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There are many good reasons that captive insurance companies should strive to implement high levels of corporate governance, as Andrew Walsh and Phillip England from Anderson Kill explain.
Every company should strive to implement the best corporate governance practices, and captive insurance companies are no exception. Since most captives are ‘single parent’, the shareholder is in a position of control and should be familiar with a captive’s ongoing business.
Nonetheless, governance best practices will not only enhance the performance of the captive program but will also help avoid enhanced regulatory scrutiny from insurance regulators and tax authorities.
Captive owners should be ready for their governance practices to be assessed by their domiciles as part of the application process, and during subsequent examinations. Good governance is one of several factors that will carry weight in favour of the taxpayer during an Internal Revenue Service (IRS) examination or action alleging that a ‘sham’ insurance company has set up as a tax shelter.
Scope of governance
Generally, corporate governance refers to the processes and control structures relating to the operation of a business by management, guided by responsibilities to the company and its shareholders, and balanced by the interests of internal and external stakeholders, including officers and other employees, customers, suppliers, lenders, regulators and local and regional communities.
The corporate governance practices and principles that an entity is expected to implement are set forth in its:
• Organisational documents (articles of incorporation, by-laws);
• Agreements between the company and its capital providers (shareholder agreements, covenants to creditors);
• Statutes governing business entities and insurance companies (and the regulations promulgated thereunder);
• The standards of the captive’s auditors;
• Applicable case law; and
• The policies of applicable tax and securities authorities which include, in the case of US entities, Securities and Exchange Commission (SEC) regulations (for publicly traded affiliates) and revenue rulings published by the IRS.
There is no one-size-fits-all set of best practices, and governance should be tailored to each company depending on the size of the company and the complexity of the risk it retains, whether it is closely held, and the requirements of its domicile. The Bermuda Monetary Authority (BMA) recognises a ‘proportionality principle’ among insurers, recognising that there are varying risk profiles which arise from the nature, scale and complexity of their programmes. Consequently, Bermuda’s regulator, in section 3 of the Bermuda Insurance Code of Conduct, expects from higher-risk programmes “more comprehensive governance and risk management frameworks compared with those of a lower risk profile”.
Regulatory (and internal) standards for governance
In 2014, the National Association of Insurance Commissioners (NAIC) finalised the Corporate Governance Annual Disclosure Model Act, which calls for insurers—including captives—to provide to their regulator a confidential report summarising their “corporate governance structure, policies and practices to permit the Insurance Commissioner to gain and maintain an understanding of the insurer’s corporate governance framework” (section 1, article 1).
Specifically, the model act requires disclosure of an insurer’s board structure, its policies and practices, frequency of meetings, review procedures, suitability standards for management, code of conduct and ethics, performance evaluation, compensation practices and succession planning among other policies and practices.
To date, according to insurance news website PropertyCasualty360, only the state of Iowa has adopted the model act, but the NAIC is reported to expect full participation among the states by 2019.
Most statutes governing business entities provide that holders of equity elect a board of directors or board of managers to manage the company. The board, in turn, appoints the officers of the company who have power to bind the company in contract and to direct and supervise employees.
Officers are given discretion to operate the company on a day-to-day basis, but major initiatives should be taken only with the consent (or under an authorising resolution) of the board of directors. By statute, typically, boards of directors cannot amend the Certificate of Incorporation in order to, for example, authorise and issue a new class of securities, without the consent of a majority of the shareholders.
"Bermuda’s regulator expects from higher-risk programmes “more comprehensive governance and risk management frameworks compared with those of a lower risk profile”.
A company’s organisational documents and its agreement among shareholders (eg, the Shareholders’ Agreement or Limited Liability Company Operating Agreement), as applicable, often supplements external governance policies. For example, the agreement may require an enhanced vote of shareholders for certain major actions, contain a covenant to elect certain directors, and/or require a certain number of independent directors, as may be defined therein.
Directors are ultimately responsible for the successes and failures of the business of the captive insurance company and should be able to function in an objective and informed manner. Accordingly, the directors should bring a mix of business and insurance expertise and should set the tone ‘from the top’ by setting expectations of respect, integrity, ethical values, and control activities, as well as accountability for itself and the officers.
According to section 4.2 of the Insurance Code of Conduct, “The board should have an appropriate number and mix of directors to ensure that there is an appropriate level of experience, knowledge, skills and expertise commensurate with the nature, scale and complexity of the insurer’s business.”
As part of their process, auditors will examine whether the captive is adhering to applicable laws and regulations; a board therefore is well served if it has an industry expert keeping abreast of regulatory and statutory changes. The board should also have a member who can draw upon his or her experience to help the captive develop appropriate internal controls, which is another factor that auditors take into consideration.
Good governance practices include the participation of independent and non-executive members of the captive’s board of directors. Generally, an independent director is neither a shareholder (or a nominee of a shareholder) nor policyholder of the captive, and has no material pecuniary relationship with the company.
Accordingly, a captive’s attorneys, accountants and captive managers would not typically be considered independent considering the compensation they receive for engaging with the company. The independent director is often the one who asks the types of questions that will come up during an audit and challenge assumptions, decisions and practices of the company.
The directors are chiefly responsible for setting corporate strategy and, as fiduciaries, they should act with due care and diligence. They should make sure that they understand, focus, and update the company’s business plan as needed.
They should continually evaluate the company’s strengths, weaknesses, opportunities and threats. Domiciles impose ‘suitability’ standards in relation to an individual’s fitness to be a director, and have been known to suggest alternative directors to those whose biographical affidavits disclose red flags, such as a personal bankruptcy or criminal history.
The board should also strongly consider directing the captive to purchase officers and directors liability insurance to cover their legal fees in the event that they are sued by the owners of the captive or its policyholders.
Boards should meet frequently as needed to address the captive’s ongoing strategy, risk management, internal controls and internal audit and compliance issues, and should generate clear documentation of their actions. The board should also develop internal policies and procedures to address potential conflicts of interests among board members. Depending on the size of the captive, the board should consider establishing committees such as an investments committee (guided by an investment policy) and an audit committee.
In contrast to requirements for non-insurance corporations, domiciles typically require at least one meeting of the board of directors to be held within its borders annually. Boards should comply with this requirement (many view it as a good excuse to play golf in Bermuda or go skiing in Vermont!).
Regular meetings can be held elsewhere, and board formalities should be followed, such as notice and quorum requirements. Minutes of the meeting should be taken and circulated to the board members for review and comment. Minutes are typically adopted as an agenda item at the following meeting of the board.
In conclusion, as domiciles ramp up their scrutiny over governance practices, captive boards should review their current practices and make necessary adjustments. A captive is supposed to operate in the normal and customary manner of an insurance company and that includes a focused board of directors.
Andrew Walsh is a corporate attorney in the Stamford, Connecticut office of Anderson Kill. He can be contacted at: firstname.lastname@example.org
Phillip England is a shareholder in the firm’s New York office and chairs the firm’s captive insurance services group. He can be contacted at: email@example.com
Andrew Walsh, Phillip England, Anderson Kill, captive insurance, tax, IRS, NAIC,