A captive insurer, whether organized offshore or in a U.S. jurisdiction, frequently is not licensed—i.e., authorized—to transact insurance in the state in which the policyholder or insured risks are located. Because of this, in many instances, particularly where an offshore captive is involved, scrupulous efforts are made to conduct all “insurance activity”—e.g., all negotiations regarding terms of the insurance, payment of premiums and delivery of the policy—exclusively in the captive’s domicile so as to avoid engaging in any conduct that would require licensing in the insured’s state of domicile or in any other state. Needless to say, this approach creates a substantial compliance burden. Moreover, it sometimes causes problems with the adjustment of claims, which may require activity at the point of claim.
Captive insurance, however, often can be written on an “unauthorized” basis so that some or all insurance activities may lawfully occur where the insured or the covered risks are located without the need for licensing outside the captive’s domicile. This approach can make compliance easier and is more suitable for many captive programs. Nevertheless, it has substantial consequences for the structuring of the captive program, the role played by insurance consultants and the obligations of the insured under state law.
Often, the issue of licensing is resolved with a “fronting arrangement,” which is an arrangement whereby an insurer licensed in the relevant jurisdictions (the “front”) writes the risk on a direct basis and reinsures it in whole or in part to the captive. Fronting arrangements are popular, and indeed often necessary, with association captives and where the risk to be insured. For example, workers’ compensation is specifically required to be written by an authorized insurer under state law.
Fronting works because states generally do not require reinsurance to be written on an authorized basis, preferring instead to regulate reinsurance indirectly through credit for reinsurance laws applied to the ceding insurer. A fronting arrangement, however, has its costs. These costs include fees retained by the fronting carrier; the cost to the captive of posting collateral to satisfy state credit for reinsurance laws and the fronting carrier’s security requirements and transaction costs, including the time and expense of negotiating a reinsurance agreement with the fronting carrier, legal fees and consulting fees.
Captive insurance written on a direct basis avoids the cost and complications that can arise from a fronted program, but now the captive must contend with state laws requiring that persons transacting the “business of insurance” in a state be licensed by that state. Generally speaking, state laws do not distinguish between an unauthorized captive insurer and any other type of unauthorized insurer. Thus, unless a specific exception for unauthorized insurance applies, the placement of insurance to the captive is prohibited under state law.
Although state laws generally prohibit unauthorized insurance, many state regulators do not, as a matter of practice, attempt to regulate unauthorized single-parent captives that insure only their parent and its corporate affiliates. This attitude may have its origin in the view that a single-parent captive does not write true “insurance” because risk is not spread outside the corporate group. From a more practical perspective, the light touch regulators often apply to single-parent captives recognizes that the insured is dealing with its own enterprise.
Nevertheless, placing even single-parent captive insurance without clear statutory or regulatory authority carries material risks. First, there is the risk that an unwritten regulatory policy that might allow the placement (or at least not take an active regulatory stance toward it) will change, exposing the insured, the captive and any consultant involved in the placement to regulatory action. Second, from a consultant’s perspective, a broker or consultant who assists the placement of insurance to an unauthorized captive insurer in violation of state law can be found liable to third party claimants under an insurance policy written by the captive if the captive becomes insolvent and the claimants are unable to recover. Third, directors and officers of an insured who approve a placement that violates state law could be violating duties they owe to their company, possibly exposing them to personal liability. Finally, professional liability insurance—both that covering directors and officers and that of any consultant involved in a placement—may exclude coverage for liability arising in connection with the placement of unauthorized insurance in violation of state law.
State regulators take a different view towards association captives and other group captives. The regulation of group captives is more vigorous and more demanding of clear legal authority to place the insurance, either through a fronting arrangement or under an express exception to licensing under state or federal law. Any of a number of exceptions may be available, depending on the kind of captive and the state.
In every state, a risk retention group (“RRG”), if properly chartered and regulated in its state of domicile, may offer commercial liability insurance without having to be licensed in that state, so long as it has made the notice filing required by federal law. RRG’s are liability insurance companies authorized by a federal statute, the Liability Risk Retention Act of 1986, 15 U.S.C. §§ 3901 et seq.
In addition, the Due Process Clause of the U.S. Constitution and the McCarran-Ferguson Act, 15 U.S.C. §§ 1101 et seq., place certain limitations on the ability of the states to regulate insurers located outside their territorial boundaries. See State Bd. of Ins. v. Todd Shipyards Corp., 370 U.S. 451 (1962). These limitations on state authority, however, are fairly narrow and their application to most captive programs is limited at best.
Nevertheless, depending on the state, one or more statutory exceptions to the general prohibition against unauthorized insurance may be available to allow a captive placement. Exceptions which captives may utilize include a specific exception for captive insurance, an exception for insurance self-procured by the insured, and an exception for insurance obtained by more sophisticated insureds are often referred to as “industrial insureds.”
A few states have a specific exception allowing the placement of insurance to an unauthorized captive that is properly organized and regulated under the laws of its domicile state. This type of exception, however, like the other state exceptions discussed here, tends to vary from state to state and may not be available to all captive programs.
Many states permit insureds to self-procure insurance on their own behalf from an unauthorized insurer. This exception can be applied to captive programs, but most states require all negotiations regarding self-procured insurance to take place outside the state. To comply with this requirement, the insured must have a representative who resides outside the state or who travels to a location outside the state to conduct all negotiations.
Self-procurement also can be tricky for the insured’s insurance consultant. Even if the consultant acts solely on behalf of the insured, it is not always clear whether an insured may take advantage of the self-procurement exception where a third party is involved in the procurement of insurance. Some state regulators take the position that self-procurement must take place solely between the insured and the insurer, without the involvement of any third party. This aspect of the exception may require careful limitation of a consultant’s role to avoid any direct involvement in the procurement of the insurance. Finally, when insurance is self-procured, the insured must report the transaction, pay a premium tax and sometimes pay a regulatory fee.
Many states permit unauthorized insurers to provide insurance to “industrial insureds,” who presumably are sophisticated enough not to need the protection of state regulatory authorities. A typical definition of an industrial insured is an insured (i) who procures insurance by use of the services of a full-time employee acting as a risk manager or the services of a regularly and continuously retained qualified insurance consultant; (ii) whose aggregate annual premiums exceed $25,000 (a larger figure applies in some states) and (iii) who has at least 25 employees. Similar to self-procurement, the placement of unauthorized insurance under the industrial insured exception usually requires the insured to report the transaction and pay a premium tax. The industrial insured exception, however, does not carry the same prohibition on in-state activities that usually applies to self-procurement.
The state and federal laws that permit the placement of insurance to an unauthorized captive vary considerably depending on the type of captive, the structure of the captive program and the laws of the particular state or states involved. These laws have important implications for captive insurers, their insureds and consultants who are involved in captive placements. Careful consideration should be given to the requirements and exceptions in this area to ensure that sufficient legal authority exists for a placement to the captive and that the parties structure their roles to avoid unnecessary legal risks.
Joe Holahan is Of Counsel in Morris, Manning & Martin’s Washington, D.C. office and is Director of the firm’s Terrorism Insurance Group. His areas of experience include privacy and data security, compliance with the Health Insurance Portability and Accountability Act of 1996 (HIPAA), state and federal insurance regulation, and managed care. He received his bachelor’s degree from University of Virginia and his law degree from Catholic University of America, J.D., 1990.