Jean-Paul Louisot reports on key trends in the captive insurance market from the Captive Insurance Companies Association conference held in Arizona
The growth of the captive insurance industry in the US, as part of the overall interest for alternative risk transfer mechanisms to finance risk, is a major trend of the last two decades. This growth has benefited both the property/casualty insurance sector and the employee benefit sector.
However, this growth is largely due to a greater acceptance by mid-size corporations and they are largely responsible for the sustained growth as regional firms are beginning to embrace the captive insurance mechanisms as part of their overall finance strategy. That may be one of the driving forces behind the growing interest for “on-shore” domiciles.
Indeed, what strikes the first-time visitor from Europe is the number of states of the US represented with booths and participants at the recent Captive Insurance Companies Association conference held in Arizona. Industry veteran, Vermont, was there along with Hawaii, while many western states were present, including Nevada and the local rising star on its own territory, Arizona, home to several-hundred captive insurers.
But “The First State”, Delaware, had a prominent place along with Washington DC with their new legislation on protected cell and incorporated cell companies. In fact, a total of 30 of the 50 states have now enacted legislation to facilitate the incorporation of captive insurance/reinsurance companies on their statute books. The latest to join the band, Michigan, approved new legislation while the conference was taking place.
Clearly, the latest trend in domiciled insurance companies is “on-shore”. No wonder then that the proposed Internal Revenue Service regulation was fought tooth and nail by a vast alliance led by CICA.
The proposed captive insurance regulation would have eliminated a key tax benefit for insurers that cover another member of a consolidated group, included in a consolidated federal return. To make a long story short, the tax benefit of incorporating an insurance company would have been wiped out and the reserves (especially the incurred but not reported) treated as a non-tax deductible expense. Clearly this would have penalised severely the “on-shore” domiciles.
However, in the words of outgoing CICA chairman, Les Boughner, in his announcement of the great news on the opening of the conference: “We have won a great battle, but the war goes on.” Or to quote the warning by Caroline McDonald in a recent issue of National Underwriter: “While captive backers have earned the right to celebrate (and indeed the chair opened a bottle of champagne at CICA’s conclusion session on tax issues), they want to keep in mind the IRS doesn’t give up easily, and that other battles will need to be fought.”
Actually, the amazing turn of events is that the IRS withdrew its proposal before going into public hearings. It seems that the technical argument developed by the lawyers hired by CICA and associates convinced tax authorities behind closed doors, but one cannot but wonder if some state officials did not add their voice at the prospect of a possible massive ‘redomestication’ of on-shore captive insurance companies, so actively courted in the last decade.
The major motives for choosing a domicile remains pretty much the same. Taxes are a major consideration of course, but the capital requirements should not be underestimated, as well as access to the reinsurance market and the existence of a strong financial environment. Finally, should the owners’ desire to do business in an exotic locale be completely ruled out? Well it may play poorly at stockholders’ annual meetings, in which case, for American companies, Vermont would clearly look more frugal for an East Coast-based company, and Arizona for a West Coast-based company. And that may be part of the reasons for their respective successes.
Segregated cells
Another American specialty are the risk retention groups, which have been allowed to retain and mutualise risks without incorporating an insurance company as such, especially in areas where the market offered no or scant cover like professional indemnity in the healthcare field.
On the other hand the marked interest of the mid-size market to the captive insurance world called for specific solutions whereas multi-parent bodies have sometimes proved risky, especially if some ‘bad apples’ make their way into the ‘mutuality’. This is precisely to avoid good accounts being contaminated by the bad ones, and reason why the concept of segregated cells was invented.
The segregated cell is isolated from the results of the other cells and even the general creditors of the holding company. However, they have proved difficult to move and some domiciles now allow the cells to be incorporated separately, thus improving portability. However, the question of the validity of an insurance transaction could be raised by the IRS if the segregation is really effective, unless the cell itself represents enough mutualisation for which employee benefits offer a solution as the beneficiaries are all the employees and their families.
Not lacking imagination, the big brokers have come up with solution to offer vehicle for diversification to their clients. Established in 1997, the Green Island Reinsurance Pool is the facility available to Marsh-managed captive insurers. Through the pooling mechanism, captive insurers assume and cede premiums and losses among a group of participating bodies. Thus, they are left with unrelated risk, one of the key elements the IRS looks for when determining if a captive is an insurance company for tax purposes. Furthermore, the loss stability produced by the pooling mechanism serves to stabilise cash expenditures for participating companies.
Jean-Paul Louisot is senior director knowledge resources, IIA, and dean of curriculum, CARM Institute