Banks have made dramatic changes to risk management in the past decade—and the pace of change shows no signs of slowing. Providing strategic direction for a bank entails understanding what drives the creation of value – and what destroys it. The corporation needs to understand which risks it can take and which risks it should avoid.
Not all bank risks can be addressed by commercial insurance coverages. Often banks must self-insure key risks – whether deliberately, as a process of professional risk management – or by default, through lack of planning.
Serious emerging risks such as cyber security, data privacy and brand rehabilitation can create significant exposures for financial institutions of all sizes. At the same time, commercial insurance carriers often impose higher deductibles, and more restrictive endorsements. Significant gaps in coverage and exclusions remain in most commercial insurance policies. This creates unfunded risks, which must be evaluated as a part of any bank’s enterprise risk management process.
A growing number of banks are forming private insurance companies – commonly known as captive insurance companies – to cover these types of unfunded risks.
Is a Captive a too aggressive tax strategy?
It’s always wise to steer clear of a captive strategy based on tax savings. But if a captive is created for the right risk management reasons and managed correctly, by experienced and specialized professionals, it can help meet a wealth of business planning objectives planning – affording Risk Management, Asset Protection, Estate and Tax Planning and Exit strategies.
The American Banking Association clarified its position on bank captives in a 2015 letter to a Congressional Committee, “Captive insurance entities are an important tool within enterprise risk management strategies in financial services companies…”.
There are very specific guidelines to making your captive work, have it protect you, be compliant as an insurance company, and get the available tax advantages that Congress has seen fit to apply in order to build insurance capacity for smaller companies.
The captive strategy is employed by almost every major national corporation, all of whom use them effectively and without significant issue. In fact Congress just increased the premium limit for captives to $2.2 million – from a previous maximum of $1.2 million.
What happens to my premium payments?
Your institution can cover a wide variety of legitimate risks. An actuary will develop premiums and apply actuarial formulas that dictate minimum cash reserves, what the internal costs of reinsurance should be, and what risks you can legitimately insure against. The list of unfunded risks you may insure is long and comprehensive. You can also move some of the costs of commercial risk into your captive by taking higher deductibles on workers comp, general liability and other outside coverages.
You pay your premiums to an insurance company, who issues your policies. In turn, the insurance company reinsures the premium to your captive – less fees and claim reserves. Your captive insurance company can then invest net premiums for the profit of the insurance company, which you own.
Assuming all goes well, at some point in the future you will realize those profits as distributions from the captive you own at a tax-advantaged rate, (i.e. capital gains).
With a captive, bank owners can:
- Develop a formal internal risk management process
- Fund selected unfunded business risks
- Identify and close gaps in existing coverage
- Reduce high commercial expense and loss ratios
- Transfer high risks to traditional insurers
- Leverage government-provided tax incentives
- Build tax-deferred resources to fund growth