Phil Zinkewicz considers how US regulators view the captive insurance industry
Us insurance regulators' perceptions of the captive insurance industry have changed dramatically over the last 25 years. Today, many US regulators are actively pushing their state legislatures to implement captive insurance company legislation to allow for the formation of captives within their domiciles. This desire to see corporations establish captive companies within their state borders stems from the fact that captives can act as an additional revenue stream to help bolster faltering state coffers.Furthermore, captives and risk retention groups can provide capacity in troubled lines such as doctors' and hospital malpractice. And so, in one sense, onshore captive insurance companies have become the 'darlings' of today's US insurance regulators as competition grows among states for captive insurance company formation.
Captive friendly"There is no question that states have become more 'captive friendly'," said Thomas Jones, a partner in the Chicago office of the international law firm McDermott, Will & Emery. Mr Jones, a frequent speaker on offshore and onshore captive insurance companies, continued: "In the last five to ten years, states have constructed captive insurance company laws regarding captive investment, capitalisation and levels of permitted risk retention that are not all that different from offshore captive regulations. These laws allow states' captives more flexibility than in the past. Of course, there are tax consequences that vary state-by-state but, overall, US regulators have adopted the onshore captive concept and the area is growing."Andrew Barile, president of California-based Andrew Barile Consulting Co, agrees that state regulators are looking favourably on the onshore captive movement. "State regulators and legislators have come to recognise that captives not only bring in revenues to the state, but also provide employment to the state's citizenry," he said. "Of course, some of the captive laws need adjustments, especially in the area of fronting. But overall, state regulators are looking to capitalise on the onshore captive movement."This relatively recent 'thumbs up' attitude towards captives on the part of US regulators is in stark contrast to how they viewed the captive concept a quarter of a century ago. In the 1970s, such companies held in disrepute among US regulators as well as the Internal Revenue Service (IRS). Part of that distrust was because too little was known about captive operations.Initially located in far-off tax havens where the regulatory environments were considered, at best, lax in terms of reporting requirements, and where US insurance regulators had no authority, 'pure' captives were viewed by IRS officials as merely a means by which large corporations could 'park' money earned in the US and thereby avoid paying US taxes. In addition, insurance regulators were concerned about the financial worthiness of these captives, especially those that had, by the late 1970s, begun writing third-party insurance business in the US. This concern stemmed from the now infamous Carnation case, in which the IRS denied Carnation Company permission to deduct the premiums it paid into its pure captive because, the IRS said, the captive was not, strictly speaking, an insurance company unless it wrote third-party business. Following this decision, companies that owned pure captives began doing just that - writing third-party insurance coverages - in order to retain the tax deductibility.
'Shell' company dangerA further reason for the negative stance adopted by US regulators towards offshore captives was the distinct 'underworld' element that had entered the captive arena. During the early 1980s, a number of captive insurance companies domiciled in offshore jurisdictions that were writing third party business were found to be mere 'shell' corporations, taking in premium dollars but not paying claims. Legitimate insurers on both sides of the Atlantic which had dealings with these 'dummy' captives were seen as victims, and the US regulators charged with untangling this global mess became more wary than ever of the captive movement.However, during the mid-to-late 1980s, things began to change. Stung by the scandals of the early 1980s, certain offshore jurisdictions - Bermuda being among the most notable - began to relax their hold on captive company financial information to help ease the concerns of regulators in the US.Furthermore, the impact of the hard market of the mid 1980s brought with it the need for new insurance industry capacity in the US, and large, reputable players in the global insurance industry began establishing their own captives to provide that capacity. US regulators started to appreciate the role that captives could play in stabilising the hard insurance marketplace, thus bringing greater legitimacy to the concept of captive insurance companies.
Captive US growthToday, regulators acknowledge the significant value of offshore captives and have adopted their credo into their own home states. As a result, the onshore captive company movement in the US appears to be burgeoning.Vermont was the first state to allow for the formation of captive insurance companies back in 1980. Initially, take-up was slow due to the offshore captive scandals at the time, but by the mid 1980s, for the reasons already mentioned, the Vermont captive arena began to grow. Last year at third quarter, the captive division in the state reported that it had issued 23 new captive licenses, bringing Vermont's total to 656 domiciled captives, according to the Vermont Banking, Insurance, Securities and Health Care Administration (BISHCA). Thirteen were pure captives, with seven risk retention groups, two industrial insured captives and one association captive. "I'm pleased to see the number of companies forming their captives in Vermont," said Governor Jim Douglas. "I remain committed to making Vermont the best place in the world to have your captive insurance company." Leonard Crouse, Vermont's Deputy Commissioner of Captive Insurance, said: "I continue to be impressed by the number of high calibre programs that we are working with. We have been seeing a large volume of quality risk retention groups, medical malpractice captives and captive formations for terrorism coverage."Among the new licensees in Vermont at the end of the third quarter of last year were Continental Airlines, the Roman Catholic Diocese of Pittsburgh, Memorial Sloan-Kettering Cancer Center, Marvin Lumber and Cedar Co (Marvin Windows) and Boston Scientific.In order to retain its dominant position in the US onshore captive insurance market, Vermont's insurance regulators periodically 'take their show on the road', participating in educational seminars and major industry conferences across the country.
Bigger appleNew York has also jumped on to the onshore captive insurance company bandwagon. A law allowing businesses to establish captives in the state was signed by Governor George Pataki in 1997. Late last year, Superintendent of Insurance Gregory Serio announced that the state insurance department had licensed Haversine Insurance Co as a captive insurance company in New York, insuring risks of Omnicom. Omnicom is a holding company that manages a portfolio of global firms operating in sectors such as advertising, marketing services, communications, interactive/digital media and media buying services. When making the announcement, Mr Serio said: " New York state is committed to continuing to meet the changing needs of business and as the creation of captives becomes a more viable solution for companies like Omnicom to manage their own risk, New York will continue to be a solid choice."Omnicom Group is the eleventh New York business which has taken advantage of the state's captive law. Randall Weisenburger, Ominicom's CFO, said: "The New York Insurance Department made the approval and registration process streamlined and user-friendly, allowing Omnicom to gain greater control, improve cost efficiencies and flexibility in managing our risk management process."But other states are not ready to be outdone. Captive legislation has been passed in South Carolina, Arizona, Colorado, Nevada, Montana, Tennessee, Delaware, Florida, Rhode Island, Illinois, Kansas, South Dakota, Arkansas, Kentucky, Maine, Hawaii and the District of Columbia, according to the Captive Insurance Companies Association (CICA). South Carolina ranks a distant second to Vermont as an onshore captive arena with 50 captives.The District of Columbia has 20 captives, Georgia has 17; Arizona has 16; Colorado matches New York with 11; and the other states have captives in single digit figures.
Tax avoidance claimsHowever, while US regulators have embraced the onshore captive company concept, concerns have been raised once again about the possible abuse of these self-insurance vehicles, and these concerns have entered into the US presidential political arena. In January of this year, the Wall Street Journal published an article by John McKinnon, which stated that some states were complaining they had lost millions in tax revenue because of tax-avoidance schemes involving an insurance program that former Vermont Governor and former Presidential hopeful Howard Dean had promoted while he was governor of the state.Mr McKinnon said that Illinois and New Mexico were challenging tax benefits that US companies were claiming from Vermont's captive insurance companies.According to the article, some experts believed that captives had become increasingly popular as a corporate tax dodge at a time when other tax shelters were being shut down.Some US insurance regulators are saying that companies that own captives are 'over-reserving' and taking tax deductions upfront, rather than waiting for losses to occur, as other companies without captives must do.The issue boiled over in the last presidential primary election, when in a two-hour National Public Radio debate between Democratic Presidential candidates. Senator John Kerry accused Howard Dean of hypocrisy regarding his position on President Bush's corporate tax breaks, saying that Mr Dean had attacked the President for helping Enron and other big corporations, while as governor providing tax incentives to corporations to set up captives in Vermont. "Howard Dean gave up tax revenue to create a snowy Bermuda in the fields of Vermont," Mr Kerry said.However, promoters of the onshore captive concept in the US argue that Mr Kerry's contention is nothing more than political rhetoric. "No responsible professional who is advising and counselling prospective captive owners would advocate forming a captive solely for tax reasons," said Michael Mead, president of MR Mead & Co, a Chicago-based insurance intermediary."Captive owner/managers have selected Vermont and other well-regulated domiciles for the sensible insurance regulation that has been enacted by their legislatures, and for the efficient and consistent application of those regulations by state administrators. If tax advantages are also in the equations, they will play their role. For example, most people in the captive industry are aware that Arizona imposes no taxes on captives.As to the captive insurance company's reserves, which are estimated by highly trained regulators, there are always inconsistencies and disagreements among well-intentioned professionals. Those examining the captive industry must recognise that Congress sets US tax policy, which is then administered by the IRS - not the Governor of Vermont or any other domicile. The accusations that Vermont's insurance regulations promote captives as 'tax havens' are misguided and misplaced," according to Mr Mead.There are others who also believe that the over-reserving allegations against owners of captives are a tempest in a teapot. Mr Jones of McDermott Will & Emery said that captive owners are just like policyholders in mutual companies. "Their concerns are risk financing and loss reduction. Company CFOs don't want to over-reserve for tax benefits when they can use that money for investment purposes. And the goal of captive regulation is not tax-oriented, but rather to protect against insolvency."Mr Barile of Andrew Barile Consulting said: "When you look at the reserves of captive insurance companies, you have to look at each case separately.If a captive is writing long-tail business, such as general liability and workers' compensation, you can't tell whether that company is over-reserved until the claims start coming in, and that can be as long as ten years later. Look at what's happening in the regular insurance marketplace.Because of long-tail claims coming in, companies have found out that they are seriously under-reserved and have been for some time. They are plunking down huge sums of money to boost reserves to catch up with claims. So, if a regulator tells me my company is over-reserved, I say, 'prove it.'"So, the regulatory climate in the US relating to captive insurance companies, unlike in years past, is a rosy one with more flexible legislation for onshore captives, revenues flowing into states' coffers and increased employment. Nevertheless, there are still thorns in those roses. The issue of whether captives represent tax dodges remains unanswered and perhaps always will.