US Captive 2015 by James Lynn

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US CAPTIVE www.captiveinternational.com

Captured in the blink of an eye On its 10th anniversary, US Captive charts a decade of change and growth

A 50-year war

Leader of the pack

Protected in court

The captive industry’s long and complex battle with the IRS—with no end in sight

How Vermont pioneered onshore captives and continues to lead from the front

Users of protected cell captives will sleep easier following a recent court ruling

Editorial Wyn Jenkins, Managing editor

US Captive is published by Newton Media Limited. Kingfisher House 21-23 Elmfield Road BR1 1LT, United Kingdom Email: info@newtonmedia.co.uk Director and publisher Nicholas Lipinski Managing editor: Wyn Jenkins Telephone: +44 203 301 8214 Email: wjenkins@newtonmedia.co.uk Deputy editor: Francis Higney Telephone: +44 203 301 8228 Email: fhigney@newtonmedia.co.uk Sub-editor: Ros Bromwich Advertising: Robin Johnson Telephone: +44 203 301 8202 Email: rjohnson@newtonmedia.co.uk Production, art direction and design: Fisherman Creative ©Newton Media Limited 2015 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electrical, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher. The views expressed in US Captive are not necessarily those shared by the publisher, Newton Media Limited. Wishing to reflect the true nature of the market, the editor has included articles from a number of sources, and the views expressed are those of the individual contributors. No responsibility or liability is accepted by Newton Media Limited for any loss to any person, legal or physical, as a result of any statement, fact or figure contained in US Captive. This publication is not a substitute for advice on a specific transaction. The publication of advertisements does not represent endorsement by the publisher. US Captive – ISSN 1751-0678 Cover: Aleksandar Mijatovic / Shutterstock.com A publication by:

A solid decade, but so much more to come US Captive magazine is celebrating 10 years of publishing in this issue—for a decade, we have documented the rise and rise of this market, through great change, diversification and increased complexity.

increased the options for captive owners. The flipside of this has been a growing regulatory burden and increased oversight on a number of fronts. Regulators at every level are

It is sometimes tempting when reflecting on the past and how things have changed to make oversimplified or exaggerated statements about the growth of an industry and the extraordinary innovation of its practitioners during that period. It is important, in such instances, to try to retain true perspective. The fact is that many industries do change quickly, driven by both external forces and those within. So has the industry changed in a way that is really so extraordinary?

also more suspicious than ever of any form of risk transfer they do not completely understand, and that too has a knock-on effect. Yet through all these challenges the market has continued to grow. Why? The reality is that aside from regulatory challenges and other changes that have beset this market, within corporates across the US there has been a growing and increasing understanding of all forms of alternative risk

Certainly, it has grown. Exact numbers are hard to come by, but the sector has more than doubled and maybe tripled during the past 10 years. Good solid growth indeed, but nothing compared with some other industries during the same timeframe.

transfer including captives—and an increased

The number of US states that embrace captives has also grown steadily although there is a difference between the number that have enacted legislation compared with the number which actively market themselves and seek this form of business.

years ago—it made perfect sense on paper and

willingness to use them. Parallels may be made with other forms of risk transfer such as insurance-linked securities. That mechanism was first tried and tested almost 20 its proponents were certain it would take off and flourish, such is its logic and rationale. That market is indeed now flourishing but it took 20 years to truly find its feet. The same may be true of captives. One the one hand it is

Legislation has changed in many multifaceted ways. On the one hand, regulators and captive managers have concocted a variety of schemes and vehicles that have assisted the growth of this market. The creation of XXX/AXXX life insurance/ annuity reinsurance vehicles has been very significant, while micro-captives have also flourished through utilising the 831(b) tax election. Meanwhile, protected cell legislation

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and the use of serial captive vehicles have also

a much older and more seasoned industry yet, for all its steady growth over the past 10 years, maybe it has still not truly flown as it could. So what does that perspective mean when it comes to the captives industry? Solid and pleasing growth, yes. But there could be so much more to come from this increasingly diverse and innovative industry in the next decade.

US Captive 2015

Contents Ten years of captives Foreword Dennis P. Harwick, president of the Captive Insurance Companies Association, offers his perspective on a decade of the captive insurance industry within the US.

A decade captured in the blink of an eye US Captive As US Captive celebrates its 10th anniversary we cast an eye over a decade of change in the captive insurance industry.

A history of the (captive) world and its battle with the IRS USA Risk Group Gary Osborne of USA Risk Group takes a walk through the ongoing debate between the US captive industry and the IRS and highlights some important court cases.

Much ado about captive life reinsurance Dentons The legal standing of captives is not in question, but doubts linger in some quarters as to their safety, as Michael Kasdin, Sandra Hauser, Carter White and Matthew Gaul of Dentons describe.

Montana court rules on legal status of a PCC Hassans With a rising number of US states enacting captive legislation, Nigel Feetham of Hassans looks at four of the newest entrants into the space and assesses their prospects in a crowded ﬁeld.

Overcoming data challenges in a regulated environment Ventiv Technology Tools are now available that deliver control, auditability, efﬁciency and transparency over the entirety of a captive’s operations, as Ilka McHugh and Angus Rhodes of Ventiv Technology explain.

US Captive 2015

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Contents Leading the ﬁeld Vermont Vermont remains the primary US state for captive formation and continues to go from strength to strength despite the soft markets, competition and regulatory threats.

A mature environment for captives Nevis Kimone Moving, director of the Nevis Investment Promotion Agency, and Derek Lloyd, director of AMS Insurance (Nevis), speak to US Captive about the jurisdiction’s continued success.

A winner in the domicile sweepstakes South Carolina Jay Branum, South Carolina’s director of captives, explains how its adherence to robust regulation and professional ethos means it remains in a good position to fend off the challengers.

A transforming environment Missouri Maria Shefﬁeld from the Missouri Department of Insurance examines what some of the recent changes have meant, the innovation in structures, and the impact of Obamacare.

44 The new era of captive waves BVI The British Virgin Islands is well poised to take advantage of the growing number of opportunities in the offshore captive insurance market.

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Ten years of captives Dennis P. Harwick, president of the Captive Insurance Companies Association, offers his perspective on a decade of the captive insurance industry within the US.

Ten years ago I wrote: “States that established themselves early as domiciles for captive insurance companies—such as Vermont and Hawaii—are being challenged by a more recent group of domiciles— such as Arizona, Nevada, South Carolina, Montana and the District of Columbia—with even more states pursuing the enabling legislation to authorise the formation of captives.” Who would have predicted that 10 years later we would have around 38 states with the enabling legislation for captives? Or that those states would include Texas, Florida, and Ohio? Although counting captives is notoriously difficult because of the varying ways that domiciles report, by my reckoning, the number of captives in 8

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the US has increased from approximately 1,000 at the close of 2003 to approximately 2,600 at the close of 2013 (final numbers for 2014 are not yet available). By any measure, the growth of captives in the US— both by the number of captive domiciles and by the number of individual captives—has been dramatic. What is even more amazing is that this has happened despite the fact that the last five or six years have been a soft market. In one of my early Forewords, I noted: “There was a time when companies and organisations turned to captives and risk retention groups only when a ‘hard market’ in the commercial insurance industry left them with few options. Many experts said that captives would last only until the commercial market softened.” Well, guess what? They were wrong! Even in a soft market, there have been hundreds of additional captives joining the US captive industry. One of the hallmarks of the captive industry has always been its willingness to be creative and flexible in addressing the risk management needs of potential captive owners. In addition, captive managers and captive regulators have designed www.captiveinternational.com

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s US Captive celebrates its 10th anniversary with this issue, I have been asked to offer a 10-year retrospective on the US captive insurance industry—which dovetails nicely with the fact that in January 2015, I celebrated my 10th anniversary as president of the Captive Insurance Companies Association (CICA) and now have the honour of writing the Foreword to US Captive for the 10th time!

Foreword

“When asked what makes a good domicile, my answer is always the same: good regulators.”

Federal Insurance Office (FIO), the International Association of Insurance Supervisors (IAIS), the Organization for Economic Cooperation and Development (OECD), or even the European Union (think Solvency II), were not a big concern. My, how times have changed. Today, some—or all—of the players listed above have to be considered.

and approved more flexible vehicles for utilising captives—ranging from the behemoth XXX/AXXX life insurance/annuity reinsurance vehicles to the micro-captives utilising the 831(b) tax election. At the same time, protected cell and serial captive vehicles have increased the number of options for captive owners.

Captive insurance regulation is now part of an interconnected world. Some of this increased scrutiny comes from the financial crisis of 2008/2009— even though the insurance industry in general (and captives in particular) weathered that storm virtually unscathed. Why this increased scrutiny? I see several forces at work. First, there is a perception by many insurance regulators that captives have been

Active domiciles No retrospective of the last 10 years would be complete without a discussion of the increase in the number of captive domiciles. There have always been more domiciles than many people realised because there are a number of states that have captive-enabling legislation on the books, but who have licensed few, if any, captives.

It surprises many people to learn that Colorado was the first state to authorise the formation of captives (although only a few captives are licensed in Colorado today). Do you think of Kansas, South Dakota, and Arkansas as captive jurisdictions? They’ve had the enabling legislation for more than a decade, but each has only a few captives.

unregulated or under-regulated—ignoring the fact that every captive is fully regulated by its domicile and captives have a much better solvency record than do their commercial insurance company brethren. Second, the inevitable response of most regulators is to call for a more uniform (one size fits all) and a more easily administered regulatory template. All of this ignores one of the great observations about captives: when you’ve seen one captive, you’ve seen one captive! In April I had the honour of organising a session at the 2015 RIMS Conference called The Future Sustainability of Captives in a Regulatory World. The panel’s conclusions were simple:

Some states passed captive legislation as an economic development tool. Others passed the legislation because they wanted to lure large companies headquartered in that state to bring their captives ‘home’. Some states jumped into the captive arena, then lost interest for financial or political reasons. When asked what makes a good domicile, my answer is always the same: good regulators. Some states have made the investment in training their existing commercial insurance regulators to understand captives. Others have sought captive expertise from outside their borders. The bottom line is that the best jurisdiction for a captive owner is a state that has made the commitment to developing a knowledgeable captive regulator, along with the necessary availability of captive service providers. Despite the growth in captive domiciles, the most dramatic change in the captive industry over the past 10 years has been the expansion of regulatory oversight of the captive industry. Ten years ago, about the only person a captive owner or manager had to pay attention to was their home state’s captive regulator. The Internal Revenue Service was an occasional concern, but that was mostly on the grander issue of whether captive insurance companies were real insurance companies for federal income tax purposes. The National Association of Insurance Commissions (NAIC), the www.captiveinternational.com

• Increased regulation is not going away; • Increased scrutiny is the sign of a maturing industry; and • Despite increased regulation and scrutiny, captives still constitute the most creative, flexible, and economic way for sophisticated risk managers to address increasingly complex risk management scenarios and insurance coverage challenges. Just imagine what the US captive industry will be like when the commercial insurance market hardens again. Captives have not only survived the challenges of the past 10 years, they have thrived. And there is every reason to believe that the next 10 years will be even better. Welcome to the world of captives.

Dennis P. Harwick, president Captive Insurance Companies Association US Captive 2015

A decade captured in the blink of an eye

US Captive 2015

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Ten years of change

As US Captive celebrates its 10th anniversary we cast an eye over times past and on a decade of change in the captive insurance industry.

decade is a long time in any industry. Fashions change, people move on, new concepts arise, old ones evolve. The captive insurance market in the US has been no different. PHATIC-PHOTOGRAPHY / SHUTTERSTOCK.COM

It has seen extraordinary growth over the past 10 years in every sense. As Dennis Harwick, president of the Captive Insurance Companies Association (CICA)—for the past decade as it happens—stresses, it is and always has been difﬁcult to assess numbers of captives. He estimates, however, that the number of captives has more than doubled in the past decade from around 1,000 in 2003 to somewhere around 2,600 in 2013—the most recent years for which ﬁgures are available, although this is likely to have increased again since then.

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US Captive 2015

He also makes the point that this growth has been steady and seemingly immune to the cyclical nature of rates in the traditional insurance markets. It was once thought that captives were more likely to be formed when rates were hard in traditional insurance, forcing risk managers and CFOs to explore alternative and more cost-effective methods of risk transfer. But this logic seems not to have applied in recent years. Harwick attributes this, in part, to the increasingly innovative and ﬂexible nature of the way captives may be used—driven by a mixture of captives managers and regulatory changes opening up new business in new vehicles. These have ranged from the large XXX/AXXX life insurance/annuity reinsurance vehicles to micro-captives utilising the 831(b) tax election. He also notes that protected cell legislation and serial captive vehicles have also driven growth in some sectors while also making the numbers of captives harder to count.

Widespread acceptance In tandem with this growth in the numbers of captives across the US, the number of states that have embraced this form of risk transfer have also increased greatly. State after state in the US has accepted the virtues of captives. Harwick estimates that 37 or 38 states now have legislation enabling the use of captives. One thing that has not changed since the start of the decade is that Vermont remains the leading state by captives domiciled, a position it’s held from the very start. Dan Towle, director of financial services of the State of Vermont, attributes the growth partly to a deeper acceptance in the US of the use of this form of risk transfer—Vermont has ensured it has maintained pace with these changes. Towle describes the industry as having transitioned from being an “alternative risk transfer” mechanism to being a mainstream insurance tool. To put the sector’s growth in perspective, in Vermont, gross written premium volume has grown from $10.9 billion in 2004 to $25.5 billion in 2014. “The industry changes quickly and Vermont has kept ahead of it, maintaining the strategy that has made us successful since the beginning. We find quality companies and regulate them in a manner consistent with their risk profile,” says Towle. 12

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Such evolution is not unexpected given the way that the insurance market has changed. The past decade has seen a wide range of crises ranging from natural disasters, to cyclical changes, to regulatory revamps. And yet the growth of the market continues unabated. “Over the last 10 years the trajectory of the US captive market has been like that of a shooting star,” says Arthur Perschetz, principal at insurance law firm Arthur D. Perschetz and a veteran of the captive industry. “People started to notice them when many states started reporting that they had them, such as Vermont and South Carolina,” he explains. “Other domiciles started to see the benefits of captive insurance entities providing the opportunity for the business entity to provide insurance within their jurisdiction. They’re seen as a big plus—if it’s not going to their jurisdiction it will go to another one.” Perschetz says he expects this growth to continue; any initial reluctance to captives is now long gone. There are a significant number of people now within the industry who are very well known and have an expertise in dealing in the captive arena.

More and more uses Captives are here to stay and will be used more and more as companies are able to get involved with smaller captives in those states that have tax advantages for small captives. Even some of the larger entities are going in and forming their own risk management programmes. “As people go on with onshore/offshore reinsurance I think they are seeing a multitude of uses and ways that they can craft a captive that can be a little bit more ﬂexible than a traditional company insuring itself,” Perschetz says. “It’s now a very vibrant market—the states that were the initial leaders have done exceptionally well and the states that joined after the captive train left the station are coming back and looking at what they can do to attract more captive business in their domiciles. “The US economy is in quite a good state now and people are suddenly realising what self-insurance is. The traditional market has been a bit on the rigid side and people are starting to realise that if they have sufﬁcient capital, it’s a good deal for them to be able to manage their own risk by forming a captive. “States like Vermont and South Carolina have excellent captive operations. It puts these domiciles generally in a better light for being a www.captiveinternational.com

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“The industry changes quickly and Vermont has kept ahead of it, maintaining the strategy that has made us successful since the beginning.” Dan Towle

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good place to do business, which can ﬂow over from captive to captive within the domicile. “Captives are relatively new but they get larger and larger, and they can become quite sophisticated. Some hospital systems in the US have assumed the risk rather than buying insurance from the commercial market. They’re forming their own captives, where they have a much better way of managing the risk and the loss expense side of it.”

Reluctance and regulation Not everything has been easy for this industry in the past decade. Regulation has also changed over this period with the amount of regulatory oversight increasing and deepening for a wide range of reasons that include the crippling financial crisis of 2008–2009, which shook the US and the wider financial industry deeply. Harwick at the CICA points out that 10 years ago, captive owners needed to worry only about legislation in their home state. Now, a whole plethora of different bodies take an active interest in the activities of captives including the Internal Revenue Service, National Association of Insurance Commissions (NAIC), the Federal Insurance Office (FIO), the International Association of Insurance Supervisors (IAIS) and even the Organization for Economic Cooperation and Development (OECD). A number of states have resisted the implementation of legislation to enable the formation of captives. “Some states are not interested in attracting captives. Those states think there’s too much captive infrastructure to build and there’s a lack of expertise among the people at work within the state insurance arena,” Perschetz believes. “Captive insurers can become quite sophisticated, more than your typical insurance company. Some state officials who approve insurance companies just might not recognise the need or make the effort to attract captives. “They might not understand, or they might think that it’s a bit too risky—and they have to have some internal employees who are capable of dealing with regulating captives. “A lot depends on where the state is and how sophisticated it is— some of them might think that it’s an extra burden that they have to deal with, whereas others see opportunities to create additional jobs and make the insurance department a little bit more important than it had been before.”

Experience counts Experience is paramount in terms of captives and state regulators. It’s fair to say that over the wide spectrum of states that are now captive domiciles there are some that are doing things right—and some that are doing it wrong. What differentiates these from each other? Perschetz says: “The states that have been more successful than others are the ones that have very good captive laws, they have more experienced staff within the insurance arena who are committed to dealing with captives and the people that are coming into the state to form captives. “It’s a challenge that they relish, going into a whole new area like captives, which can be more sophisticated than the traditional market. They get to work more effectively and closely with the captive owners. “The states that are getting it wrong are the ones that are not welcoming captives into their domiciles. There are people who are looking at it as just one more thing that they have to work with. In the beginning some of them looked at captives as something that was unique and a little bit off-base for the traditional market and the traditional regulators. 14

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“The states that joined after the captive train left the station are coming back and looking at what they can do to attract more captive business in their domiciles.” Arthur Perschetz “The states that got it right—Vermont, the District of Columbia, Delaware and South Carolina—were the leading states that initially got their feet wet in the water of captives. Some states like Montana have seen what’s happening with those leading states, and have seen the beneﬁts of having a captive domicile and are getting involved as well.” South Carolina certainly takes the regulatory approach very seriously. Asked about the path that the state has taken since he started working there two-and-a-half years ago, Jay Branum, director of captives at South Carolina Department of Insurance, says building a bespoke regulatory framework suited to captives is the key. “As a starting point for the development of a captive regulatory policy, I take it as a matter of principle that the captive sector is a discrete sector with its own characteristics which regulators should be prepared to acknowledge, understand, and respect as quite different from the traditional re/insurance sector,” Branum says. “Some captive regulators refer to themselves as ‘ﬁrm but fair’, and I would certainly be pleased if our regulatory approach in South Carolina were recognised for those qualities. Two other attributes I would also like us to be associated with are ‘pragmatic and balanced’. “By pragmatic, I mean reasonable, practical, and business-minded. By balanced, I mean trying to strike the right balance between being responsive to the business needs of captive stakeholders on the one hand, and being true to our overarching mandate as solvency regulators on the other. “Getting that balance right is something we strive to do every day. We take very seriously our responsibility to safeguard South Carolina’s reputation as a respectable and attractive place for world class companies to establish subsidiaries and conduct business.” At the moment approximately 38 US states are captive domiciles— some with just a few on the books, some with hundreds. As the market grows still further knowledge of these insurers continues to spread. Who knows how many the market will have after another decade? It would be fair to say that many more state insurance departments will have heard of them, will have adjusted local legislation to try and attract them and will be trying to build on past progress. The next 10 years will be interesting to watch. As Harwick says, captives have not only survived the challenges of the past 10 years, they have thrived—and there is every reason to imagine that the next decade will be even better. www.captiveinternational.com

A brief history of the (captive) world— and its ongoing battle with the IRS The captive industry in the US and the IRS have been embroiled in an often complex, costly and confusing battle around the way in which captives should be taxed. Gary Osborne of USA Risk Group takes a walk through the recent history of this ongoing debate and highlights the most important court cases.

he captive industry has been around for almost 50 years and for almost that long has been ﬁghting with the Internal Revenue Service (IRS) in seeking to have captive insurance companies receive the favourable tax treatment allowed by

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the US tax code for insurance companies. The normal tax treatment of business expenses is that they are deductible when paid. Insurance companies get to deduct expected losses when they are incurred. The public interest in ensuring that insurance companies have sufﬁcient funds in reserves to meet their future obligation to pay claims when they are settled means that

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Tax

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“Multiple entities or sufficient unrelated risk can be structured to follow the court cases of revenue rulings and create a tax position that is strongly defensible.” insurance companies are able to deduct uncertain future commitments (subject to some discounting factors), giving them a substantial deferral of income until known claims are settled out. Self-insured companies are not able to deduct loss reserves and incurred-but-not-reserved amounts, they can deduct losses only when they are paid. Thus if a corporation could form an insurance company that met the known rules to achieve insurance company tax treatment it could achieve a significant tax deferral benefit. The benefit is a timing issue as the insurance company treatment is allowing the acceleration of the loss deduction to year one instead of receiving the tax benefit as the claims are paid out, say over 10 years for workers’ compensation. If expected workers’ comp losses for 2014 were $10 million, a captive passing muster would be able to deduct the full $10 million as an expense, as opposed to a self-insured which would probably be able to deduct $2 million in actual claims payments made in 2014. The remaining $8 million in claims would be deducted from 2015 to 2024 as they were paid. The benefit of the $8 million acceleration depends on internal rates of return but actuarial firms have ballparked the benefit as between 6 percent to 8 percent, or $500,000 to $650,000, annually in the above example. A simple captive would cost approximately $80,000 in operating costs and while there may be many other reasons for forming this company, the tax efficiency remains an often decisive factor in the formation of a captive. (Other reasons can include lack of markets, access to lower cost reinsurance, a profit centre, policy wording flexibility, collateral relief, a cost allocation tool and other insurance or business problems.) 18

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The IRS long held to the “economic family” argument which took the position that a captive was not acting as an insurance company when it was a controlled entity of its parent company. The basic argument was that the captive did not meet the two basic tests for insurance: risk distribution and risk transfer. Risk distribution is the law of large numbers at work. The IRS believes that insurance should “spread” the risk of loss among “many” entities or exposures. This grey area has been the biggest battle ground for the captive industry. Risk transfer means that the insurance company must be able to make either a proﬁt or a loss. The issue here has always been what constitutes a “loss”. The industry for many years used a rule of thumb of a 10 percent chance of losing 10 percent (for property and casualty exposures). This position has been challenged but there is, to date, no clarity to this issue. Part of the issue was that some risks (eg, workers’ compensation) have a long payout pattern and an insurance company could easily recoup the 10 percent risk margin through investment income, which might call into question whether the captive is really “making a loss”.

Important court decisions Helvering v LeGierse, 312 US 531 (1941) established that both risk transfer and risk distribution are required for a contract to be treated as insurance. Throughout the 1970s and 1980s the IRS held to its doctrine of the economic family and courts disallowed deductions for premiums paid to captives in Carnation v Com’r, 71 TC 400 (1978), Stearns-Roger v Com’r, 577 F.Supp 833(d.Cob 1984) and Clougherty Packing v Com’r, 84 TC 948 (1985). Sears, Roebuck v Com’r 972 F.2d 858 (7th Cir. 1992) took this position to an extreme. Sears paid $14 million to Allstate, a wholly owned company. Allstate wrote over $5 billion in premiums so the Sears premiums constituted less than 0.5 percent of the total premium written. The IRS contended this did not meet risk transfer or risk distribution and was simply moving money between related companies. The court disagreed, indicating that there was clearly risk distribution among numerous entities and that Allstate could suffer a loss from the Sears business. www.captiveinternational.com

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TODD WINCHEL twinchel@wilmingtontrust.com 212.941.4406

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The captive industry started to win, beginning in the late 1980s with a now seminal case. In Humana v Com’r 881 F.2d 247 (6th Cir. 1989) the 6th circuit court of appeals held that a “brother-sister” captive insurance structure constituted insurance for federal income tax purposes and thus premiums from the captives brother-sister entities were deductible. The court also held that premiums from the captive parent were not deductible. The decision was based on a “balance sheet” approach, whereby “risk shifting” is recognised if the value of a loss is transferred from a brother-sister’s balance sheet to the captive. Brother-sister refers to multiple separate legal entities. The structure in Humana was approximately 30 companies under a holding company and the holding company was the owner of the captive. This was followed in Kidde Industries v US, 40 Fed Cl.42 (1991) while The Harper Group v Com’r 96 TC 45 (1991) found that risk transfer and risk distribution were achieved when the captive received 29 to 32 percent of its premiums from unrelated parties. Amerco and a number of its subsidiaries purchased insurance policies from Republic Western Insurance Company and deducted the premiums for income tax purposes. In Amerco et al v Com’r, 9th Cir. (1992) the insurance business from the Amerco group constituted from between 26 percent to 48 percent of Republic’s business; the remaining insurance business was unrelated. Because Republic was a subsidiary of Amerco, the IRS determined that the transactions did not constitute “insurance” for income tax purposes, and disallowed the deductions. Amerco petitioned the Tax Court for a redetermination and the Tax Court held that the arrangement between Amerco and Republic constituted insurance for federal income tax purposes. Following on from these defeats in Harper, Kidde, Harper and Amerco, the IRS issued three revenue rulings in 2002. •

Rev Ruling 2002-89 indicated that 50 percent unrelated risk qualiﬁes as sufﬁcient risk distribution for insurance company tax treatments.

•

Rev Ruling 2002-90 indicated that 12 or more subsidiary companies, where no one sub comprised more than 15 percent of the total premium, also achieved sufﬁcient risk distribution for tax treatment as insurance

•

Rev Ruling 2002-91 indicated that seven or more unrelated insureds in a group captive also achieved risk distribution and risk transfer.

There was no explanation as to why seven entities worked for unrelated companies but it needed 12 subsidiaries to achieve risk distribution. It is worth noting that the “safe harbour” rulings are set much higher than some of the court cases discussed previously. In Rent-A-Center and Affiliated Subsidiaries, 142 TC 1 (2014) the court held that in order to have risk distribution, the insurer needs to insure a large enough pool of unrelated risks. The Tax Court said a captive may achieve adequate risk distribution by insuring only subsidiaries within its own affiliated group. There were a sufficient number of statistically independent risks in the Rent-A-Center case given the large number of stores, employees and vehicles. This decision is considered significant in that the court seemed to look at total exposure units more than number of entities in determining risk distribution and also that it did not place much import on an intercompany loan, a fact the IRS had previously argued was evidence of a lack of risk transfer. Most practitioners are unwilling to go out on a limb and argue that Renta-Center has moved the bar. It is still seen as prudent to look for seven or more subsidiaries or to try and find 30 percent or more unrelated risk if 20

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“The captive insurance company, in turn, can elect under a separate section of the tax code to be taxed only on the investment income from the pool of premiums.” IRS website a captive owner wants to achieve favourable tax treatment. These levels are still in the “grey” area which could be challenged by the IRS as being outwith their safe harbour but are seen as very defensible based on the court cases discussed in this article. It is also worth noting that the IRS issued proposed guidance on risk transfer and risk distribution in September 2011 which would have “looked through” to a segregated cell and each cell would then be looked at to see if it met risk distribution and risk transfer tests as if it were a standalone entity. There has been no follow-up to this guidance but many in the cell industry have acted as if it is the expected IRS position, even though it has not been formalised.

Other federal tax issues Small insurance company election There has been a huge increase in the formation of captives that write premiums below $1.2 million and elect to pay tax only on their investment income under IRS code section 831(b). The aggressive use of this vehicle by estate and tax planners has resulted in the IRS including captive insurance in their “dirty dozen” list of tax scams. To quote from the IRS website: “Another abuse involving a legitimate tax structure involves certain small or ‘micro’ captive insurance companies. Tax law allows businesses to create ‘captive’ insurance companies to enable those businesses to protect against certain risks. The insured claims deductions under the tax code for premiums paid for the insurance policies while the premiums end up with the captive insurance company owned by same owners of the insured or family members. “The captive insurance company, in turn, can elect under a separate section of the tax code to be taxed only on the investment income from the pool of premiums, excluding taxable income of up to $1.2 million per year in net written premiums. “In the abusive structure, unscrupulous promoters persuade closely held entities to participate in this scheme by assisting entities to create captive insurance companies onshore or offshore, drafting organisational documents and preparing initial ﬁlings to state insurance authorities and the IRS. The promoters assist with creating and ‘selling’ to the entities often times poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums’, while maintaining their economical commercial coverage with traditional insurers. “Total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufﬁcient. The promoters manage the entities’ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.” www.captiveinternational.com

Cascading federal excise tax Premiums ceded to insurers or reinsurers outside of the US are subject to a 4 percent federal excise tax (FET) on direct premiums and 1 percent on reinsurance premiums. The IRS held that this tax “cascaded” and was due if an offshore company reinsured to another non-US company and so on. This was an area of audit effort in recent years looking for foreign schemes and additional revenue. Validus Reinsurance, a Bermuda company, decided to challenge this tax. Validus ﬁled suit in the US District Court challenging the IRS’ determination and assessment of tax on the grounds that the FET does not apply to transactions between two non-US reinsurers that occur outside the US. Validus also contended that the IRS lacks the power to tax transactions between non-US parties. The District Court ruled in favour of Validus. It noted that Validus’ transactions are retrocessions and reasoned that the plain language of the statute does not impose a FET on retrocessions. 953(d) Election In 1989, the IRS published Notice 89-79, which provides substantive and procedural rules regarding an election under section 953(d). Section 953(d) allows a controlled foreign corporation engaged in the insurance business to elect to be treated as a US corporation for US tax purposes. A controlled foreign corporation that makes this election will be subject to tax in the US on its worldwide income but will not be subject to the branch proﬁts tax or the branch-level interest tax imposed by section 884. Further, the FET imposed under section 4371 on policies issued by foreign insurers will not apply. The need for a closing agreement and letter of credit (LoC) to cover possible tax obligations to the US has become more contentious recently. The IRS has been using a more aggressive formula in determining required

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amounts as the formula says “10 percent of the electing corporation’s gross income”. When a captive wrote $1 million in premium in December of (say) 2014 the IRS, in several cases, argued that the corporations gross income should be $12 million ($1 million in December would be held to be $12 million annualised). This would require posting a LoC for $1.2 million instead of $100,000. There is some thought this is being done to make life more difﬁcult for offshore companies to take the 831(b) election.

Where we are today The captive world has had a string of court successes that today create a reasonable road map for a company to follow to achieve insurance tax treatment for a captive subsidiary. Multiple entities or sufﬁcient unrelated risk can be structured to follow the court cases of revenue rulings and create a tax position that is strongly defensible. However, the explosion of 831(b) small insurance company captives has put captives back in the crosshairs of the IRS. It is clear the IRS is still looking to challenge captive insurance arrangements where it sees an operational fact pattern that is unusual for an insurance company or a fact pattern that has had questions raised in court decisions. Watch out for RVI Guaranty and Subsidiaries v Com’r which is being tried currently. It is addressing another unclear insurance issue—what constitutes insurance risk as opposed to business risk. This case could have major impact on many of the esoteric covers being written in some 831(b) captives and whether the IRS will have some court guidance as to what is business risk as opposed to insurable risk. The ﬁght goes on! Gary Osborne is president of USA Risk Group. He can be contacted at: gosborne@usarisk.com

US Captive 2015

Much ado about captive life reinsurance Despite the fact that the legal standing of captives is not in question, doubts linger in some quarters as to their safety, as Michael Kasdin, Sandra Hauser, Carter White and Matthew Gaul of Dentons describe.

n June 2013 the New York Department of Financial Services (DFS) presented an alarmist report, Shining a Light on Shadow Insurance: A Little-known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk, which condemned many in the life insurance industry.

Specifically, the DFS challenged the use of captive reinsurance to manage capital and reserves. Dubbing this practice “shadow insurance”, DFS asserted that these arrangements amount to financial “alchemy” designed to hide financial weakness and inflate capital ratios—despite specifically approving many of the structures at issue. DFS ultimately concluded that these arrangements place the broader financial system at risk. DFS did not conclude that captive reinsurance is unlawful, nor did it seek to unwind or penalise any carrier who engaged in these transactions. Rather, it recognised that regulators, including those in New York, regularly approve these types of transactions. DFS also implicitly agreed that no disclosure rules had been violated by these transactions. After publication of the report, DFS did not pursue more aggressive rules governing reserves to clamp down on what it declared to be a dangerous practice. Instead, New York has actually reduced its reserve requirements, including significant reductions for universal life policies with secondary guarantees. Nonetheless, the report’s inflammatory analogies to the “subprime mortgage fiasco” and attendant financial crisis ignited a vigorous debate between and among insurance regulators and, predictably, class action litigation against many insurers employing these structures. The insurance industry has responded. In The Use of Captive Reinsurance in Life Insurance, an American Council of Life Insurers (ACLI)-funded study and analysis of captive reinsurance arrangements in life insurance from

US Captive 2015

May 2014, Professor Scott E. Harrington of the University of Pennsylvania states that “captive reinsurance arrangements are an important tool for efﬁciently managing capital and the gap between statutory and economic reserves for certain products.” Each transaction is closely monitored and approved “by regulators and rating agencies.” These transactions facilitate lower prices for life insurance, and in fact more insurance protection for more people, without excessive ﬁnancial risk. Captive reinsurance is not new, is not unique to life insurers, and is not “in the shadows”. According to the National Association of Insurance Commissioners (NAIC), captive reinsurers underwrite more than 25 percent of reinsurance policies for the US life industry. Regulators have known about these transactions for many years. New York and other states have been approving these transactions after a thorough review process—designed to ensure the transactions are safe to the insureds and to the system.

Capital management and captives It should go without saying that, as Harrington writes: “Other things being equal, insurers that hold more capital in relation to their liabilities have lower insolvency risk and receive higher ﬁnancial strength ratings than insurers with less capital.” In addition to simply providing an insurer with another tool to manage its surplus, the use of captive structures improves reserving ﬂexibility. Reserves clearly affect the amount of assets an insurer must hold. Because reserves increase the amount of liabilities an insurer is holding on its books, they increase the assets an insurer must hold. As such, reserves have a direct impact on the cushion of assets available to pay policyholder claims.

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SFIO CRACHO / SHUTTERSTOCK.COM

Dentons

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US Captive 2015

Harrington states that higher reserves, on average, require “higher premiums to cover the increased [capital] costs.” Managing capital through the use of captive reinsurance helps insurers maintain appropriate surplus levels while providing consumers with more affordable policies. Lowering the cost of providing insurance also increases the supply of insurance in the market, as even detractors of captive reinsurance would recognise. In the early 2000s, new regulations signiﬁcantly increased reserve requirements. Regulations XXX and AXXX required higher reserves. The assumptions used in calculating these reserve requirements are extremely conservative. They are infrequently updated and fail to take into account improvements in mortality and underwriting standards. Ultimately, these reserves far exceed the actual economic reserves necessary to pay claims. Recognising the burden imposed by XXX and AXXX, regulations were developed to speciﬁcally permit captive reinsurance. Using these rules, an insurer can cede risks to a captive and obtain statement credit for the cession. In so doing, the insurer reduces the assets it must hold. The risks have been transferred, so the ceding insurer can now redeploy capital that had previously been tied up. Speaking generally, a ceding insurer can receive credit where: •

The captive is authorised;

•

The captive’s obligations are backed by a letter of credit (LOC);

•

The ceding insurer withholds funds on its balance sheet;

•

Assets are placed in a trust account; or

•

The ceding insurer’s parent guarantees the transaction.

The most popular way to receive credit is by using an LOC. In these transactions, the insurer cedes its redundant reserves to the captive, and the captive secures its obligations with an LOC. In other words, using an LOC, an insurer is able to transfer part of its risk, via its captive, to an unafﬁliated bank. Again, this is heavily regulated. Captive reinsurance transactions must be approved by the ceding insurer’s regulator and, in many instances, by the captive’s regulator. Additionally, insurance rating agencies monitor these transactions. They have extensively studied and analysed the details and risks of captive reinsurance transactions in the life insurance industry, and factor that knowledge into their ratings.

The policy debate Following the publication of the 2013 DFS report, other regulators have publicly disagreed with the conclusions. Rather than impose a moratorium, the NAIC recently adopted new, far more lenient and practical actuarial guidelines for calculating reserves. This alternative encourages “principlesbased” reserving. A NAIC study group white paper further recommends improved disclosure, greater uniformity of regulation, and areas for further study—all without a moratorium or signiﬁcant new restrictions. “The fundamental challenge of insurance solvency regulation,” as Professor Harrington has described it, “is to establish ﬁnancial reporting rules, controls, and monitoring systems that help achieve the right balance between safety and soundness on the one hand, and the cost of coverage to consumers on the other.” In the end, the debate comes down to “how much is enough?”. Harrington’s study effectively de-bunks the “shadow insurance” view. He describes “how captive arrangements are used to manage capital and reserves”, explains the regulatory environment and the scrutiny regulators have given to these arrangements, and describes “the extensive evaluation of the arrangements by insurance rating agencies”. All of this work and research demonstrates that captive reinsurance is hardly “in the shadows”. A second part of Professor Harrington’s study, published in January 24

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“Evidence suggests that captive reinsurance arrangements generally provide a method of satisfying formulaic reserve requirements at lower cost to insurers and policyholders than would be achievable without such arrangements.” Professor Scott Harrington 2015, is titled The Economics and Regulation of Captive Reinsurance in Life Insurance. This “explores the prevalence, economic benefits and risks, and regulation of captive reinsurance arrangements in life insurance to provide context and insight to help inform the policy debate over the role and regulation of the arrangements.” It makes three points. First, it highlights “the development and oversight of captive reinsurance arrangements have received substantial attention over time” from regulators and rating agencies. Second, it illustrates “available qualitative and quantitative evidence suggests that captive reinsurance arrangements generally provide a method of satisfying formulaic reserve requirements at lower cost to insurers and policyholders than would be achievable without such arrangements, and without creating significant insolvency risk or systemic risk.” And finally, Harrington reviews the new regulatory framework adopted by the NAIC, concluding that it was not needed but probably prudent. Even critics of captive reinsurance see a policy question and not an issue of legality. Two economists on this side of the debate, Ralph Koijen and Motohiro Yogo, who have been vocal critics of captive reinsurance, do not allege that it is illegal.

Here come the lawsuits Litigation has naturally flowed from the DFS report. Plaintiffs have seized on the notion that insurers were deceiving the public about their financial strength, that the financial system might be in jeopardy, and that their policies may not be as ‘valuable’ as they thought. Class actions are now pending in several jurisdictions alleging various causes of action ranging from statutory violations to conspiracy to full-on offences under the Federal Racketeer Influenced and Corrupt Organizations (RICO) Act. The insurers are vigorously defending themselves, and they will no doubt be buoyed by the fact that even the DFS report concedes that these practices are lawful. Nonetheless, the pressure exerted by these cases can be immense, and it will be interesting to see how they impact the greater policy debate, and whether insurers are comfortable standing firm behind practices that appear, from all reasonable standpoints, to be a net benefit to everyone involved in the industry—including policyholders. Michael Kasdin, Sandra Hauser and Matthew Gaul are partners of Dentons. Carter White is an associate. He can be contacted at: michael.kaskin@dentons.com www.captiveinternational.com

MO CLOSE TO HOME

Montana court rules on legal status of a PCC Despite their common usage throughout the world, the legal status of protected cell companies has rarely been tested. A recent judgment by Montana Federal Court will make for interesting reading— and it should allay the fears of many, as Nigel Feetham, partner at law firm Hassans tells US Captive.

espite the rapid growth of the use of protected cell companies (PCCs) in many jurisdictions globally, there have been very few court cases that have tested the legal detail of this type of company. A June 2015 ruling by Montana Federal Court will make for interesting reading to captives professionals in all parts of the world. Although the ruling was in a US court, other jurisdictions will have looked on with interest. By way of background, Nigel Feetham, partner at law ﬁrm Hassans, points out that Guernsey was the ﬁrst jurisdiction globally to introduce PCCs. It did so in 1997 but many other jurisdictions followed soon after, including Cayman, Bermuda, Gibraltar and Malta.

reported court cases on the subject anywhere in the world and, until recently, none where a court has considered in detail the legal status of a protected cell company. Accordingly, the recent decision of the Montana Federal Court may now be regarded as the leading global judicial authority on the subject of PCCs. That case is Pac Re 5-AT v AmTrust NA, No. CV-14131-BLG-CSO, 2015 US Dist. LEXIS 65541 (D. MT, May 13, 2015). The question before the court was essentially who was the proper party to a contractual dispute concerning a PCC.

In more recent years a segregated company regime has been implemented in many states of the US, in the UK, Dublin and Luxembourg. There are now probably thousands of such companies conducting business internationally, although they have been especially popular in the insurance ﬁeld, Feetham says.

“In a declaratory judgment action arising out of a demand for arbitration by one party to another under a captive reinsurance agreement, the court held that the protected cell under the applicable local legislation was not a separate legal person from the PCC, did not have capacity to sue or be sued in its own name, and that since the protected cell had acted on behalf of the cell on a captive reinsurance agreement, accordingly the PCC was a proper party to the dispute,” Feetham explains.

Yet, surprisingly, there have been less than a handful of

As Judge Ostby pointed out, although the underlying issues in the

US Captive 2015

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Protected cell companies

arbitration were complex, the issue before the court was relatively simple. “A number of arguments were put before the court by both sides,” Feetham says. “One side argued that the relevant cell was the only proper party to arbitration because the cell, as a protected cell, had segregated assets and liabilities from the PCC and the other protected cells. “The other party argued that the PCC was a proper party to the arbitration on the basis that the cell was a non-existent legal entity, and as a result, the PCC was liable for the obligations it incurred in the cell’s name.” It was also argued that because Montana’s protected cell statute indicated that a protected cell was not a separate legal person from the PCC, the company was the proper party to be named in any litigation. “The court had no difﬁculty in reaching its decision,” Feetham says. “The court analysed the legal status of a PCC in detail and held that a protected cell did not have a separate legal identity, and absent a statutory grant to the contrary, a protected cell did not have the capacity to sue and be sued independent of the PCC. www.captiveinternational.com

“Consequently, the motion for summary judgment was granted to the cedant and the captive reinsurer was held to be the proper party to the arbitration.” Feetham says that the court’s logic was correct and that any argument that the proper party to the arbitration could be anyone other than the PCC itself was doomed to failure. “Based on the clear words of the relevant statute and reasoned analysis of the concept of the ‘protected cell’, the argument that the proper party to the arbitration could be anyone other than the PCC itself was doomed to failure from the outset,” he says. “For years, however, the industry has been concerned that a court might view the cellular structure as a complex Gordian knot and use its judicial sword to cut through it without proper legal consideration of the situation presented. “Instead in this case, it is gratifying to see that Judge Ostby (unlike Alexander the Great) patiently and intelligently untangled the knot by hand, in accord with long-standing insurance industry practice while leaving the cellular structure intact.” US Captive 2015

JIRI FLOGEL / SHUTTERSTOCK.COM

“The argument that the proper party to the arbitration could be anyone other than the PCC itself was doomed to failure from the outset.”

Overcoming data challenges in a regulated environment As the volume and types of data grow rapidly, tools are available that deliver control, auditability, efficiency and transparency over the entirety of a captive’s operations, as Ilka McHugh and Angus Rhodes of Ventiv Technology explain.

ith the strong rate of growth in the number of captives (7 percent annual growth, according to the Marsh Risk Management Research 2014 Captive Benchmarking Report), parent organisations certainly recognise the value from having their own insurance carrier.

It is certainly a good time to be in the business of captive management. At the same time, however, there are challenges caused by parent corporations continuously reviewing performance and value, plus everincreasing regulation. What may not be fully recognised is that effective data management is key to efﬁcient captive operations and also central to solving many of a typical captive’s challenges. Captives handling larger volumes of data, or with many data sources, cannot afford to ignore the demands arising from increased regulation and governance. Moreover, as business requirements change (for instance, adapting to a change in the risk management strategy of the parent) data management must evolve and keep pace with changing requirements. In short, there is a heightened need for efﬁcient operations in the captive, and effective handling of data is at the core of this need.

Key challenges and related opportunities Captives have never had a more acute need for accurate, comprehensive data. That’s because they must be very ﬂexible in their use of data: responding to reporting requests from parents, regulators and other stakeholders and satisfying growing operational demands. Businesses today demand efﬁciency and cost-effectiveness as a matter of course. 28

US Captive 2015

Captives must be well positioned to demonstrate their value to parents through, for example, managing cash flow effectively, aligning corporate and business-unit risk appetite, and flexibility to bring in additional programmes for coverage. It’s important to understand how data management is related to the key challenges captives face, with data being part of both the problem and solution. Compliance with Solvency II or the equivalent legislation, as well as expanding corporate governance around risk management, is a significant challenge for many captive managers. Today’s captive manager needs control, auditability and transparency over all operational data such as premiums and claims. Accurate figures are key, since reporting on gross and net positions and reinsurance arrangements will directly impact the capital the captive has to hold. Until recently many captives have underestimated the challenges in satisfying the parent company’s own financial reporting requirements. Yet it’s hardly surprising that corporate boards are calling for accurate, comprehensive reporting on the captive’s potential impact on the enterprise’s finances; after all, a captive is part of its parent’s balance sheet. Here again, data management is crucial to providing auditable financial transactions that cover, for example, all premium and claims-related activities and movements. Another challenge is giving actuaries the data they need to calculate capital requirements, claims reserves and premium allocations. Actuaries are being more forceful in their demands for a higher level of scope and detail, auditability and reliability in order to make these calculations. www.captiveinternational.com

And when captives go to market, commercial carriers are demanding extensive data for competitive pricing. Regulators are increasingly expecting captives to be run like commercial insurance carriers, including having proper risk management policies in place as well as ﬁt and proper people in key positions such as risk management, ﬁnance and audit. Furthermore, proper documentation is expected.

•

Manage legal compliance with Solvency II or its equivalent;

•

Provide auditable ﬁnancial transactions to cover all premium and claims-related activities and movements;

•

Manage loss exposures;

•

Manage the ﬂow of premiums and cash;

•

Access to accurate, comprehensive data is a prerequisite to activities such as:

Provide an auditable and transparent view of ground-up claim costs from the gross and net perspective;

•

Allocate and calculate premiums for global programmes;

•

Managing counterparty exposure;

•

Track captive incoming and outgoing premiums and commissions;

•

Meeting strict reinsurance policy and claim notiﬁcation time limits;

•

Monitoring aggregates and claim positions; and

Calculate and track proportional and non-proportional premiums per participant re/insurer; and

•

Managing premium cash ﬂows between corporate, captive, commercial insurers, reinsurers and business units.

•

Calculate premiums written to premiums earned.

Where to next? Using data properly will help to manage risk within the parent where visibility of the parent’s risk proﬁle and appetite is paramount.

How captives can harness the power of data Many captive managers handle their risk management needs with a variety of ad hoc (typically spreadsheet-based) and localised systems. As captives grow in complexity and responsibility, however, informal systems and processes often become inadequate. For many captives, developing and implementing a new technology solution is the answer to inadequate existing systems. The solution for them is a risk management information system that automates a broad range of processes, from underwriting to claims management to ﬁnance and corporate and regulatory reporting.

A clear driver to adopting technology is managing ever-expanding volumes of data—whether related to risks, policies or claims—and doing so with a set of disparate processes and systems. When considering an investment in technology, it is important to prepare a robust business case and identify the benefits that will arise from the investment. It’s also important to know whether your captive can benefit from a technology solution. Not every captive needs a specialised technology, and for those that do, there’s no one-size-fits-all answer. We invite you to learn more about data management and the technology solutions available (including determining whether and how they apply to your captive) by downloading our eBook, The Captive Insurance Company’s Guide to Overcoming Data Challenges in a Regulated Environment at www.ventivtech.com/captives

These systems usually integrate with existing ﬁnancial and other appropriate internal and external systems and should be able to: •

Manage complex insurance programme structures;

•

Handle complex allocation of claims ﬁnancials;

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Angus Rhodes is product marketing & business development director at Ventiv Technology. He can be contacted at: angus.rhodes@ventivtech.com Ilka McHugh is director of Solutions Consulting EMEA at Ventiv Technology. She can be contacted at: ilka.mchugh@ventivtech.com US Captive 2015

ALEXANDER SUPERTRAMP / SHUTTERSTOCK.COM

Data management

Leading the ďŹ eld Vermont remains the primary US state for captive formation and continues to go from strength to strength despite the soft markets, competition and regulatory threats. US Captive examines what has driven this success through the decades.

he US state of Vermont remains the leading domicile in the US for captive insurance companies, far ahead of rivals like Utah and South Carolina, its closest competitors.

Vermont licensed 16 new captives in 2014, according to data released by the Vermont Captive Insurance Division, taking the total number of captives domiciled in the state to 1,040 licences covering 584 active captives managing some $25.5 billion in gross written premium at year-end 2014. In contrast, Utah hosts around 400 captives and South Carolina some 230. Vermont has a long history of being a captive-friendly state. It was one of three in the US, including Colorado and Tennessee, which led the way in

US Captive 2015

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PATRICK BREIG / SHUTTERSTOCK.COM

Vermont

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US Captive 2015

passing legislation designed to attract captive insurance companies in the 1970s. However, while Colorado and Tennessee have developed more slowly in terms of developing their presence in this market, Vermont has never looked back and continues to storm ahead. The new captives formed in the state last year comprised 10 pure captives, two sponsored, two special purpose ﬁnancial insurers, one association and one risk retention group. Two new captives were also redomesticated, from Bermuda and Delaware. Growth in 2014 was down compared with previous years, the fall attributed primarily to the prolonged soft market and added competition from other US states.

A refreshing approach This has been a blip, however. Vermont has prospered in the captive market in recent years while other US states have not, something that Dan Towle, director of financial services of the State of Vermont, attributes to the state’s willingness to constantly reinvigorate its legislation and appeal. “Vermont was the first to give the business and regulation of captive insurance a fresh look and because of our success we have kept that same model going forward,” Towle says. “We are always trying to find new ways to do what we do better. That has been an important part of why we have been successful for more than three decades.” Dave Provost, the deputy commissioner of captive insurance, adds: “I think that Vermont’s size [it is the sixth smallest state in the Union] was— and still is—an advantage. A few jobs makes a difference in our small economy, and those few have grown to a few hundred. “That might not get noticed in many of the larger states, but it has a disproportionate impact in Vermont.”

“Vermont has always sought quality companies that want to be regulated in a manner consistent with their risk profile. We have never wavered from that model.” Dan Towle Towle also stresses that Vermont has always nurtured the quality of its offering; it has never chased growth at the expense of seeking quality businesses. “Vermont has always sought quality companies that want to be regulated in a manner consistent with their risk profile” he says. “We have never wavered from that model. We do not chase numbers simply for the sake of growth. “If there are 50 quality companies that come before us, we want to license them all. If there are no quality companies, we are not going to chase companies that don’t fit our profile. Because of this discipline, we have built a global reputation as the gold standard. “For more than three decades we have offered consistency, stability,

We are at the forefront of the insurance business. Locally, nationally and globally. Rely on us to create new solutions for new problems in this ever-changing marketplace. Dentons. The Global Elite law firm challenging the status quo.* *Acritas Global Elite Law Firm Brand Index 2013 and 2014.

US Captive 2015

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Defending the reputation Defending this lead comes as the industry copes with a number of threats to the captive market in general. One speciﬁc challenge came at the start of 2015, when the Internal Revenue Service (IRS) listed the abuse of captive insurers for tax purposes in its ‘Dirty Dozen’ list of 2015 tax scams. What advice does Vermont provide to make sure that companies can avoid being linked to this? Towle explains exactly what the IRS was looking at in some detail. “Let’s be clear,” he says, “the IRS did not list captive insurance on the 2015 Dirty Dozen, they listed 831(b) captives on the list. 831(b) captives are not a core market for Vermont and make up a very small percentage of what we license. If Vermont was a domicile that primarily licensed 831(b)s I would be concerned. “What I am concerned about is the reputational risk that these small captives may bring to our industry. In Vermont we license captive insurance experience and innovation all without any surprises. That has been the cornerstone to our success.” Of course, building such success is one thing—defending such a lead in the market is something else. Towle points out that captive insurance is a big business for a small state such as Vermont and that very few jurisdictions can say the same. As a result, Vermont has the ability to change its laws and react quickly to the ever-changing insurance marketplace. In addition, Towle claims that Vermont has never rested on its laurels and that the state is always trying ways to improve what it does. “Our governors and legislatures have always supported us and given us the resources needed to be successful,” he says.

companies for risk management reasons and any domicile that is doing anything but that does bring a risk to the industry as a whole.” Provost points out that at last count, less than 5 percent of Vermont’s captives made the 831(b) tax election. “Our philosophy in licensing any captive is that it has to make insurance sense. We expect companies to make all favourable tax elections that are available to them, but that has nothing to do with regulating the insurance company,” he says. “If we have a conversation with a company that is interested in forming a captive in Vermont, and the discussion is 20 minutes of tax talk before the word ‘insurance’ is uttered, we’re not likely to be accepting an application.”

Many challenges. One solution. Managing your captive is more demanding than ever. Ventiv Technology understands this and has been creatively solving risk management challenges for more than 40 years. Don’t take our word for it. Business Insurance magazine recognized our industry-first Combined Corporate & Captive Risk Management Solution with its 2015 Innovation Award.

Learn how Ventiv can help you at www.ventivtech.com/captives

Problem

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Solved

US Captive 2015

A mature environment for captives Kimone Moving, director of the Nevis Investment Promotion Agency, and Derek Lloyd, director of AMS Insurance (Nevis), review the figures from 2014 and speak to US Captive about the jurisdiction’s continued success and some of the challenges and threats facing offshore financial centres.

014 was another successful year in the ongoing development of the Nevis financial services industry and in particular for the captive insurance sector and its continued rise to prominence within the global standings for captive insurance jurisdictions. “Forty-six new entities were licensed as captive insurance companies in the domicile last year, together with three new reinsurance companies. Furthermore, four new insurance management companies were licensed during the year, taking the total number of insurance managers now registered in the jurisdiction to 18,” says Kimone Moving, director of the Nevis Investment Promotion Agency. “Early signs for 2015 suggest cause for similar optimism, with a number of new applications already approved for the year to date and the Registrar of International Insurance and his colleagues dealing with a further volume of current licence applications.” Derek Lloyd, director of AMS Insurance (Nevis), who has now entered his second decade of service within the group, has been involved with 34

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Nevis

the captive insurance sector in Nevis since enactment of the original insurance legislation in the territory, the Nevis International Insurance Ordinance 2004. “AMS Financial Group has had a physical presence in the jurisdiction since the late 1990s with its sister company, AMS Trustees (Nevis), and it was therefore a natural progression to establish AMS Insurance (Nevis) in the domicile on enactment of the international insurance legislation in 2004,” says Lloyd. “It has been an interesting journey over the last 10 years as the jurisdiction has climbed the ranks of captive domiciles globally and will no doubt continue to do so. AMS has been delighted to be a part of that growth as the domicile has continued to mature and evolve. “Like many of the Caribbean jurisdictions, a signiﬁcant proportion of Nevis’s captive business has emanated from US parent companies and continues to do so. However, the raised proﬁle and status of Nevis internationally has seen an increasingly diverse business stream coming to the jurisdiction in recent years, in terms of both insurance activity undertaken by the licensee and the geographical origin of that business.” Lloyd admits that the likes of Bermuda remain the domicile of choice for many of the major multinational reinsurance companies, but he says Nevis has an increasing reputation as the domicile of choice for the smaller start-up reinsurance entities seeking to establish a foothold in that sector. “Likewise, the appeal for potential captive owners from Europe, Asia and Latin American is presently gathering momentum, particularly for the latter two where the captive solution to alternative risk transfer mechanisms is relatively new as a concept in many of the countries,” he adds.

The Nevis offering There are a number of key factors behind the successful and sustained development of the jurisdiction. a) Consistency of approach from the regulator, the Nevis Financial Services Regulatory Commission; b) A pragmatic supervisory and regulatory regime;

BOYTSOV / SHUTTERSTOCK.COM

c) A cost-effective professional and regulatory fee environment for the captive to operate in; and

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d) Flexibility of legislation to allow captive owners to run their captives. From the commencement of licensing back in 2004, the Nevis regulators have made themselves readily accessible to insurance managers and captive owners alike. As the volume of business has grown in the domicile, additional resources have been added to the regulatory body to maintain a consistent level of service that now spans 10 years. US Captive 2015

There is total transparency in terms of the beneficial owning and corporate structure within any licensed and regulated insurance entity and extensive due diligence is required for anybody owning, operating or acting as a director to a licensed and regulated insurance entity from within Nevis. The regulators pride themselves on maintaining the ability for pragmatic supervision and regulation of those entities. In common with many jurisdictions, 2015 has seen the first regulatory fee increases imposed since enactment of the original legislation with proportionate increments to the current application and licensing fees for the different types of regulated insurance entities. However, the jurisdiction still offers a competitive environment for the potential captive owner to establish its new entity in respect of both regulatory and professional fees. . Similarly, the legislation further allows the captive owner to make its own practical decisions on the running and operations of the company itself, whether that be the appointment of local or international legal counsel, the engagement of local or international auditors, the hosting of board meetings within the jurisdiction or not and the flexibility to have the bank account(s) wherever may be most appropriate for the individual entity, whether that be within the international banking system or, commonly, with the same financial institution as the parent.

Challenges for Nevis—and elsewhere While it is generally an upbeat message coming from the Nevis ﬁnancial services sector, Lloyd feels that it would be naïve to believe that no continued challenges remain to be met by Nevis and other international ﬁnancial centres. Such challenges fall into the following areas: 1.

Competition;

External regulatory bodies and government agencies; and

International banking.

The growth in both captive entities and the number of domiciles now providing captive registration and licensing is a regular topic within the captive insurance media. Lloyd feels strongly that, as in any walk of life, competition within the industry is generally healthy. “It inevitably provides wider choice and greater value for money to new and prospective captive owner alike. It should also ultimately improve service standards throughout the industry,” he says. “Whether there is sufficient business to support the current volume of jurisdictions and service providers that have emerged in recent years is a moot point and certainly subject to debate at present. Many of the newer domiciles are individual US states, seeking to capitalise on a mixture of patriotism, political and media-generated paranoia about the international financial centres and lucrative, commonly tax-driven, incentives to bring existing captive business domiciled outside of the US back to the US in general and, commonly, to the home state of the parent company itself.” Further challenges lie in providing knowledge and understanding to the international regulatory bodies overseeing the captive industry and in turn, addressing the often-seen media bias and resultant public misperceptions that commonly exist toward the sector generally, and to international finance centres. Since the global economic crisis back in 2008, international bodies such as the International Monetary Fund, the Organisation for Economic Cooperation and Development, the Financial Action Task Force and the EU have understandably and correctly sought a commonality of operating standards and tax transparency within some of the smaller jurisdictions. “Such operating standards and transparency have existed in the captive sector globally since long before the economic crisis,” says Lloyd. “This is commonly at a much higher level than certain of those bodies wish to 36

US Captive 2015

“It has been an interesting journey over the last 10 years as the jurisdiction has climbed the ranks of captive domiciles globally, and will no doubt continue to do so.” Derek Lloyd regulate their service providers and customers in their own back yards.” Something that has bemused him in recent years, he says, is both a lack of understanding and a lack of desire to have any understanding of the licensing and supervision of captive insurance companies in jurisdictions such as Nevis. “For all beneficial owners and directors of a licensed and regulated insurance entity there is a full and comprehensive vetting process, from both the licensed and regulated service provider and the regulatory authority itself,” he says. “This includes on a personal level, bank and professional references, notarised photo ID, criminal and anti-money laundering affidavits, utility bills confirming residential address and corporate due diligence including submission of audited financial statements and tax returns for the operating companies. “Furthermore, among the US parent companies licensed and regulated in Nevis, almost unilaterally they seek 953(d) election under the Revenue Service Code meaning that they are a foreign insurance company duly registered with the IRS as a domestic US corporation for tax purposes.” However, Lloyd believes, the biggest threat to the current status quo is the global banking position. “The implementation of the Foreign Account Tax Compliance Act (FATCA) and other similar reporting programmes has created an environment of fear and uncertainty in many quarters, causing a number of international banks to no longer wish to deal with entities owned and operated by US citizens, and US banks are becoming increasingly reluctant to open accounts for international business companies. “Whether that situation is individually motivated by the financial institutions themselves or part of a wider political agenda remains a matter of some debate at present.” Lloyd concludes that Nevis and the other international finance centres can only endeavour to continue to meet these challenges head on, and to persist in a transparent and professional manner in the conduct of their business. Kimone Moving is director of development and marketing at Nevis Investment Promotion Agency. She can be contacted at: kmoving@nevisfinance.com Derek Lloyd is director of AMS Insurance (Nevis). He can be contacted at: derek.lloyd@amsfinancial.com www.captiveinternational.com

BUILDING A STRONGER VOICE FOR THE CAPTIVE INDUSTRY As the only global domicile-neutral captive insurance association, CICA leverages its neutral status to forge collaborative relationships and grow a stronger, more impactful voice for the captive industry.

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A winner in the domiciles sweepstake

US Captive 2015

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South Carolina

South Carolina was one of the first states to legislate in favour of captives. Jay Branum, South Carolina’s director of captives, explains to US Captive how its adherence to robust regulation and professional ethos means it remains in a good position to fend off the challengers. How do you view the proliferation of onshore domiciles in the US, and how do you think things will shake out over the next five to 10 years? If you look at the proliferation of states in the US that have passed captiveenabling legislation within the past ﬁve or six years and ask yourself how many of those states are likely to achieve something like critical mass, it’s very difﬁcult to see how most of them will, for a number of reasons. For one thing, it takes time and a sustained investment approach on the part of any state that aspires to ‘play home’ to an appreciable number of captives and appeal to a broad range of prospective captive owners—in other words, to build a solid portfolio. The economics of state government do not support the build-up of regulatory resources on anything other than a piecemeal basis. By regulatory resources I mean a staff fully dedicated to the captive sector with a proper understanding of its distinctive dynamics.

SERGEY NIVENS / SHUTTERSTOCK.COM

Beyond that, the economics of the captive management business model will simply not support the concentration of resources at ofﬁces in more than a handful of states—certainly not in this age of electronic record-keeping, ﬂexible delegations and workload balancing, and the widespread use of remote working arrangements. The bulk of captive management work will be done in those locations where it makes most sense in the context of the particular captive manager’s operations. So I think that most of the relative newcomers to what I sometimes refer to as the ‘domiciles sweepstakes’ will struggle to project a compelling value proposition that will allow them to differentiate themselves and build critical mass. And I certainly don’t see any plausible or realistic scenario for the emergence of a thriving captive programme and captive business sector in dozens of different states within the next decade.

Do you regard this proliferation phenomenon as a positive or a negative for the captive movement overall? Does it raise any particular concerns for you? I don’t think it necessarily has to be viewed as either a positive or a www.captiveinternational.com

negative. As I have often said, choice is a good thing, and to the extent that captive owners have more choices, that is good for them. However, I also think that a number of regulators and practitioners share a concern that in their drive to license more and more captives, some domiciles may apply a lower degree of scrutiny both at the licensing stage and as a matter of ongoing solvency and compliance monitoring. Should that trend manifest itself over time in captives with solvency problems, unsound business plans, patterns of troubled operations and sloppy compliance and the like—especially in domiciles with minimal capital and surplus requirements, token filing requirements, and the absence of financial condition examinations—then you can expect to hear charges that captive regulators are indulging in a ‘race to the bottom’. There will be louder calls for more stringent and more uniform regulation of the whole captive sector, and perhaps even efforts to subject captives to the kinds of requirements that are more appropriate to the traditional insurance sector, but which are wholly inappropriate to captives and not at all in keeping with the ‘principle of proportionality’ embraced by the International Association of Insurance Supervisors (IAIS). My view is that if market forces are allowed to dictate the direction and results of this proliferation trend without regulatory overreaction by forces at either the National Association of Insurance Commissioners (NAIC) or the federal level (forces that are likely to have little understanding of the captive sector and may even be hostile to it) then the captive sector will be just fine. Captive parents will make the choices that further their own interests and managers will do the same. Some captives will go ‘belly-up’, as undoubtedly they should, just as others will be shut down because they no longer meet the changing needs of their parents. The pendulum having swung too far in the direction of proliferation, it will sooner or later swing back in the direction of consolidation. Some states’ programmes will become dormant or moribund—I am not rash enough to predict which ones—especially as overall economic conditions continue to improve in those states.

What was it about South Carolina that attracted you to take your current assignment? When I arrived in South Carolina in November 2013, I found two assets of inestimable importance to the state’s position and prospects as a domicile. The ﬁrst was a dedicated captive team within the department built over the near decade-and-a-half since the inception of our programme in 2000. That team includes seasoned captive professionals with a strong background in the industry working alongside exceptionally talented ﬁnancial analysts, all focused exclusively on the 250 or so captives that had been established in our state up to that time. Clearly, the Palmetto state had long since achieved critical mass in numbers of captives licensed and in acquiring and developing captive expertise within the department. US Captive 2015

The second source of strength was a high concentration of professional captive service providers resident within South Carolina. Charleston in particular has developed into a real captive hub. Virtually all the global captive management firms have professionally staffed offices in Charleston from which they provide management services to captives domiciled not only in South Carolina but also in Delaware, the District of Columbia, North Carolina, Tennessee and states outside the south east region. In almost every case, the individuals who run their firms’ captive management offices in South Carolina have transferred in from other long-established captive domiciles such as Bermuda, Cayman, and Vermont, and have brought with them a wealth of practical experience and captive-specific know-how gained from years of working elsewhere

“Facilitating the creation and build-up of value for captive owners over time is the bottom line rationale, the raison d’être of our whole sector.”

in the captive sector. During 2014 four new captive management ﬁrms opened ofﬁces in

the ranks of other prominent management ﬁrms with a long-standing

Is there a regulatory philosophy or set of values that you would like to be identified with as chief regulator of and advocate for the South Carolina captive programme?

presence in the state—companies such as Marsh, Aon, SRS (Strategic

Absolutely. It boils down to four things. The ﬁrst is professionalism across

Risk Services) and USA Risk Group. This is what critical mass really looks

the board and closely allied to that is the second, which is consistency of

like—not just the sheer number of captive licences issued.

execution. Both of those relate to the internal workings of the department.

Charleston and moved experienced personnel into the state to run those ofﬁces: Willis, JLT Towner, Somers Risk Consulting, and R&Q joined

These moves represent very real investments in South Carolina by these individuals and their families, as well as by their employers, all to

The third is the quality of our portfolio of captives—we don’t want to be licensing rubbish. Quality trumps numbers of licences on our scale

the beneﬁt and betterment of our whole captive programme. The result

of values. And if companies do get into trouble with their solvency or

is a cluster of professional captive service providers—a genuine captive

any other aspect of their operations we need to ﬁnd out why and take

community resident within the state—largely concentrated in Charleston,

appropriate steps to put them on the path toward full compliance in terms

but to a lesser extent also in Columbia, and Greenville, South Carolina.

of ﬁnancial and operational soundness, or be prepared to do whatever

This is a tremendous asset to our domicile and sets us apart from every

else the statutory regime calls for under given circumstances.

other onshore domicile with the exception of Vermont.

The fourth and ﬁnal thing is probably the most fundamental and most

The bottom line is that South Carolina had all the ingredients to

easily overlooked, and that is to emphasise the element of owner choice

consolidate a position alongside Vermont, and perhaps one or two

and owner value. In essence, none of this activity takes place if the

others, in the top echelon of onshore domiciles. It just needed a new

captive service providers—the captive managers, the consultants, the

approach to some old issues and challenges—new ideas, a sustained

legal and other advisers—as well as the regulators, aren’t about providing

dose of high energy and an insistence that our policies, practices, and

prospective and actual captive owners with smarter, more sophisticated

procedures all need to make sense.

and individually tailored ways to help manage and ﬁnance risk. Captives cater to that need.

What changes and accomplishments can you point to during your tenure to date? In my ﬁrst few months on the job, we mapped and critiqued each step of all our internal processes with particular focus on the application and licensing process, which we totally revamped to eliminate redundancies and needless red tape. These process improvements are, and will continue to be, ongoing. We also started to pay more attention to staff development and undertook a range of new marketing initiatives. All these steps were preceded by sitting with captive managers during

As we each play our respective roles in the process, we should not lose sight of the fact that what we are really doing or should be doing is facilitating the creation of something of value that hopefully will be sustainable. Facilitating the creation and build-up of value for captive owners over time is the bottom line rationale, the raison d’être of our whole sector, and I don’t hear other people out there articulating that particular message. It seems to be taken for granted at some level, but I don’t think that we can afford to do that. That element underpins everything that we do and we shouldn’t allow ourselves to forget it.

my ﬁrst week on the job to hear about their perceptions of the domicile, their experiences in dealing with the department, their frustrations,

Anyone can say ‘we’re a business-friendly’ or a ‘captive-friendly’

challenges and opportunities. These sessions yielded invaluable insights

state and mean it, but it takes a lot more than that in order to be a

as well as practical information of great use in identifying and addressing

credible captive domicile. You have to let people know that you have an

internal and external issues.

understanding of the business itself and the reasons that companies form captives in the ﬁrst place. I believe that regulators would do well

I saw right away that there was no shortage of opportunities to make big improvements fast and to see them bear fruit. By moving forward quickly on multiple fronts, we were able to attract and license 20 new captives in 2014, compared with only three during 2013. Importantly, we did so without lowering our prudential standards. Four of those 20 new captives were established pursuant to enhancing legislation passed in June 2014, which allowed the formation of a wider range of cell company structures on either an incorporated or an unincorporated basis. 40

US Captive 2015

to (a) acknowledge and respect the ﬁnancial and risk management imperatives that drive business owners and executives to establish these insurance subsidiaries, and (b) to adopt a regulatory approach that is commensurate with the nature, scale, and complexity of the activities and risk proﬁle of each individual captive.

Jay Branum is South Carolina’s director of captives. He can be contacted at: jbranum@doi.sc.gov www.captiveinternational.com

A transforming environment

The US captive landscape has changed greatly over the past 10 years. Maria Sheffield from the Missouri Department of Insurance examines what some of these changes have meant, the innovation in structures that has taken place, various IRS decisions and the impact of Obamacare.

aptives continue to flourish with increasing momentum in the US, even with—and despite—the many changes we have seen in the captive landscape. As we congratulate US Captive on its 10th year of publication, I thought it appropriate to reflect on this remarkably resilient industry that will continue to face both opportunities and challenges as we look to the future.

Traditionally, growth in the captive insurance market was driven by insurance market contractions; a reaction to market conditions. Captives today are a more sophisticated approach to self-insurance and are a part of the strategic risk management plans of companies both large and small. As the industry has changed, so has the environment in which captives are formed. In honour of US Captive’s 10 years of covering the US captive market, I developed a top 10 list of the most dramatic regulatory changes that I believe have affected the captive industry in the past decade:

(1) Proliferation of US domiciles Domicile choice is now more complex and reﬁned. More than 35 states have enacted some form of captive legislation, with a majority of these states passing or reﬁning legislation in the last 10 years. In 2014 there was a net increase of 365 captives formed in US domiciles, which represented 80 percent of the net global growth of captives. This rapid growth has led many to ponder whether the required expertise to support the industry is available in all domiciles.

US Captive 2015

Not all new captive domiciles are attracting the same type of companies and no doubt differences between domiciles will likely become more apparent over time.

(2) NAIC involvement The National Association of Insurance Commissioners (NAIC) has increasingly become involved with matters affecting captives. The possible addition of captives to the deﬁnition of “multi-state reinsurer” drew a very loud response from the captive industry. The proposed change was originally intended to include Regulation XXX and AXXX captives but due to what was believed to be broad and vague language, there was great fear that all captives would be included. An expedited comment period increased concerns. In May 2015, the Financial Regulation Standards and Accreditation Committee of the NAIC adopted proposed revisions to the Part A: Laws and Regulations Accreditation Preamble which would include regulation of those captives and special purpose vehicles (SPVs) that assume XXX or AXXX business, variable annuities and long-term care business.

(3) Micro captives These captive insurance companies, which are writing less than $1.2 million in premium a year, may elect to be taxed only on investment income, as per section 831(b) of the Internal Revenue Code should the captive meet certain risk-shifting and risk-distribution requirements.

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Missouri Department of Insurance

This type of captive has accounted for the largest number of captive formations in the past 10 years and has led to signiﬁcant growth in domiciles that have chosen to focus on these smaller captives. This rapid growth has caught the attention of the Internal Revenue Service (IRS) which has chosen to focus on what it sees as abusive behavior. While each captive regardless of size should be measured against traditional tax tests imposed by the courts, it is anticipated these smaller captives will continue to face increased scrutiny.

(4) Implementation of healthcare reform Whether you like to call it Obamacare, or the Patient Protection and Affordable Care Act (PPACA), or simply the Affordable Care Act (ACA), there is no question changes to the delivery of health insurance have been, and will continue to be, front and centre for employers. As employers have implemented ACA requirements, many organisations with fully insured health beneﬁt plans and relatively healthy workforces have seen their premiums go up. This development has, in turn, spurred great interest in self-insurance and captive insurance programmes as well as debate in some states over the deﬁnition of stop-loss as more employers are looking to offer stop-loss in their captives.

(7) Federal home loan banks (FHLBs) The interest of Real Estate Investment Trusts (REITS) in setting up captives to access the FHLBs led to the FHLBs jointly agreeing to a three-month moratorium on admitting captive insurers in June 2014. This was a surprising move as the Bank Act has permitted all insurance companies— without qualiﬁcation—to be eligible for membership in the FHLBs for more than 84 years. Although the Federal Housing Finance Agency has provided no indication as to whether it will continue its quest to change the current membership requirements of the FHLBs, many of the banks have now started once again to process membership applications of captive insurance companies.

(8) Original coverages Emerging risks are more complex and traditional risks are occurring more frequently. Increasingly, companies are looking beyond the traditional property and casualty risks to focus more attention on an array of emerging risks, including cyber security, extreme weather and executive liability issues. Over the years there has been a developing trend of captives serving as a sort of incubator for new coverages that are slow to develop in the traditional market.

(9) XXX and AXXX With January 1, 2016 set as the date for full implementation of Solvency II, the directive that has been more than 10 years in the making, many in the captive industry are now proceeding with final preparations. Solvency II will obviously affect captives as a subset of the overall insurance industry just as US solvency modernisation implementation will have an effect on overall capital requirements. As insurance regulators continue to look for more efficient ways to ensure solvency and better assess when a company is in a hazardous financial condition, captive management will become increasingly complex.

(6) Federal interest While captive insurers are regulated at the state level, the federal government is becoming increasingly interested in the captive insurance market. A Federal Insurance Ofﬁce (FIO) report in December 2013 included recommendations on captive reinsurers. Congress has also taken an interest as legislation has been introduced in both the US House of Representatives and the US Senate to increase the premium limitation on small insurers—831(b) captives—for federal tax considerations. This heightened federal interest has the potential to affect both the cost and the complexity of captive structures.

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An important regulatory modernisation issue for the NAIC has been the regulatory framework for calculating life insurance reserves. Life insurers have traditionally used captives to ﬁnance redundant reserves required in the NAIC rule-based environment to obtain surplus relief. The ﬂexibility allowed by some states in the establishment of the special purpose captives continues to be a source of debate at the NAIC. The generally agreed-upon solution is to move from the rules-based approach to what is known as principle-based reserving (PBR) which some believe will minimise the need for life insurer-owned captives.

(10) International issues These include the expanding efforts of the International Association of Insurance Supervisors (IAIS), such as the May 2015 draft of the Application Paper on the Regulation and Supervision of Captive Insurers. The increasing pressure from international regulatory bodies for more uniform regulation of captives means captives undoubtedly face future regulatory, tax and legal challenges which may not be easy to predict but will most likely create more compliance issues. Maria Shefﬁeld is the captive programme manager in the Missouri Department of Insurance. She can be contacted at: maria.shefﬁeld@insurance.mo.gov

US Captive 2015

MARKUS GANN / SHUTTERSTOCK.COM

(5) Solvency modernisation

US Captive 2015

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BVI

The new era of captive waves

As one of the world’s leading international business centres, the British Virgin Islands is well poised to take advantage of the growing number of opportunities in the offshore captive insurance market with its competitive rates and strong regulatory environment.

he British Virgin Islands (BVI) prides itself on being a ‘onestop shop’ for financial services including fiduciary services, trust and estate planning, fund establishment, administration, ship, mortgage and aircraft registration services, and the formation and management of captive insurance companies. With such a comprehensive offering, the BVI as a jurisdiction is excited about its ability to provide a wide flexible range of captive solutions. BVI is a compliant, well established and highly sought-after internationally recognised insurance centre. Pioneering, innovative and leading the way in global business solutions, the BVI is known for connecting markets, empowering clients and facilitating investment, trade and capital ﬂow.

EPICSTOCKMEDIA / SHUTTERSTOCK.COM

The lines of business are wide-ranging due to the ﬂexibility of a captive. Typical risks run from property and casualty and D&O through to unusual risks that cannot be insured in the traditional marketplace (such as a pandemic, pollution, cyber attacks). As businesses expand into North American and other markets, insurance programmes are framed to provide cover to multinational and jurisdictional risks and new exposures.

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The rise in interest for risk transfer programmes offshore can be directly attributed to a number of factors and the need for more sophisticated products to address growing risk appetite. However, one of the main hurdles is increasing awareness of the risk management solutions available so that shareholders and managers understand the benefits and operations of a captive. For example, a large multinational with a risk profile to manage can benefit from a captive, with direct access to the reinsurance markets. A company may also need a suitably rated fronting carrier acceptable to the jurisdiction and access to skilled professionals, and may also wish to consult with experts and conduct a feasibility study. As an US Captive 2015

internationally recognised jurisdiction embedded in the global economy, the BVI remains well-positioned to offer solutions for employee beneﬁts in varying industries worldwide.

No requirement to hold board meetings in the BVI

From a regulatory standpoint, BVI legislation allows for the formation of BVI business companies to carry out regulated activities with the relevant approval from the Financial Services Commission, the BVI’s regulatory body. With respect to insurance licensees, the legislative provisions allow for the formation of legitimate captive insurance structures that meet the captive owner’s needs in properly mitigating and managing risk.

records. This can save an entity signiﬁcant cost, time and effort.

In preparation for the wave of captive opportunities on the horizon in the US market, the BVI has managed to propose two (2) new categories of licences:

No statutory requirement for directors

Category E: Pure captive—related party business-only lightened regulations (notiﬁcations for changes such as shareholder, director and senior ofﬁcer, audit exemptions, etc). Category F: Captives writing related party business with a maximum unrelated party (third party) business in order to qualify as an insurer for any purpose under the laws of a foreign jurisdiction.

Board meetings can be held in another jurisdiction as long as proper minutes are taken and those minutes are then ﬁled with books and

No requirement to capitalise a captive in the territory with a BVI bank Funds can be deposited in an account in the US and—provided the entity’s captive manager receives bank statements and evidence that there is capital in accordance with the law in the bank account—there is no requirement to have the account in a bank situated in the BVI.

Directors do not have to be in the BVI and the captive can have professional and back ofﬁce support anywhere to suit its business. Politically stable environment BVI has a very stable political and economic jurisdiction based on UK common law or in the case of ﬁnancial services, international law, making it an internationally recognised, business-friendly jurisdiction in which to carry out captive business.

Removal of the strict arrangement between general and long-term insurance, ie, strictly segregated and classiﬁed—to be classiﬁed as property and casualty or life and health—provides the Commission with the ability on a case-by-case basis to issue a licence to an insurer to carry on property and casualty and life and health insurance business.

The domiciliation of a broad range of international captives

Segregated portfolio or cell formations will require the Commission’s written approval. Currently, segregated portfolio companies (SPCs) may be formed under the BVI Business Companies Act, 2004 to carry on insurance business.

Sound legislation

Why the BVI?

competitive and at the cutting edge.

The BVI offers a number of advantages for captives considering it as their domicile of choice.

of local expertise can be a major deciding factor in choosing a particular

Maintenance of strong international regulatory standards BVI has signed a numerous tax information exchange agreements in recent years that place the domicile on the OECD’s ‘white list’ of favourable global domiciles. The legislation and regulation are ﬂexible in their application, and compares favourably to the main competing jurisdictions. Comparatively low unit costs of labour It is relatively easy to get affordable support staff. If one compares jurisdiction costs with those charged in other domiciles, the BVI remains very competitive.

The domicile is more global in terms of captive formations, with a signiﬁcant portion of captives being from East Asia and Russia. This again helps to strengthen the reputation of the BVI’s offering internationally.

Clients of the BVI continuously beneﬁt from our evolving legislation which ensures international standards are applied, our reputation as a trusted and reliable jurisdiction is upheld and our products remain

For those considering a captive domicile, the availability and ﬂexibility jurisdiction. In tune with this important consideration, the BVI is wellpositioned to attract captives to its shores, with the domicile boasting a sizable bench of captive talent. A quick visit to the BVI regulator’s website (www.bvifsc.vg) provides some indication of the level of talent resident in the islands. Among the insurance entities that call the BVI home are an impressive array of 13 insurance managers and 17 insurance agents all of whom work closely with the captive market. There are also four brokers and ﬁve loss adjusters servicing the market and a growing pool of captives—most with parents based in the US—that have opted to domicile in the BVI.

Tiered fee structure* for captive insurers, based on gross written premiums similar to those of domestic insurers. The proposed tiers are:

The BVI plays host to a number of leading accounting and fiduciary firms and international law firms with truly global footprints, offering captive owners a diverse range of world-class insurance, accounting, claims handling and legal expertise to satisfy all their captive needs.

• GWP of $500,000 or less • GWP of $500,001 up to $999,999

About BVI Finance

• GWP of $1,000,001 to $4,999,999

BVI Finance is the marketing and promotional arm whose mandate is to project the jurisdiction’s position as a pioneering, innovative leader in global business solutions, and as an internationally respected finance centre. For more information visit www.bvifinance.vg

• GWP of $5,000,000 to $9,999,999 • GWP of $10,000,000 and above *Fee amounts have not been finalised

US Captive 2015

www.captiveinternational.com

W o r l d

C l a s s

CAPTIVE K n o w - H o w

South Carolina has long been one of the nation’s premier captive domiciles. In partnership with the captive business community, our Captive Division continues to set the standard for excellence among America’s captive domiciles. What sets our domicile apart from all the others? FIND OUT. Visit us at captives.sc.gov

The Pursuit of Captive Excellence BO TA NY BAY P L A NTATIO N C H A RLES T ON , S OUT H C A ROLIN A

State of South Carolina Department of Insurance Captive Division

capitol center  main street, suite  | columbia, south carolina  captives.sc.gov