Morris Manning & Martin, LLP

LETTER FROM WASHINGTON - A Measured Approach Toward Captives is Needed: "Sentence First, Verdict Afterwards" - The Queen of Hear

08.18.2014

As noted in numerous recent publications, captives have been receiving an increased amount of regulatory attention, not just from the domicile states which regulate them, but, more significantly, from national or international bodies.  The NAIC Captives and Special Purpose Vehicles Working Group completed its examination of captives and now two captive related proposals are being considered at the NAIC.  First, the Financial Condition (E) Committee has been asked to determine whether a captive manager should be considered to exercise “control” over a risk retention group (“RRG”) under the Holding Company Systems Act.  Second, the Financial Regulation Standards and Accreditation (F) Committee is considering a proposal to include captives in the definition of “multistate reinsurer” in the preambles to Parts A and B of the NAIC Accreditation Standards. 

Both of the above proposals would impose substantially greater regulatory compliance responsibilities and costs on captives.  In fact, the proposal to consider captives to be multistate reinsurers would effectively impose traditional regulatory licensing and reporting requirements on reinsurance captives.

Captives have recently drawn the attention of international bodies, as well.   The Organization for Economic Co-operation and Development (“OECD”) included captives in its examination of methods by which “multinational entities” reduce income taxation (“base erosion”) in its recent study “Addressing Base Erosion and Profit Shifting”.  The Federal Insurance Office (“FIO”) referenced life and annuity reinsurance captives (but not captive insurance in general) as a potential danger to the financial solvency of that segment of the insurance business.  That position was further supported by a recent report of the Financial Stability Oversight Council, which asserted that, while state regulators must approve reinsurance cessions from insurers to captive reinsurers, inconsistent state regulatory practices, capital requirements and accounting issues might undermine regulatory oversight.

The use of captives has been an important component of business and non-profit entity risk management for decades.  Captives were created offshore initially in the 1970s as a result of the failure of the commercial insurance industry to provide coverage at affordable prices to certain niche markets.  As the use of captives grew in the 80s and a few states adopted captive laws, the types of coverages available through captives expanded.  In today’s market, captives provide competition in the market because coverage that may not be available or affordable can be assumed, either in whole or in part, by the insured’s captive.  As a result, capacity in the insurance market, particularly in niche markets, expands.

What is driving this increased attention to captives?  Even though captives have continued to grow in number over the past few years, there have been no major insolvencies of captives or in the traditional insurance industry.  By contrast, bank failures precipitated the Great Recession and the increase in bank regulation in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which resulted.

Three causes seem to be foremost in increasing the attention on captives.  First, there is more competition among insurance regulators and the appetite for regulation has been enhanced due to the perceived failure of financial regulation, which contributed to the Great Recession.  The exclusive dominion of the states over insurance regulation is long gone.   Now the states have to deal with the specter of the FIO, which has the authority and capability to examine the insurance industry and its regulation and to issue substantive reports, which will influence both state and federal regulators and legislators (particularly Congress).  In addition, the states have to consider the positions of international groups, such as the International Association of Insurance Supervisors (“IAIS”) and the OECD. 

Second, there has been the proliferation of captive domiciles.  There are now 38 states with some form of captive law.  Fifteen years ago there was just a handful.  Several states which have previously exhibited an aversion to captives have adopted favorable laws in an effort to provide a home to the captives to be formed by their domestic companies. 

Third, there has been substantial growth in “micro captives”, also sometimes called “831(b)” captives.   These are small captives with limited capitalization which are frequently operated in a bundled fashion by a single operating entity.  In some cases, concerns have been expressed by regulators or other critics that these entities are undercapitalized or do not actually transfer risk.  Micro captives are frequently promoted by financial advisors who emphasize their potential tax effects, rather than simply the insurance benefit.  This issue has come to the attention of the IRS, which has announced that it is investigating the use of micro captives.  Moreover, there are several cases in the IRS pipeline challenging captives of this sort and at least one recent case (Salty Brine 1, LTD, et al. v. United States of America, 5:10CV00108 (TX U.S. Dist. Ct., North) (2013), which has disallowed the tax benefits of “insurance company” status.

Proposals to give non-domiciliary states broad regulatory authority over captives are misplaced.  The abuses of micro captives are being attacked by the IRS, which is in the best position to deal with the problem since the problem is driven by the tax benefits of micro captives, not their regulation by states.  Once it is clear that tax advantages cannot be obtained if the micro captive is not properly structured demand will evaporate. 

Captives are an integral part of the commercial risk management system.  State regulators should examine significant issues, such as whether life and annuity reinsurance captives which assume risk from traditional reinsurers are properly structured and regulated.  However, they should not expend their limited time and attention on the operation of the captive system as a whole, which operates well and provides a valuable service to commercial insureds.