Domiciles: business friendly or tax focused? How to prepare your captive
Since the passing of the Nonadmitted and Reinsurance Reform Act of 2010 (NRRA), the captive insurance industry has had a much keener focus on the impact of direct placement tax and the “conduct of business” in all jurisdictions.
This came to the fore with the state of Washington’s aggressive pursuit of premium taxes as discussed in Joseph Holahan’s August 2018 piece “ Dealing with the threat of extra-domicile tax”. Since the passage of NRRA there have been other high-profile settlements with the State of Washington including Costco, whose captive settled for $3.6 million in March 2019.
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. Consider that shortly after news broke of Washington’s actions against Microsoft’s captive, the North Carolina Captive Insurance Association shared in its newsletter that the state was considering legislation to exempt captives domiciled in other states from all North Carolina state taxes—clearly a pro-business stance.
“It is important to review NRRA’s definition of the ‘home state’ in conjunction with the facts and circumstances around proposed programme structures.”
Changes in state and federal laws, as well as the favourable and unfavourable actions of state legislators and regulators, highlight the continued need to evaluate captive insurance programmes on an ongoing basis, not just at their initial establishment. The captive domicile should be reviewed, to ensure that it is located in the optimal jurisdiction, in conjunction with each programme’s specific structure (direct, fronted, lines of business).
Most states have some form of direct placement tax (DPT) on the books, but some lines of business or types of organisations may be exempted. It’s even possible that the structure of a direct transaction itself may not be subject to DPT.
When evaluating where a new captive should be domiciled, or where an existing captive is already domiciled, it is important to ensure key considerations are addressed, including:
- Implications of premium taxes (federal excise, self-procurement, surplus lines);
- Home state of the insured;
- Programme structure—fronted versus direct written;
- Specific lines of business being re/insured in the captive;
- Captive owner’s prioritisation of domicile characteristics; and
- Where business is being conducted.
In addition to a captive domicile’s fees and premium taxes, it is important to review the captive and the insured’s exposure to federal excise and DPTs. A captive domiciled offshore which qualifies as an insurance company for tax purposes but does not elect to be taxed as a US corporation would likely be subject to federal excise tax (FET) on the insurance premiums (4 percent for direct written and 1 percent for reinsurance).
DPTs apply to surplus lines placements and placements with a nonadmitted carrier. A captive insurer, while licensed in its state of domicile, would be considered a nonadmitted carrier in any other state or jurisdiction.
With the passage of NRRA, the home state of the insured (not the captive) has the rights and responsibilities to collect such taxes. Therefore it is important to review NRRA’s definition of the “home state” in conjunction with the facts and circumstances around proposed programme structures to ensure the most correct jurisdiction is identified as the home state, as there is some level of variability based on defined factors used to determine “home state”.
It is estimated that 40 to 45 US jurisdictions have a DPT on their books. However, even within some of these domiciles it has been found that certain lines of business are exempted from the tax. Further, some jurisdictions may exempt insurance programmes of not-for-profit or tax-exempt insureds. All these factors should be considered when reviewing which domicile is best for a new or existing captive.
According to a recent industry survey (in March 2019) there are 29 jurisdictions in the US with at least one licensed and active captive on the books; more than 10 more have captives-enabling legislation on their books. What this means is that within the US alone there are a large number of options for finding the optimal captive insurance domicile.
There are natural groupings within the domiciles: those with long history and consistent regulatory regimes; those with no premium taxes; some jurisdictions waive audit requirements based on premium levels, while others have flexibility with respect to captive examinations.
Geography can also be a relevant factor in determining a domicile. For example, the captive of a not-for-profit entity that is domiciled offshore can have negative public perception issues and board meetings can be considered a “junket”, not to mention the potential exposure to DPT and federal excise taxes if the transactions are not structured properly.
As part of any line of business evaluation, either at inception or as part of an ongoing review, a financial cost:benefit analysis of a fronted versus direct written programme should be performed. Such an analysis should include review of whether the line of business, if direct written, would be subject to FET and/or DPT under the home state’s laws, and whether the home state even has a DPT. The direct written structure should be compared to the cost of a fronted structure.
These considerations are not limited to premium taxes, however, and may include contractual requirements of certain coverage levels, an organisation’s cost of capital, collateral requirements and forms, control over claims adjudication, etc.
The questions of premium taxes and domicile regulation aren’t new ones. Nevertheless, recent actions in the industry have highlighted why it is so important for captive owners to keep a continual eye on their captive structure to ensure it is operating in the optimal jurisdiction and in the most cost-efficient manner—meeting its organisation’s needs.
To that end, it is essential that captive owners and industry leaders continue to monitor the landscape as it develops as we are likely to see an increasing differentiation between those jurisdictions which see benefits in increasing premium tax revenues versus those which see the benefits of adopting a pro-business, low tax approach.
Time will tell which approach finds greater success.