Captive Insurance Subsidiaries Proliferate Among Bank Holding Companies


captive-insurance-3-2-16.pngBanking 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.

When the Sky is Falling, Don’t be Chicken Little


crisis.jpgFor bank executives and directors, crisis situations can take many forms. In the post-financial meltdown environment, there are an ever-growing number of crises that can arrive at your door.  Your bank does not have to be on the verge of failure to face a crisis. A bad examination, an inquiry from the SEC, a data security breach, a money laundering or lending discrimination allegation or a major compliance issue could make you feel like the sky is falling.  Advance preparation can go a long way in helping you effectively sort through and address these issues.  When your institution is faced with one — or increasingly a combination — of these issues, the key is not to lose your head. Instead, pause and then implement these five basic steps:

1. Assemble your Crisis Management Team

You should have a crisis management plan available in preparation for the day when the sky falls. Plans provide a blueprint for responding to crises and are favored by regulators because they mitigate the negative impact of crises. The plan should designate a crisis management team to handle the crisis. This team typically includes a member of executive management, the bank’s chief legal officer, a senior officer from the affected line of business, and outside counsel experienced in these kinds of major regulatory breakdowns. This core team may be supplemented by others, such as human resources, public relations, information technology, finance, compliance, and/or internal audit. 

The plan also should outline the timing for informing the board of directors and the board’s level of involvement in responding to the crisis. Plans should require the audit committee chairperson to be informed immediately, with a clear understanding about how the rest of the board will be notified. This is especially important, not only because directors are the ultimate stewards of the institution, but also because board members are keenly aware of the reputational and legal impact a crisis can have on the institution and perhaps even on the board members themselves.

2. Take Immediate Action

If the crisis involves an ongoing activity, consult with legal counsel and the relevant business executives to discuss permanently or temporarily shutting down the activity in an efficient, orderly manner to avoid further harm. Consistent with the crisis management plan, the board’s audit committee chairperson (and other board members as appropriate) should be apprised promptly of the actions taken or to be taken. 

3. Develop a Short-Term Plan

The institution’s short-term plan for addressing the crisis should include an evaluation of the need for an internal investigation by internal or outside counsel. The short-term plan also should consider whether the institution’s regulator(s) or law enforcement should be notified and the extent to which key constituencies, including employees, customers, shareholders, and the public need to be informed. It is essential to act in an expedited yet careful fashion to assess key evidence and the applicable legal framework in formulating a short-term plan.

4. Follow a Coordinated Approach

A crisis often creates multiple areas of exposure in the form of government enforcement actions, private litigation, reputational harm and customer relations issues. The institution’s approach to responding to the crisis must take into account all of these risks. For example, an institution will need to decide whether there are mandatory disclosures (e.g., under the securities laws or various customer notification laws for data security breaches) or other disclosures (e.g., to regulators) that must be made. These disclosures, in turn, may affect other areas of exposure.

5. Develop and Execute a Long-Term Plan

To weather a crisis effectively, an institution must stay focused on its key objectives, while remaining flexible to adjust.  An institution’s long-term plan, depending on the crisis, may include: remediation of the harm, implementation of enhanced internal controls, improved management reporting to ensure appropriate monitoring, and increased internal audit standards to test the institution’s compliance responses.

Conclusion

Too often, an institution returns to business as usual after a crisis. However, one of the best ways to avoid future crises is to incorporate lessons learned from the current crisis. Effective crisis management requires considered and concerted action. Incorporating these five steps will better position your institution to respond to crises when they occur. Advance preparation will serve as shelter, shielding your institution on that fateful day when the sky actually does fall.