Morris Manning & Martin, LLP

LETTER FROM WASHINGTON - Captives in the Spotlight


The captive industry used to be a relatively exclusive and little-known segment of the overall U.S. insurance industry.  It was conceived in the 1970s as an offshore mechanism to assist large, generally multi-national corporations fill holes in their insurance programs due to the unavailability of affordable coverages or to provide coverages that were not available in the domestic market.  In the 1980s, several states passed captive laws and some of the business came onshore.  Nonetheless, the preponderance of the business remained in Bermuda, Cayman and the Channel Islands.

As more states adopted captive laws (there are now almost forty that have some kind of captive law), and as more premium was diverted from the traditional industry to captives, the impact of captives on the traditional market increased.  While data on the industry can be speculative or anecdotal, the best available information is that there are nearly 6,000 captives in operation in the world.  It is commonly understood that as much as half of the U.S. property casualty market demand may be filled by captives.  

Because captives are subject to non-traditional regulation, and captive domiciles vary in their capability, there is a school of thought that captives are less capitalized and subject to insolvency more than traditional companies.  In some cases, this may be true.  However, a recent study by A.M. Best (“State of the Captive Insurance Market,” August 6, 2013), revealed captives perform better than their traditional counterparts due to diminished marketing costs and the benefit provided by risk management motivated by the fact every dollar saved in claims falls to the corporate bottom line.

Admittedly, the universe of captives analyzed for this study is only a slice of the global market, but it does show that regulation which takes into consideration owner involvement and self-interest (captive regulation) can be quite successful.  However, the growth of captive insurance and its apparent success has attracted the attention of the regulatory community, both offshore and domestic (U.S.).  Here are a few examples:

  • The National Association of Insurance Commissioners (“NAIC”) Captive and Special Purpose Vehicle (SPV) Use ( E ) Subgroup has been in operation for well over a year and has exposed its research on the regulation of the captive industry.  While the initial motivating force behind the Working Group was the concern that SPV captives were being used to avoid the reserving requirements of regulation XXX and AXXX, the Group delved into issues that were tangential to that issue.  Not surprisingly, one inquiry has lead to another, and the issue of captive regulation has appeared in the agendas of other NAIC working groups.  
  • The issuance of “Shining a Light on Shadow Insurance” by the New York Department of Financial Services (“NYDFS”) put the captive industry in the cross hairs of regulators.  While the report detailed some of the possibly financially risky practices of insurers using SPVs, the report was limited to insurers regulated by the NYDFS.   Superintendent Lawsky asked for a moratorium on all captive formations and was rebuffed by the NAIC.
  • The Federal Insurance Office (“FIO”) leaked that it was interested in the captive industry and its regulation.  The federal advisory committee for the FIO put on its agenda captive regulation.
  • The Organization for Economic Co-operation and Development (“OECD”) released a research paper entitled OECD Base Erosion and Profit Sharing (BEPS) Report, February 2013 which included captive insurance arrangements among the mechanisms utilized by some multinational corporations to diminish taxable income.  Other such devices include established tax dodges such as “transfer pricing”.
  • The International Association of Insurance Supervisors (“IAIS”) has continued its work to “harmonize” the regulatory regimes of the U.S. and European Union countries, which includes treating captive affiliates of insurers as traditional insurers.
  • The controversy continues over whether the definition of “non-admitted insurer” in the Non-Admitted Risk and Reinsurance Act (Title V of Dodd Frank) applies to captives.  A court case, or series of cases, may be needed to determine this question, which may have a significant effect upon U.S. domiciles.

The success of the captive industry has caught the attention and imagination of not only the corporate world but also the regulatory community.  The industry will be subject to regulatory growing pains and, in that sense, is a victim of its own success.  Dodd-Frank (mentioned above) has enshrined in the law the concept of “too big to fail.”  The captive insurance industry is now, at least for regulators, too big to ignore.