Over the past few years, the use of captive insurance companies by community banks has been on the rise. Reasons that community banks have found these arrangements beneficial as a part of their risk management process include things such as increased access to types of coverage that may otherwise be cost-prohibitive in the general marketplace, reduced insurance costs, flexibility in the underwriting and claims processes, and pricing stability along with many other incentives.
Consider Administrative Costs
While captive insurance companies have the potential to provide substantial benefits to community banks, the administrative costs of these arrangements should be carefully considered before entering into this type of an arrangement. There are additional costs for things such as actuaries to compute premium amounts and management duties (generally outsourced) that must be taken into consideration when measuring the potential benefits of a captive insurance company.
There are tax consequences to consider when evaluating the use of a captive insurance company as well. If the captive receives $2.2 million or less of premium payments during a year (prior to 2017 the maximum annual premiums limitation was $1.2 million), then the captive is eligible to make an IRC Sec. 831(b) election, in which the company elects to be treated as a “small insurance company.” With this election in place, only investment income is taxable to the captive, and the premiums received are not subject to taxation. However, the bank still receives a tax deduction for the premiums paid to the captive. On a consolidated basis, this results in a permanent tax deduction in the amount of premiums paid from the bank to the captive.
In the past, some taxpayers abused these tax rules by forming captive insurance companies that did not legitimately mitigate any risks of the insured corporation. Instead they would write policies to insure risks that had virtually no probability of ever occurring (like hurricane insurance for an entity located in plains states). They would receive the tax benefits from deducting the premiums each year, and the captive could then ultimately liquidate tax-free into its parent company and return all of the premium payments in full since no claims were ever made on the insurance company, and no income tax was ever paid on the receipt of the premiums.
The IRS recognized the abuse occurring in these sham arrangements, and in fact listed captive insurance companies on their “dirty dozen” list of sham transactions in years past. To combat the abusive arrangements, this past November, the IRS issued some stringent reporting requirements for participants in captive arrangements. Also, Congress put forth a risk-sharing standard of the PATH Act in order to share risk adequately for IRS purposes.
While the benefits of a captive insurance company may be significant, the administrative burdens and increased IRS risk profile associated with forming and operating a captive require careful consideration by bank management.
Contact your Eide Bailly Professional for assistance with risk management.
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