Not all states play fair

A year on from the settlement between Microsoft’s captive, Cypress Insurance Company, and the Washington State Office of the Insurance Commissioner (OIC), and there is still a great deal of uncertainty in the US captive insurance market around direct placement taxes.

The next major settlement was between pharmaceutical company Johnson & Johnson’s captive, Middlesex Assurance Company, and New Jersey, followed by another Washington case involving multinational retailer Costco’s captive, NW Re.

These cases follow the passage of the Nonadmitted and Reinsurance Reform Act of 2010 (NRRA), part of the Dodd-Frank Act, which requires that only the home state of the insured can collect surplus lines premium taxes. It also permits states to enter into interstate agreements to allocate those taxes, based on the risks covered in a state.

Direct placement taxes—also known as self-procurement taxes—are taxes charged to an insured by a state for insurance procured outside the state. Each state has its own laws around direct procurement taxes but not all states have this type of tax in their laws.

When NRRA was enacted, it did not specifically exclude captives, and many states have used this to justify imposing self-procurement taxes on insured entities in their states. Under this legislation, the home state of the insured entity is the only state that has the authority to collect premium taxes for an insurance policy.

A big threat
Whether NRRA applies to captives continues to be a point of contention, where cases can be described as one state insurance department versus another.

The concern of regulatory overreach by home state regulators on captives domiciled in other jurisdictions is considered by Dan Towle, president of Captive Insurance Companies Association (CICA), to be “potentially the biggest threat“ to the US industry in 2019.

While there is the concern that this may embolden other states that do not have captive insurance laws to come after captives, Rich Smith, president of the Vermont Captive Insurance Association (VCIA), says he is not concerned that other states will follow Washington’s example.

“I don’t want to exaggerate the impact of regulatory overreach from states on the captives industry. We have not seen a tidal wave of tax and regulatory issues from states focusing on captives and overall the environment for the captive insurance industry remains very strong,” says Smith.

“My concern is that we may negatively impact our industry with the proverbial ‘death by a thousand cuts’—that is, no one example of overreach creates an industry-wide impact, but cumulatively the individual state actions will make it more difficult for the captive insurance industry to operate successfully.

“This requires the captive insurance industry and risk management leaders to be continuously vigilant and fight against state overreach.”

State actions
On May 9, 2018, the Washington OIC issued a cease-and-desist order against Microsoft to stop using its Arizona-domiciled captive, Cypress Insurance Company, to directly insure its parent.

Cypress Insurance Company settled with Washington to pay $573,905 in unpaid premium taxes and $302,915 in interest and penalties.

Washington doubled down on its aggressive stance at the end of 2018, offering captives that had “unlawfully” insured any risk in the state in the past 15 years a self-reporting period of 18 months to pay significantly reduced fines. Fines and penalties increase every six months for captives that fail to self-report, starting July 1, 2019. Captives that do not self-report before June 30, 2020, will face the maximum fines and tax penalties, Washington OIC warned.

Another Arizona captive, NW Re, owned by Washington-headquartered Costco, was the first prominent settlement where the captive self-reported its unauthorised activity.

Costco’s captive agreed to pay Washington OIC $3.6 million in unpaid premium taxes, penalties, interest and a fine. NW Re had provided deductible reimbursement for Costco’s liability and workers’ compensation from 2000 until 2019 without authorisation.

So far, Washington OIC has collected around $4.4 million in agreements with captive insurers.

“The State of Washington’s position may well be the start of a changing landscape in the captive insurance industry, where states position themselves as either business-friendly or tax-focused,” says Pete Kranz, executive managing director and captive practice leader of Beecher Carlson.

Aggressive or friendly?
New Jersey has also taken a more aggressive stance towards captives, as can be seen in the case of Johnson & Johnson (J&J).

In June 2018, the New Jersey Tax Court ruled that in Johnson & Johnson v Director, Division of Taxation, the multinational pharmaceutical company was required to pay premium taxes on all US assets insured by its Vermont-based captive, Middlesex Assurance.

From 2008, J&J had proactively paid self-procurement taxes to New Jersey based on the premiums of all its US-based risks. Following the passage of NRRA, J&J argued the previously paid self-procurement taxes were not applicable to its transactions and had requested a refund of around $55 million. The New Jersey Tax Court denied the refund.

States such as Georgia, Ohio, and North Carolina have said they aren’t going to assess the taxes, and are taking a more business-friendly approach.

North Carolina introduced a bill in March 2019 aimed at attracting redomestications of captive insurance companies back to the state through a “premium tax holiday”. This would temporarily exempt existing foreign and alien captive insurers from premium taxes—if those captives are approved by the North Carolina Department of Insurance to redomesticate to North Carolina by December 31, 2020.

House Bill 220 has been delayed, however, as the North Carolina House Insurance Committee claimed it was not given adequate time to consider the proposal around premium tax holidays in full.

A shift to home state?
One of the consequences of NRRA is that it may encourage large, multistate companies to redomicile their captives to their home state, where they are headquartered, in order to reduce premium taxes associated with non-admitted and reinsurance premiums.

Almost 30 jurisdictions in the US have at least one licensed captive, and many have specific captive legislation, meaning US companies have a large selection of domicile to choose from.

States such as Georgia, Tennessee, and Texas have all seen substantial growth in the number of captives domiciled there in the last few years, a number of which are the result of redomestications.

Gary Osborne, vice president at Risk Partners, and former president of USA Risk Group, told US Captive that these issues around tax have driven many captives to redomesticate to where their parent companies are based.

He argues that captive owners can reduce the risk that a state will obtain jurisdiction and tax the captives’ transactions if they limit the activities of their captives outside their domiciles.

“If you have the ability to put your captive in your home state—do it,” says Osborne.

He describes a number of situations where he has advised captive clients to form a captive in—or redomesticating to—their home state and that has saved them millions of dollars that they otherwise would have to pay in self-procurement taxes, or has suited the operations better from a regulatory point of view.

Trailblazers
While Osborne was at captives manager USA Risk Group, the firm helped form the first captive to be domiciled in Florida.

“It was about a six-month process to get it approved in Florida. It was a hospital, and they wanted the sovereign immunity by being in their home state. They were protected by some of the medical laws which meant it was very beneficial to have the captive in their home state,” he explains.

Osborne adds that he is in the process of helping one captive redomesticate from New Jersey following the J&J decision.

Having the captive domiciled in the home state addresses any issues relating to “mind and management”, such as the location of central management and control of the organisation.

Kranz adds: “There are natural groupings within the domiciles: those with long history and consistent regulatory regimes, and those with no premium taxes. Some jurisdictions waive audit requirements based on premium levels, while others have flexibility with respect to captive examinations.”

While it can be beneficial to see whether a parent company’s home state has captive insurance laws and domicile the captive there, Osborne suggests that domiciling a captive in the home state isn’t always the solution. Certain domiciles are not as well established, and do not offer the same speed and efficiency from the regulator, nor offer the same level of access to service providers, he says.

“Having a captive in the home state doesn’t solve everything, especially if you’ve got a bad state,” he explains.

The interpretation of whether NRRA applies to captives varies from state to state, although established domiciles such as Vermont, South Carolina, and Delaware have been known to promote this stance.

“I can understand why Vermont doesn’t like it. They obviously want captives to form in Vermont, and almost nobody has Vermont as their home state,” says Osborne.

“Vermont is trying to say the NRRA does not apply to captives. The problem with that is that it doesn’t stop self-procurement taxes from applying. You’re still potentially subject to self-procurement tax.

“So we’re trying to take the position: ‘we’re in our home state, under NRRA we write all our policies in Georgia. We’ve paid all our taxes, you can leave us alone. If you want a share of taxes, take it up with Georgia’.”

As the captive insurance industry in the US becomes more home state-focused, Osborne wonders if captives managers are going to do themselves out of business eventually if many of these home state captives and their parent companies can do the management internally.