The US captive landscape has changed greatly over the past 10 years. Maria Sheffield from the Missouri Department of Insurance examines what some of these changes have meant, the innovation in structures that has taken place, various IRS decisions and the impact of Obamacare.
Captives continue to flourish with increasing momentum in the US, even with—and despite—the many changes we have seen in the captive landscape. As we congratulate US Captive on its 10th year of publication, I thought it appropriate to reflect on this remarkably resilient industry that will continue to face both opportunities and challenges as we look to the future.
Traditionally, growth in the captive insurance market was driven by insurance market contractions; a reaction to market conditions.
Captives today are a more sophisticated approach to self-insurance and are a part of the strategic risk management plans of companies both large and small. As the industry has changed, so has the environment in which captives are formed. In honour of US Captive’s 10 years of covering the US captive market, I developed a top 10 list of the most dramatic regulatory changes that I believe have affected the captive industry in the past decade:
(1) Proliferation of US domiciles
Domicile choice is now more complex and refined. More than 35 states have enacted some form of captive legislation, with a majority of these states passing or refining legislation in the last 10 years. In 2014 there was a net increase of 365 captives formed in US domiciles, which represented 80 percent of the net global growth of captives. This rapid growth has led many to ponder whether the required expertise to support the industry is available in all domiciles.
Not all new captive domiciles are attracting the same type of companies and no doubt differences between domiciles will likely become more apparent over time.
(2) NAIC involvement
The National Association of Insurance Commissioners (NAIC) has increasingly become involved with matters affecting captives. The possible addition of captives to the definition of “multi-state reinsurer” drew a very loud response from the captive industry. The proposed change was originally intended to include Regulation XXX and AXXX captives but due to what was believed to be broad and vague language, there was great fear that all captives would be included.
An expedited comment period increased concerns. In May 2015, the Financial Regulation Standards and Accreditation Committee of the NAIC adopted proposed revisions to the Part A: Laws and Regulations Accreditation Preamble which would include regulation of those captives and special purpose vehicles (SPVs) that assume XXX or AXXX business, variable annuities and long-term care business.
(3) Micro captives
These captive insurance companies, which are writing less than $1.2 million in premium a year, may elect to be taxed only on investment income, as per section 831(b) of the Internal Revenue Code should the captive meet certain risk-shifting and risk-distribution requirements.
This type of captive has accounted for the largest number of captive formations in the past 10 years and has led to significant growth in domiciles that have chosen to focus on these smaller captives. This rapid growth has caught the attention of the Internal Revenue Service (IRS) which has chosen to focus on what it sees as abusive behavior. While each captive regardless of size should be measured against traditional tax tests imposed by the courts, it is anticipated these smaller captives will continue to face increased scrutiny.
(4) Implementation of healthcare reform
Whether you like to call it Obamacare, or the Patient Protection and Affordable Care Act (PPACA), or simply the Affordable Care Act (ACA), there is no question changes to the delivery of health insurance have been, and will continue to be, front and centre for employers. As employers have implemented ACA requirements, many organisations with fully insured health benefit plans and relatively healthy workforces have seen their premiums go up.
This development has, in turn, spurred great interest in self-insurance and captive insurance programmes as well as debate in some states over the definition of stop-loss as more employers are looking to offer stop-loss in their captives.
(5) Solvency modernisation
With January 1, 2016 set as the date for full implementation of Solvency II, the directive that has been more than 10 years in the making, many in the captive industry are now proceeding with final preparations. Solvency II will obviously affect captives as a subset of the overall insurance industry just as US solvency modernisation implementation will have an effect on overall capital requirements.
As insurance regulators continue to look for more efficient ways to ensure solvency and better assess when a company is in a hazardous financial condition, captive management will become increasingly complex.
(6) Federal interest
While captive insurers are regulated at the state level, the federal government is becoming increasingly interested in the captive insurance market. A Federal Insurance Office (FIO) report in December 2013 included recommendations on captive reinsurers. Congress has also taken an interest as legislation has been introduced in both the US House of Representatives and the US Senate to increase the premium limitation on small insurers—831(b) captives—for federal tax considerations. This heightened federal interest has the potential to affect both the cost and the complexity of captive structures.
(7) Federal home loan banks (FHLBs)
The interest of Real Estate Investment Trusts (REITS) in setting up captives to access the FHLBs led to the FHLBs jointly agreeing to a three-month moratorium on admitting captive insurers in June 2014. This was a surprising move as the Bank Act has permitted all insurance companies—without qualification—to be eligible for membership in the FHLBs for more than 84 years. Although the Federal Housing Finance Agency has provided no indication as to whether it will continue its quest to change the current membership requirements of the FHLBs, many of the banks have now started once again to process membership applications of captive insurance companies.
(8) Original coverages
Emerging risks are more complex and traditional risks are occurring more frequently. Increasingly, companies are looking beyond the traditional property and casualty risks to focus more attention on an array of emerging risks, including cyber security, extreme weather and executive liability issues. Over the years there has been a developing trend of captives serving as a sort of incubator for new coverages that are slow to develop in the traditional market.
(9) XXX and AXXX
An important regulatory modernisation issue for the NAIC has been the regulatory framework for calculating life insurance reserves. Life insurers have traditionally used captives to finance redundant reserves required in the NAIC rule-based environment to obtain surplus relief. The flexibility allowed by some states in the establishment of the special purpose captives continues to be a source of debate at the NAIC. The generally agreed-upon solution is to move from the rules-based approach to what is known as principle-based reserving (PBR) which some believe will minimise the need for life insurer-owned captives.
(10) International issues
These include the expanding efforts of the International Association of Insurance Supervisors (IAIS), such as the May 2015 draft of the Application Paper on the Regulation and Supervision of Captive Insurers. The increasing pressure from international regulatory bodies for more uniform regulation of captives means captives undoubtedly face future regulatory, tax and legal challenges which may not be easy to predict but will most likely create more compliance issues.
Maria Sheffield is the captive programme manager in the Missouri Department of Insurance. She can be contacted at: email@example.com
Missouri Department of Insurance, Maria Sheffield, Internal Revenue Service, North America