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Captive concerns

Rapid expansion of captive domiciles can strain supply of qualified regulators

By Michael J. Moody, MBA, ARM


Captive insurance companies have become a viable approach for risk financing but, despite this fact, there are certain segments of the economy that continue to have reservations about them. Take for example an article, "Seeking Business, States Loosen Insurance Rules" which appeared in the May 9, 2011 issue of The New York Times. The article tries to compare the captive insurance industry to "the shadow banking system" that had been in effect prior to the financial crisis. The article goes on to note that corporations can "conduct Bermuda-style wizardry right in a policyholder's own backyard." The Wall Street Journal voiced a similar concern several years ago.

In truth, captive insurance companies have been around for over 50 years and have become a staple in many corporate risk management programs. Initially, they tended to be confined to Fortune 500-type companies, but more recently, they have begun showing up in mid-sized firms as well. Over the years, captives have served not only their parent's risk management needs but have made a significant contribution to the global risk financing community as well. Captives provide a much needed source of capital-efficient financing for risks that are difficult or impossible to place in the more traditional reinsurance market, thus allowing existing insurance capital to be deployed effectively elsewhere. Captives are the ultimate niche insurer since no one understands the risk like the policyholder/captive owner. So instead of applauding captives for their efficiency, how do these publications end up "bad mouthing" them?

Trouble on the horizon

A closer review of the Times article provides some hint as to the perceptions that are at the heart of this matter: regulatory oversight. It states: "State regulators normally require insurance companies to make available reams of detailed information … but not if the insurer relies on a captive. The new state laws make the audited financial statements of the captives confidential."

While this is true, it does not represent the real issue at hand; it's not the regulatory oversight, but more correctly, the lack of regulatory oversight that is the concern. Here there are several points to be concerned about.

First and foremost is the issue of the proliferation of new captive domiciles. For years, there were just a handful of captive domiciles for captive owners to choose from, but today, according to Gary Osborne, president, USA Risk Group, there are currently 36 domestic captive domiciles. Even this, in and of itself, is not a big issue until you stop and consider the ramifications to this growth.

Dennis Silvia, president, Cedar Consulting LLC, summarizes the key issue this way, "It is somewhat like when Major League Baseball wants to expand the number of teams in the league; there are just so many good pitchers to go around. Similarly, there is not the depth of experienced captive regulators to support all the new domiciles." As a result, he says, some captive regulators have very little actual captive experience and, in some instances, no financial experience either. Historically, states would select one of their traditional insurance analysts to move over to the captive side; however, this was usually problematic since traditional insurance regulation and captive regulation differ significantly. The end result is that captive regulators are relying on either industry support to help them navigate the regulatory issues or on groups like the NAIC to create model laws for their consideration. Taken in balance, both are good sources for guidance; however, the influence of one over the other creates a regulatory framework that either stifles captive growth or fosters ineffective controls over them.

What is causing this rush to become a captive domicile?

There are several reasons for this increasing interest. Osborne believes that to some extent it is "optics." Today, state legislators are actively looking for ways to increase their state's revenue, and when they look at states like Vermont, South Carolina, etc., they are struck by the amount of revenue they bring in via captive fees, taxes and associated revenue. This is coming from white collar, professional jobs with little cost to the state. This type of job-building legislation can usually gain bipartisan support, he notes, thus making it easier to pass. For the most part, it encourages new jobs in the state and shows how "business-friendly" the state is.

Silvia agrees that most states are looking for additional ways for capturing revenue. And for those states that consider becoming a captive domicile, the recent Dodd-Frank legislation may arguably hold some promise. Dodd-Frank has specific provisions that deal with a self-procurement tax, which is buried within the Nonadmitted and Reinsurance Reform Act of 2010 that took effect on July 21, 2011. He says some states are quite aware of the tax provisions and have interpreted them as a way to begin to encourage existing captives to consider re-domiciling in their parent's home states.

Osborne points to a perfect example of this approach in Missouri. "Look at their marketing material," he says. In the marketing material for Missouri's Captive Program there is a comprehensive list of reasons to consider Missouri as a captive domicile. The second bullet point is "eliminate self-procurement tax for Missouri home state business." According to Osborne, there are a number of other states that are taking a similar tack; however, their marketing material has not yet reflected this position.

Cause for concern

And, as if 36 jurisdictions were not overkill already, more states are expected to pass captive legislation and enter into the "domicile wars." This is a situation that could quickly bring the captive movement to its knees. While for the most part, most captive legislation is modeled after Vermont's captive law, there always are "tweaks" added to differentiate the law and make the state "more competitive." Almost always, this results in a weaker captive law.

And then there's the second problem, once the law is enacted—finding qualified regulators. Without state regulators that have sufficient experience in the captive arena, it is only a matter of time before one or more captives have significant financial issues, with potentially catastrophic results. The lack of experienced regulators is the real issue at hand, and an issue that needs to be resolved quickly. While there are answers to most of the shortcomings mentioned in the Times article, the lack of "public oversight" is not so easily dismissed.

In the past, the captive industry has, for the most part, come together to resolve common problems for the betterment of the industry. Several years ago, the IRS was proposing an adverse position with regard to some tax legislation, and the various segments of the captive industry came together to obtain a "stay of execution" with regard to implementation of the new tax law. Through the efforts of the leadership of several different groups and associations, the captive industry was able to petition the IRS. This action illustrated how powerful the industry can be when it acts with a single voice.

Conclusion

Initially, this article was intended to be an update of the various captive domiciles. But then I had my "Scooby" moment as I reviewed what I found out—and the words "Ruh-roh" echoed in my head. When you look at the explosive growth of the domestic domiciles, it quickly becomes apparent that there is a major issue that affects all captives. The lack of experienced captive regulators is real and is endangering not just the industry, but also the future of domestic captive domiciles. A catastrophe caused by lack of strong regulation in a domestic domicile will only serve to strengthen Bermuda and the Cayman Islands and other well-known domiciles, and we could see even more organizations taking their captive business, and significant revenues, offshore.

It is time for the industry to find a way of providing some short-term solution via specific training for captive regulators that can serve as a solid background about this distinctive risk-financing vehicle. Longer term, a more permanent solution must be developed. Most likely, the domiciliary state regulators that have captive regulations will have to come together and begin to take a leadership role in their positions as captive regulators. Additionally, some formal training program should be required for any new captive regulator so he or she can understand the uniqueness of captive insurance companies.

 

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