimates suggesting that they account for as much as 80 percent of global growth, both onshore in the US and among offshore domiciles that specialise in such formations. What is apparent is that these entities are proving an extremely attractive option to US middle market and privately-held companies that are increasingly considering the potential of captive insurance.

As Les Boughner, managing director of Willis’ captive and consulting practice indicated, “831b structured captives have rejuvenated the captive industry,” and they now account for around 320 of the 470 new formations last year, according to figures outlined by Boughner.

Derek Martisus, small captives sales leader and senior vice president at Marsh concurred, adding that “Marsh considers them to be extremely significant to the current and future growth of the captive industry”. He said that while Marsh had consciously stayed out of the 831b segment of the market for a number of years, it was now ramping up its involvement in the space. A similar situation is apparent at Willis where, Boughner said, the company has made a “180-degree switch” regarding its attitude towards 831b elect captives. “Properly structured we are now very positive about 831bs,” he said.

Tax efficiency

So what is an 831b, or enterprise risk, captive? An 831b tax election can be pursued by any captive that writes less than $1.2 million in premium, making it a strong fit for smaller enterprises that would otherwise not have enough premium or sufficient appetite to establish a larger captive writing, say, $5 to $10 million in premium. Should a smaller captive make the election it will then be taxed only on its investment income, not on its underwriting. This means the entity can take on up to $1.2 million of underwriting premium without paying tax on the figure, helping to create significant efficiencies for those considering the captive option.

As Adam Forstot, vice president at USA Risk explained: “Because of the ability to accumulate surplus tax free on the underwriting income, it does offer an opportunity for smaller programmes to develop their surplus position, ramp up or take on some risk or line that without the election might not be so economically feasible.” He cited property deductibles or an expansion of workers’ comp coverage as being typically good fits for such captives.

Forstot added that 831b captives are also serving as a springboard as parents look to build larger multiline captives. “Many parents start small with a particular line of business and will then start adding lines of business or increasing their retention, and ultimately move past the election,” said Forstot. Boughner added that as companies grow and recognise the benefits of their captives, many will consider developing their potential beyond the $1.2 million limit of the 831b tax election.

Martisus added that “once you have the structure in place you are most of the way there”. He said that conversations regarding the growth of 831b entities were happening on a weekly basis, with clients sold on the captive concept through their 831b elect entity and keen to take it further in terms of scale. He also reported instances where parents had taken the 831b tax election in reverse.

“They had a captive that was not being used and rather than run it off, they opted to reduce its size and take the 831b tax election. It’s pretty much a turn-key operation to get it up and running in a different format.”

The captive industry has been obliged to respond to rising interest in 831b captives as the US middle market has seized upon the captive concept. Martisus said that Marsh’s response had been two-fold.

“Offensively, we realised that interest in these entities wasn’t going away any time soon, so we decided that we had to get involved. Defensively, we realised other consultants were approaching our brokerage clients regarding such entities and we wanted to ensure we were the captive managers they came to when considering establishing a captive, regardless of size,” he said. Others have taken a similar attitude: reticent at first, but with an increasing realisation of their value and popularity.

New focus

It is apparent that some of the domiciles are emphasising 831b captives. David Snowball, captive insurance director in Utah, said that the state has “focused its attentions largely in that area”. He added that “in many ways I would recommend such an approach to new domiciles. 831b captives tend to be easier to work with, manage and understand”, helping states get comfortable with the captive concept as they ramp up their involvement in the space.

Snowball said that around 80 percent of Utah’s captives fall within the election, adding that the state sees such entities as a great opportunity for SMEs to take advantage of the captive concept—without the election it would not be available to them.

Utah isn’t alone in pursuing growth in the 831b area, with Delaware, Nevada, North Carolina, Oregon, Tennessee and Washington DC all being mentioned as domiciles that are taking a lead in the development and growth of 831b captives. Some of these are newer domiciles that are looking to spur initial growth, but others are more mature states that have recognised and seized upon the remarkable growth in smaller enterprise risk captives. As Fortstot explained, “Any domicile will be receptive to a captive with a sound business plan and a well-documented feasibility study, regardless of size or tax election.”

Nevertheless, 831b captives do continue to present a reputational risk to the wider captive market, due to their occasionally unscrupulous use. Forstot said that 831b captives have received a lot of attention from the Internal Revenue Service as a result of occasional negative coverage, but explained that if such captives are established for the right reasons (and the vast majority are)—“for appropriate risk management purposes and with a sound business plan and actuarial analysis”—then the captive market has little to fear.

He added that the industry must however be careful that “one or two bad apples don’t spoil the barrel”. Martisus added that it was the role of those within the industry to work with clients in order to help them stay away from those consultants who advise against the proper use of 831b captives and ensure they are using such entities for valid insurance purposes.

Not that such headwinds are denting the sector’s rapid growth—and there is every expectation that this growth will continue. Forstot said that with US mid-market firms having weathered the recent crisis, many are looking at ways to improve their operating efficiencies. An 831b captive is just such an option, particularly as understanding of the captive concept—and the tax election specifically—deepens.

He added that the Affordable Care Act may also encourage greater take-up as companies consider including portions of their benefit programmes in a captive. Forstot said that this would enable them “to blend benefits risk with property and casualty, creating risk distribution and operating efficiencies for the entity”.

Martisus said that he expects growth to continue apace, with conversations with new and existing clients regarding the 831b concept occurring on a regular basis. He added that “centres of influence” such as accountants and lawyers, which had not traditionally known about the election, are becoming increasingly informed about its potential within the US small and mid-market. As a result there are “many doors to be knocked on and considerable viable prospects for the future within the 831b space”. Future prospects are bright.