New Law Brings Good News on Captive Insurance for Banks

By Lynn M. McGuire, CPA
| 5/27/2016

support-img-lp-cfsti-article-4-captive-ins In December 2015, President Obama signed the Protecting Americans From Tax Hikes Act of 2015 (PATH Act). Most of the law focused on a set of extended tax breaks, but it also included a significant provision for financial organizations with small captive insurance companies. In addition to making it easier for banks to insure all of their business risks – including those related to cybersecurity and directors’ and officers’ liability – the provision indicates that Congress does not view all small captives as abusive.

Financial Institutions and Captive Insurance

Banks long have turned to captive insurance arrangements to better control their insurance risk. A captive insurance company is a legally licensed, limited-purpose property and casualty insurance company whose main business purpose is to insure the risks of the captive’s owners or companies affiliated with the owners through ownership, management, or control. A captive can insure risks that currently are unfunded or cost-prohibitive to cover in the commercial market.

Captive insurance can provide several benefits to banks, including:

  • Reduced first-dollar insurance costs
  • Uniform risk management
  • Enhanced organizationwide view of risk management
  • Additional and nontraditional risk financing
  • Potential premium deductions for federal and state tax purposes

Increased Premium Limit

Under the current Section 831(b) of the IRC, captive insurance companies with premiums that don’t exceed $1.2 million can elect to be taxed solely on taxable investment income. As a result, all premiums net of claims paid by the captive essentially are earned tax-deferred. This election represents a significant advantage for captives, especially when considering that the operating entity being insured will receive a tax deduction for the full amount of premiums paid to the captive.

The PATH Act raises the election premium limit to $2.2 million, effective Jan. 1, 2017 – the first increase to the limit since it was enacted in 1986. The increase is now indexed to take inflation into account annually.

Diversification Tests

The new law also adds a diversification requirement for Section 831(b) captives that is designed to prevent the captive from being used for estate planning or wealth transfer purposes. To make the Section 831(b) election, a captive must satisfy one of two new diversification tests, but this should present little obstacle for most bank captive insurance arrangements.

One of the prescribed tests is met if the spouse or lineal descendants of the owners of the entities insured by the captive don’t own 2 percent or more of the captive (directly or indirectly) than they own of the insured businesses. If, as is typically the case in bank captive insurance arrangements, a holding company owns all of the insured entities and the captive, the test easily will be satisfied because the ownership of the captive and each insured entity is identical.

The Bigger Picture

For captives in general, the new PATH Act provision is a strong indication that, although Congress sought to address some of the estate planning abuses associated with captive arrangement, it intends to preserve the Section 831(b) election. Thus, banks can use the arrangement to achieve risk management benefits and potential underwriting profits, while using the tax benefits to offset costs and initial underwriting risks.

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Lynn Mcguire
Lynn McGuire