The good and bad in captives regulation

David Kirkup, CFO and COO of Captive Alternatives (CapAlt)

What were the most important events in captives insurance in 2016?

1. There were two important regulatory bookends on the year with the Protecting Americans from Tax Hikes (PATH) Act of 2015 in January, and the Internal Revenue Service (IRS) Notice 2016-66 at year’s end which requires extensive disclosure by captive managers and owners. Both notices were ambiguous and poorly worded, leading industry pundits to pore over the implications for the future of captives.

Nevertheless, we see some good news in both events. The PATH Act increases maximum premium limits to $2.2 million, which we take as a vote of confidence by Congress in the captive movement. The 2016-66 disclosure notice is designed to identify poorly designed captive programmes that fail to meet the guidelines set out by various safe harbour rules. This may well help to reduce competition, and to highlight those programmes, such as CapAlt’s, that operate strictly in accordance with those rules.

2. CapAlt solidified its relationship with Puerto Rico during 2016, and saw a much higher level of visibility for the island’s unique insurance and tax advantages. At the end of 2016 we approached the insurance commissioner of Puerto Rico with a revised business plan, and were successful in obtaining pre-authorisation for up to 2,000 new captives.

3. The Panama Papers were an unprecedented leak of 11.5 million files from the database of the world’s fourth biggest offshore law firm, Mossack Fonseca. They cast a negative light on some of the well-known offshore captives domiciles, which may make it harder for these jurisdictions to continue to develop new captives business.

What are the topics you expect to be the most prominent in the industry in 2017?

1. Puerto Rico will continue to develop coverage and awareness as a new destination for captive development.

2. The Trump administration will have an effect on development of new captives, although it is unclear how it will pan out. While lower tax rates may reduce demand for captives, lighter regulatory burdens may reduce the negative spotlight on captives.

3. Employers will look at self-insured health plans more closely and we will see an increase in mid-size employers opting for better cost control through the use of captives and stop loss coverages.

4. Interest in captives will continue to grow in Asia and Latin America as the advantages of risk financing and control through captives becomes clearer.

5. Medical and recreational cannabis industries will grow at an accelerating rate, and increasingly will look to captives and alternative risk to manage their burgeoning risk profile.

Dennis Harwick, president, Captive Insurance Companies Association

What were the most important events in captives insurance in 2016?

1. 2016 started with the Federal Housing Finance Agency (FHFA) announcing on January 12, 2016, that it was adopting a rule prohibiting captive insurance companies from being members of the Federal Home Loan Bank—despite overwhelming comments opposing the adoption of such a rule. Although this rule affects a relatively small number of captives, it is a reminder that captives—especially those on the creative edge—are subject to special scrutiny and criticism.

2. Much of the attention in 2016 has centred on major changes in the small captives/831(b) sector. The legislation that eventually emerged (the PATH Act), raised more questions than it answered and has set the stage for a tumultuous 2017 as owners of small captives and their managers try to understand the legislation and develop ways to comply, despite the lack of clarification from the IRS.

3. Then on November 1, 2016, the IRS dropped Notice 2016-66 requiring voluminous reporting on existing 831(b) election captives by January 30, 2017—the same day as the deadline for the comment period on Notice 2016-66.

4. On a more expansive scale, the OECD in Paris continued its push to characterise captive insurance companies as ‘base erosion/profit shifting’ (BEPS) devices. Although the OECD and its BEPS Report may seem like far off thunder, it has the potential to rattle the captives industry, particularly the offshore domiciles.

What are the topics you expect to be the most prominent in the industry in 2017?

1. After a dozen or so years in the depths of the captive insurance industry, I’ve grown wary of trying to make specific predictions. Although there are some predictable trends—more regulation, hostility from the IRS, antipathy from the National Association of Insurance Commissioners (NAIC) —the surprises often come from out of left field.

Who would have thought that the FHFA would spring a new rule prohibiting captives from membership in the Federal Home Loan Bank?

Who knew that the Senate Finance Committee would announce the ‘mark-up’ of a bill that would increase the amount of the exemption for 831(b) captive premiums with only 24 hours’ notice? Who knew about the new restrictors on 831(b) captives that would eventually work their way through the legislative process and change the landscape of the small captives sector?

2. I think that 2017 will be a year of clarification (and turmoil) in the small captives sector. The new restrictors of the PATH Act became effective on January 1, 2017. The reporting requirements of IRS Notice 2016-66 will explode on January 30, 2017. The decision of the US Tax Court in the Avrahami case will undoubtedly be released sometime in 2017.

3. Otherwise, I expect 2017 to continue the pattern of recent years where a maturing captives industry attracts the attention (mostly unwanted) of regulators big and small. Since captives—by their very nature—are usually carefully crafted solutions to specific risk management challenges, they do not lend themselves to template-based, one-size-fits-all regulation—and that drives regulators crazy!

4. 2017 will also be a year of opportunity for captives to continue their emergence as widely accepted risk management tools. Over the years I have realised that those of us who are leaders in the captives industry spend a lot of time talking about the challenges facing the industry and tend to forget that we work in a vibrant, creative sector.

Jo Willaert, president, Federation of European Risk Management Associations (FERMA)

What were the most important events in captives insurance in 2016?

According to the FERMA European Risk and Insurance Report 2016, published in October, European risk managers see the economic climate as their top risk today. This is clearly a major issue also for the re/insurance industry, along with other major concerns highlighted by the report, such as geopolitical instability, cyber attack and data privacy, IT and data systems, and interest rates and foreign exchange.

What are the topics you expect to be the most prominent in the industry in 2017?

FERMA regards the re/insurance industry as risk partners, while focusing on specific issues that concern its member associations at European level, such as regulation affecting captives and global programmes. In 2017, we will press forward with our initiative to retain the value of captives as a risk management tool for European business by avoiding undue administrative burdens. We will also continue to work with other associations internationally for coordination on global programmes.

Ian Clancy, Marsh Captive Solutions practice leader, EMEA Asia-Pacific

What were the most important events in captives insurance in 2016?

1. After close to 20 years of planning and re-engineering, Solvency II went live in 2016. While much of the impact was felt in the years leading up to 2016 as captives prepared themselves for the new regime, we took the bold step to move out from practice to reality at the start of the year. The flight simulator was effectively turned off.

Captives, along with third party insurers and reinsurers, now operate in a regime which has new methodologies to assess capital needs, more detailed risk assessment, stricter governance requirements, and more detailed reporting. Coping with this change has been a challenge for a small number of captives, but the captive population has substantially remained intact, and by its very nature in adopting the more onerous regime it is now strengthened.

2. In the current sophisticated business place in which we operate, it is often easy to overlook the core raison d’être for captives and the fact that they provide an invaluable mechanism for companies to manage their core risk efficiently and cost-effectively. Recent OECD and EU focus on cross-border pricing policies (across a number of industries) and tax arbitrage strategies within companies have blurred the waters in terms of defining a captive’s key purpose.

To the extent that we focus on core traditional risk as being the cornerstone for the formation of new captives, the continuation of soft market conditions must always be deemed a key influencer and is highly relevant in assessing captive population and trends over any particular year. Whether market conditions change in the foreseeable future is a moot point and many believe current conditions will prevail for several years to come. Others, who have perhaps been around for a little longer, remember the spikes in the number of formations of captives which followed major catastrophes and significant global events in the past and truly believe in the cyclical nature of insurance market behaviour.

Regardless of which view is held, the underlying status of insurance markets will always be a key factor in the captives industry year on year.

3. 2016 brought some political and socioeconomic change which caught many by surprise. The Brexit vote in the UK was not widely expected and the election of a new US President whose pre-election pronouncements indicated greater focus on domestic issues than on international cooperation also challenges historical positioning.

Quite how this impacts the captives industry remains to be seen, but there is no doubt it will have an effect. Captives thrive on cross-border freedoms and on global insurance programme integration—if the ‘new world’ we are now entering becomes overly protectionist at a country level, additional hurdles will need to be crossed if the industry is to continue to develop. ‘Inappropriate scare-mongering’ you may say—no, just a realistic recognition that the world is undergoing change in terms of the way it conducts its business and, as a viable business tool within that world, captives will need to adapt to this change themselves.

The challenge is not new—over time we have responded to liberalisation of markets in the EU with the various directives; to ever-evolving tax regimes and requirements; to accounting and reporting modifications and topically again, to governmental challenges to non-resident entities and profits.

What are the topics you expect to be the most prominent in the industry in 2017?

1. In the context of the OECD’s BEPS project it is important that the industry fights its corner and educates the politicians and regulators as to the true purpose and value of captives. Unfortunately, despite the industry’s best efforts, there remains a stigma (albeit minor) associated with captives so that some observers believe that tax avoidance is a key driver in utilisation. This is not the case. Captives are primarily, and always have been, risk retention vehicles and a large majority of the captives in existence today have no tax benefit associated with them whatsoever.

As discussions around BEPS escalate, our industry groups and major players in the industry need to continue and intensify their efforts to educate the key decision-makers.

2. 2017 will be the second year of the Solvency II regime and when any anomalies or weaknesses which have been identified in the processes can be addressed. While the long lead-in to the regime should have helped minimise teething problems, they will nevertheless emerge and the industry must work to ensure they are resolved in a manner which respects the underlying principles but at the same time gives due recognition to the concept of proportionality of risk, particularly as it applies to captives.

3. The new world we are entering at a socioeconomic and political level may create greater risk mitigation needs in, for example, the area of credit or political risk.

Additionally however, the concept of a new world applies to the definition of risk itself and as the business world changes in response to new technologies and transactional processes, so too will its risk mitigation needs and solutions. Cyber risk will continue to grow in importance. Cross-border supply chain exposures will be altered as a result of changing global dynamics. As the insurance industry responds to these changes, the captives industry needs to play its part—by assisting in the management and assessment of risk and by providing cost-efficient capital to mitigate or eliminate it.

Another reason why a focus needs to be centred on new risk, particularly in an EU context, is the additional capital requirements which apply to several captives as a result of Solvency II. While it is not a uniform change, many captives will now be maintaining higher levels of capital than heretofore, and in an optimum scenario this additional capacity should be put to good use, via expanded yet prudent risk retention.

Paul Owens, CEO of global captive practice at Willis Towers Watson

What were the most important events in captives insurance in 2016?

1. The industry has been preparing for Solvency II implementation for many years. In 2016 we finally saw the theory being turned into reality with the implementation of all pillars, including pillar 3 on reporting. The captives industry has embraced this development and has been supporting the gold standards that this regime provides. Many owners at first struggle with the new framework, but soon accept the benefits, with help from their advisers.

2.·There has been a lot of talk about the captives market in China. Caution and general economic conditions led initially to slower growth than anticipated but in June the Chinese Insurance Regulatory Commission (CIRC) announced the intent to authorise the first three mutual insurance companies in the People’s Republic of China. This positive move signals the drive of insurance into sectors that currently buy little, if any insurance and fully supports the Chinese overall economic plan.

3. The UK government initiated a consultation with regard to developing the UK into a leading global market for insurance-linked securities (ILS). The Bank of England subsequently published a position paper setting out a regime for the development of special purpose vehicles to support this sector. This may also lead to the development of protected cell company legislation in the UK which, supported by a targeted corporate tax rate of 15 percent, may have a significant impact in years to come.

4. The IRS has finally started to address the potential abuse of the 831(b) election. This can only be a good thing for the industry as a whole and serve to enhance its reputation.

What are the topics you expect to be the most prominent in the industry in 2017?

1. Just as the industry settles down after the implementation of Solvency II the whole issue of BEPS is likely to impact the industry as a whole. Unlike Solvency II it is a global issue not isolated to Europe. Developing and implementing plans to address BEPS issues are likely to dominate many discussions and may drive some significant changes in the industry.

2. Emerging risks such as cyber and reputation will become increasingly important within the C-suite. I would expect to see the captives industry provide more solutions, particularly given the slow development of the commercial market.

3. Constant increases in premium taxes, for example, the recent UK increase to 12 percent, will challenge the financial effectiveness of some captive structures.

4. We must mention Brexit—during 2017 we should see greater clarity as to what this will bring. Overall however, I see this as possibly creating opportunities for some domiciles as owners seek alternative solutions.

5. Attracting people to our industry is ever more important. Many practitioners have worked in the sector for many years and have a wealth of experience and knowledge. We must make sure that we continue to bring in and retain new talent, especially since the captives sector is one of the few segments that grows every year.