Banking is the business of managing risk. Be it credit risk, interest rate risk or technological risk, bankers are trying to control a highly leveraged earnings engine while avoiding risks that can result in sudden reversals of fortune.
Yet many of the biggest risks faced by bankers today are both uninsurable and unreserved for on the bank's books, such as certain cyber risks and reputational risks. Even where third-party insurance policies may be available, they may provide coverage that bankers feel is cost-prohibitive. That's where a captive insurance company may present a cost-effective, tax-efficient solution. A captive insurance company is the insurance company that you own. It allows you to insure the risks that your bank, holding company and the holding company's other operating subsidiaries may face, writing real insurance policies against which you can make claims for losses.
While a variety of structures may be used to create captive insurance companies, so-called "small" captives provide a number of unique tax advantages for owners of small to mid-sized bank holding companies. They often are referred to as 831(b) captives, named after the Internal Revenue Code section that provides tax incentives for the creation and use of such entities.
Potential benefits of 831(b) captives are well-documented and will be enhanced in coming years by recent amendments made under the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act). These include:
- Insurance for risks that you already have on your books and for which policies in the marketplace are either prohibitively expensive or nonexistent;
- Up to $1.2 million ($2.2 million beginning in 2017) in deductible premium expenses for your bank or bank holding company; and
- Up to $1.2 million ($2.2 million beginning in 2017) in tax-free premium income to the captive insurance company.
While the changes under the PATH Act are new, the legislation facilitating small captives has been in place since 1986, which begs the question, why aren't more bankers using them? The short answer is that, until recently, implementation of captives was very expensive and the legal underpinnings for them were somewhat shaky.
However, the number of captives across the county has increased rapidly in recent years according to examiners we've spoken with from the Federal Reserve. This increase has resulted in part from a proliferation of “turnkey” providers who have developed proven models and technical solutions to reduce the costs of creating and administering a captive insurance company.
At the same time, the legal underpinnings of captive insurance companies have matured. Once a business relegated to exotic, typically offshore jurisdictions, captive insurance companies now may be formed in any one of the many states that have adopted comprehensive captive insurance company legislation, such as Delaware, Vermont, Nevada and Tennessee.
Furthermore, changes implemented by the PATH Act provide much-needed clarity on the types of captive structures that will be permitted under the Internal Revenue Code and therefore eligible for the tax advantages conferred by Section 831(b). While the types of tax avoidance structures that were targeted by the PATH Act probably would never have been permissible in banking due to affiliate transaction restrictions, the legislation provided clarity as to the types of diversification and/or ownership criteria that must be met to pass muster under IRS rules.
Finally, bank holding companies are allowed to underwrite any type of insurance for affiliated or unaffiliated entities. In addition, some state banking regulators have signaled their willingness to permit the formation of captive insurance companies in light of the activities that have been authorized for national banks by the Office of the Comptroller of the Currency.
Turnkey captive insurance providers have designed solutions that capitalize on this guidance to create compliant captives that can be taken "off the shelf" and plugged into your bank holding company structure. Altogether, this means that forming a captive is now cheaper and less risky from a legal and regulatory perspective than it has been in the past.
So, is your bank holding company a good candidate for a captive? Historically, forming a captive required owners to engage and work extensively with a team of attorneys, actuaries, accountants and other professionals. This resulted in customized solutions that were tailor-made for the company's overall objectives. As it has become easier to form a captive using turnkey solutions, the customization and optimization of the captive for the sponsor’s overall business can be lost.
That's why we recommend working with a team of advisers who are familiar with captives and can assist your turnkey provider in integrating a captive as part of your overall business and risk-management goals.