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1 September 2017Analysis

Can captives avoid excessive regulation?

Since their inception offshore in the 1970s, captives have thrived in an encouraging and non-uniform regulatory environment. As the number of domiciles grew offshore and then came onshore, first to Vermont, and later in many other states, the competition among domiciles fostered creative ideas and energy, which benefited all captives.

Of course, the early captives were all single parent, or ‘pure’, captives. Therefore, the regulators did not need to worry about the failure of a captive having widespread effect on third parties.

Now, 38 states have some form of captives law, and the marketplace is crowded. New domiciles are learning from the older domiciles, and are promoting new ideas to attract formation of captives, such as no audit requirement for single parent captives, lower or no premium tax for first year captives, fewer examinations, and examination fees based on competitive bids from contract examiners.

In the race to be competitive, domiciles copy the laws and regulations of their fellow domiciles. For example, segregated cell captives started offshore, and now numerous state domiciles have varying versions of these entities, including incorporated cells, rent-a-captive cells where the participant has no ownership interest in the cell, and limited liability company (LLC) series captives (a concept borrowed from real estate law). In the current market, small captives within a cell structure are responsible for much of the growth in the formation of captives.

However, with success comes the attention of regulators. Naturally, the regulators of domiciles, new and old, do not want a captive to fail on their watch. A captive’s failure can be a disaster for a state domicile because captives, including risk retention groups (RRGs) are not covered by state guaranty funds.

A close eye on captives

The growth of US domiciled captives, particularly in the areas of medical professional liability and the reinsurance of life insurance, has caught the eye of the National Association of Insurance Commissioners (NAIC). The NAIC has no regulatory authority over insurance (which continues to reside with the states); but it does have the ability to set regulatory standards in the form of model laws and regulations and then to require the states to adopt them through the state ‘accreditation’ process. All the states and Puerto Rico are accredited now. Of course, no state has to be accredited, but equally no state wants to run the risk of losing its accreditation.

A RRG is a liability insurance company chartered in a state pursuant to the mandates of a federal law, the Liability Risk Retention Act (LRRA, 15 USC §3901, et seq). RRGs enjoy broad preemption of the laws of states other than its domicile and have the right to do business in any other state, without being licensed in that state, so long as it has ‘registered’ under the terms dictated by LRRA. Needless to say, this broad preemption of state law has attracted the attention (and occasional wrath) of some state regulators and the NAIC.

Most RRGs are captives (although a few are traditionally licensed insurers). Unlike most captives, however, RRGs generally operate in multiple states, which can create friction with non-domiciliary state regulators.

In 2005, the federal General Accountability Office (GAO) issued a study on RRGs. Among other conclusions, the GAO expressed the concern that there was a lack of uniformity among the states in their regulation of RRGs. This prompted the NAIC to spring into action by forming several working groups to study the issues raised by the GAO.

After several years of study and meetings, the NAIC grasped the concept that it could impose its model laws and regulations on the RRG domicile states, which have the principal regulatory function under the LRRA, through the NAIC Accreditation programme. The result was a multiple year process of examining each of the model laws and regulations to determine whether they did, or should, apply to RRGs.

Those laws and regulations (to the extent relevant) are now part of the Accreditation standards and so have been adopted (or, in some cases, are in the process of being adopted) in all RRG domicile states. As a result, RRGs are now treated less like captives and more like traditional insurers. This imposes another layer of bureaucratic time and expense on RRGs. Nonetheless, the results in some ways are helpful. State regulators, in general, have a better knowledge of RRGs and more confidence in the regulation of RRGs by their fellow regulators.

Thriving on innovation

What does this have to do with captives in general? Unlike RRGs, which are limited to providing commercial liability only, captives can provide numerous lines of coverage in various configurations. More importantly, captives thrive on innovation. The uniformity 
of regulation imposed by the NAIC on RRGs would be detrimental to captives.

The NAIC acts in some respects like a legislature for insurance regulation, and, like the US Congress, it responds to crises (or perceived crises). For example, the fight over principles based reserving for life insurers prompted the NAIC to look at the captives utilised by some of the largest US insurers to reinsure this ‘excess’ risk. The NAIC then set standards for these captives.

There are other ‘crises’ in the future for captives. The rapid growth of small or ‘micro’ captives which benefit from Section 831(b) tax treatment has attracted the negative attention of the Internal Revenue Service, which could prompt the NAIC to study how these small captives are regulated. Another example is that rules set by federal agencies sometimes unreasonably exclude captives: recent rulemakings by the Environmental Protection Agency and the Federal Home Loan Bank Board come to mind.

The captive industry needs to be attentive to the impulse of the NAIC to require uniformity among states and to conform to the regulatory frameworks of its cousin, the International Association of Insurance Supervisors (IAIS). Captives have thrived on creative regulation and a dynamic market. Let’s not let that slip away.

Robert ‘Skip’ Myers is a partner in the Washington, DC office of Morris, Manning & Martin. He can be contacted at: