Captive insurance has been a great benefit to risk managers and businesses that want to structure an efficient insurance program. Captive insurance regulation, however, has been a thorn in the side of some states and the NAIC because it deviates from the norm. A captive insurer is licensed in only one state, its state of domicile, and accordingly, does “the business of insurance” in only that state. Nonetheless, the risks of the captive’s parent may be located in other states.
In the case of risk retention groups (“RRGs”), another alternative risk transfer structure, the states and the NAIC have worked hard to develop a regulatory structure which deals with this issue. This effort is enhanced by the Liability Risk Retention Act, 15 U.S.C. § 3901 et seq., which is the federal law governing the authority permitted or denied to non-domiciliary states. Such a regulatory structure does not exist in the world of single‑parent or association captives, which do not benefit from a federal law. As a result, there are occasional cases that call into question the existing regulatory structure.
A decision by the Appeals Court of Massachusetts recently held that a captive insurer is liable under state claims settlement practice provisions. In Lemos v. Electrolux North America, Inc., 2010 Mass. App. LEXIS 1534 (Dec. 2, 2010), a lawnmower user obtained a jury verdict against the manufacturer for $550,000 due to injuries sustained as a result of a defective lawnmower and then brought a lawsuit against the manufacturer and its captive insurer, alleging violations of state claim settlement practice provisions (Mass. Gen. Laws ch. 176D § 3). The trial court granted summary judgment in favor of the manufacturer and its captive insurer because neither party engaged in the business of insurance, and therefore, could not be subject to the state’s claims settlement practices act. The Appeals Court affirmed as to the manufacturer and reversed as to the captive insurer.
The manufacturer in Lemos was the parent and sole shareholder of the captive insurer, domiciled in Vermont. The captive provided commercial general liability coverage, including indemnification for sums the manufacturer became obligated to pay due to “bodily injury” or “property damage.” Moreover, the manufacturer had a right and duty to defend any lawsuit seeking damages, but the captive could investigate and settle any claim at its discretion. However, the captive had only a board of directors and no employees. Accordingly, the captive was not actually involved in the investigation, negotiation or litigation of claims. The president of the captive averred that the captive’s role was “purely that of a funding vehicle for the reimbursement of [the manufacturer] for claims that are paid by [the manufacturer].”
The Appeals Court held the captive insurer was indeed in the business of insurance and therefore subject to the claims settlement practices act even though the manufacturer was not. The court rejected the captive’s argument that because the manufacturer used a captive insurer, the manufacturer was effectively a self-insurer, and therefore neither party could be subject to the insurance regulatory requirements, including the claims settlement practice provisions. The captive relied upon Morrison v. Toys “R” Us, Inc., 806 N.E.2d 388 (Mass. 2008), which held that insurance regulations could not be applied to self-insurers who have no contractual obligation to settle claims and are not otherwise regulated by state insurance regulators.
In its opinion, the Appeals Court emphasized the captive insurer’s distinct corporate identity and its engagement in the regulated business of issuing insurance policies. To support its holding that the manufacturer was not a de facto self-insurer and to distinguish Morrison, the court reasoned that the manufacturer purposefully chose a captive arrangement over a self-insurer structure due to financial benefits of the former. Additionally, the court noted that the Massachusetts insurance code identified captive insurers as “insurance companies” and did not exempt captive insurers from application of the state’s unfair trade practices act, including claims settlement provisions. In contrast, under Morrison, the self-insured manufacturer was not in the business of insurance, and its duty to defend under the insurance policy was insufficient to subject it to the claims settlement provisions.
A possible conclusion from Lemos could be that single‑parent captives with multi-state risks should be prepared to have the unfair claims settlement laws of non-domiciliary states imposed upon them. If this is the case, then these captives should be prepared for bad faith or other extra-contractual claims, which could substantially increase potential liability. A prudent captive manager therefore should make certain that any reinsurance will provide coverage for extra-contractual liability.
The broader conclusion may be that even though a captive is not transacting “the business of insurance” in a non-domiciliary state as defined by various state laws, it may be subject to some of the provisions of state law affecting claims settlement or trade practices. The Court in Lemos appears to have concluded that because the captive was providing “insurance” to its parent, it was subject to these laws regardless of whether or not it was a licensed insurer in the state.
Robert “Skip” Myers is Co-Chairman of the firm’s Insurance and Reinsurance Practice and focuses in the areas of insurance regulation, antitrust and trade association law. Skip received his bachelor’s degree from Princeton University and his law degree from the University of Virginia.