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A regulatory enforcement action has raised the spectre of how and whether captives may be subject to unexpected premium tax liabilities in states outside their domicile. Joseph Holahan of law firm Morris, Manning & Martin explores the issue.
In May, Washington State Insurance Commissioner Mike Kreidler issued an order alleging that Cypress Insurance Company, a single-parent captive owned by Redmond, Washington-based Microsoft and domiciled in Arizona, was unlawfully doing business in Washington State.
The Commissioner ordered Cypress to cease and desist conducting any further insurance business in the state and, in a related order, announced his intent to collect approximately $2 million in back premium taxes, penalties and interest.
Kreidler’s actions against Microsoft have become the object of much concern in the captive insurance community and raise anew the question: what can the owners of captives insuring risks in the US do to mitigate the risk of being exposed to regulation or unexpected premium tax liabilities in states outside the captive’s domicile?
Subject to certain common exceptions, the law of every state prohibits any person from transacting the business of insurance without being “authorised”—ie, licensed—in the state. The definition of “transacting the business of insurance” generally includes selling, soliciting, negotiating or effecting contracts of insurance. “Effecting” a contract of insurance typically includes the activities required to execute and service the insurance coverage such as conducting risk assessments, delivering contracts of insurance in the state, taking receipt of premium payments originating from the state and adjusting claims.
Captive insurance, of course, is premised on the concept that the captive does business only in its state of domicile and therefore need not be licensed elsewhere. Yet every captive insurer has some contact with the states in which it insures risks, even if the contact is limited to the fact that the insured risk is located there.
The mere fact that a captive insures risks located in a state, or that an insured does business there, alone, most likely does not constitute sufficient contacts to allow the state to regulate the captive or subject the insurance it writes to premium taxes. This principle was established by the US Supreme Court in its 1962 decision State Board of Insurance v Todd Shipyards, 370 US 451 (1962).
In Todd Shipyards, the court held that under federal limitations on state authority to regulate the business of insurance, the state of Texas could not assess a premium tax on an insurance transaction where the only contacts with the state were the fact that the insured did business in the state and the insured property was located there.
In reaching this conclusion, the court noted that the insurance transactions involved took place entirely outside Texas. The insurance was negotiated and paid for outside the state. The policies were issued outside Texas. All losses under the policies were adjusted and paid outside Texas, and the insurers had no office or place of business in Texas. In addition, the insurers did not solicit business in Texas, had no agents in Texas and did not investigate risks or claims in Texas.
Todd Shipyards remains good precedent, but lower courts deciding similar cases in more recent years generally have adopted a narrow reading of the decision and sought to limit the ruling to the facts of the case. Under these rulings, almost any contact between a captive and state that goes beyond the fact that an insured does business in the state and an insured risk is located there may be sufficient to allow the state to regulate and tax the captive’s insurance transactions.
Practical constraints make it difficult to limit the activity of a captive this way, especially in the state in which the captive owner has its principal place of business, where risk managers and officers with responsibility for the captive may be located.
Nevertheless, captives owners can and should limit the activities of their captives outside their domiciles to help reduce the risk that a state will obtain jurisdiction to regulate and tax the captive’s transactions.
To this end, the captive and its owner should have policies and procedures in place to ensure, to the greatest extent practicable, that:
All insurance contracts are negotiated, executed, issued and delivered in the domicile or a “neutral jurisdiction” in which the captive does not insure risk and the owner does not do business. Achieving this goal may require an officer of the owner to travel to the domicile or neutral jurisdiction to negotiate and take delivery of insurance contracts. A second-best alternative is to appoint a representative of the owner in the domicile or neutral jurisdiction to perform these functions on its behalf.
Premium payments are made in the domicile.
Captive board meetings and committee meetings take place in the domicile.
Communications concerning the captive directed to or originating from a jurisdiction where the captive insures risk or insureds are located are minimised.
Activities relating to the adjustment of claims in states in which the captive insures risks or insureds are located are minimised.
Especially with respect to group captives, activities that could be construed as marketing or soliciting insurance are avoided in states in which the captive’s insureds are located.
Following these guidelines can be difficult, especially in the case of an active captive insurance programme that requires ongoing management by the owner. Still, it is not unusual for a captive owner to take a broad view of Todd Shipyards, adopt policies and procedures to limit the captive’s activities outside its domicile and accept the risk of being challenged at some point by a state regulator on the position that the captive’s insurance transactions are not subject to regulation or premium tax anywhere outside its domicile.
A more conservative approach is to pay state premium taxes on the captive’s insurance policies and take advantage of one or more state exceptions to licensing. Some 43 US states have exceptions to licensing for insurance that is directly procured by the insured and for which the insured pays a premium tax.
State direct procurement requirements vary, but generally require that the insurance be negotiated primarily or, in some states, entirely outside the boundaries of the state and that the insured report the transaction to the state within 60 to 90 days and pay a premium tax on it.
A captive owner availing itself of a direct procurement exception must be careful to conduct discussions preceding the issuance of insurance outside the state, but generally there is less need to be concerned about originating premium payments from the state or adjusting claims in the state, as long as licensed adjusters are used when required.
Another exception to state licensing that captive owners may want to explore is an exemption for insurance issued to an “industrial insured”. Thirty-three states have such an exemption, which allows an unlicensed insurer to issue insurance to more sophisticated insureds.
A typical definition of an “industrial insured” is an entity that procures insurance through a full-time insurance manager or buyer or a regularly and continuously retained qualified insurance consultant, pays a minimum of $25,000 in aggregate annual premiums for all insurance risks, and has a minimum of 25 full-time employees.
As with direct procurement, requirements for industrial insurance vary by state. For example, some states require an entity to pay higher minimum annual premiums to qualify as an industrial insured, and some states limit the exemption to insurance coverage that is not readily available from insurers licensed in the state. In addition, the industrial insured exemption presumes that state premium tax will be paid—either by the captive or by the insured.
The direct procurement and industrial insured exceptions raise the issue of where any premium tax that is owed should be paid. A full discussion of this issue is outside the scope of this article, but suffice to say that the law in this area is unsettled.
Some states take the position that the tax should be paid pro rata according to the distribution of insured risks among the states. Others insist that 100 percent of the tax on any particular policy is owed in the “home state” for that policy, which generally is the state where the insured has its corporate headquarters or, in the case of an insured affiliated group, the affiliate responsible for the greatest amount of premium has its headquarters.
It is too early to say what effect, if any, Washington State’s action against Microsoft ultimately will have on captive insurance regulation in the US. Nevertheless, captives owners may want to review their policies and procedures now to ensure that they are as effective as possible with respect to reducing the risk that a captive’s operations could give rise to regulatory issues or unexpected premium tax liabilities in states outside its domicile.
Joseph Holahan is of counsel in the insurance practice at Morris, Manning & Martin. He can be contacted at: firstname.lastname@example.org
Joseph Holahan, Captives, Microsoft, Washington State, C&D, North America