Prior to 1986, offshore domiciles were the clear choice for those considering the establishment of captive insurance programs. The attractiveness of offshore domiciles largely related to tax advantages. With adequate ownership distribution, an offshore captive program would effectively pay no U.S. income tax. Offshore domiciles enacted legislation exempting captives from local taxation. They were also free to realize underwriting and investment income without the burden of U.S. or local income taxes.
In 1986, a tidal change from offshore to domestic domiciles began. This change resulted from two separate laws passed in the United States. The first extended U.S. taxation of all offshore captives principally owned by U.S. shareholders. The old strategy of diluting ownership below 10 percent for every U.S. shareholder would no longer provide exemption from U.S. taxation for owners of offshore captives.
The 1986 tax legislation also enacted a new "penalty" provision called the Branch Profits Tax. The combined provisions of the 1986 tax legislation suddenly moved the potential U.S. income tax burden on U.S.-owned offshore captives from zero to nearly 60 percent.
The second law amended the federal Liability Risk Retention Act. The 1986 change expanded the scope of the LRRA to include coverage of most types of commercial liability insurance (with the notable exception of workers' comp liability). Multistate groups could form under the LRRA and have the freedom to write business directly in any state, without suffering multistate regulation.
Today, nearly half of the states have enacted enabling legislation to attract captives. While Bermuda remains the largest domicile, with nearly 950 captives, the real growth in captive formations is domestic, not offshore. In 2006, Bermuda's net growth in captives was three. The combined growth in domestic captives was about 150. Vermont and Nevada led the pack with 37 and 34 new captives, respectively.
The reasons for this are numerous.
Group captives operate more efficiently in domestic versus offshore domiciles. Sponsors of group captives can now use efficiencies of the domestic captive statutes and LRRA provisions to build their captive program. They can avoid the use of expensive fronting arrangements to get their product to market.
They can also avoid expensive agent-driven retail distribution networks by electing a direct marketing approach with authority to write in all jurisdictions while being subject only to the regulation of the domestic domicile. Domestics are also more efficient because they're, well, domestic. From the West Coast it can take up to two days to travel to and from the mandatory annual board meeting at an offshore domicile. The real cost to captive board members is the productivity they lose to make that meeting.
Most domestic domiciles are friendly to those who want to form captives. While maintaining stringent regulation to preserve solvency, domestic legislators are willing to consider changing statutes to accommodate the newer, creative uses for captives.
There also could be significant exposure to the 30 percent branch profits tax for offshore captives that are not taxed as U.S. corporations. The branch profits tax is in addition to the federal income tax that U.S. owners pay on the deemed distribution of current income from the offshore captive. This exposure is nonexistent for domestic captives.
There are also additional protections to the solvency of domestic captives. Most captive states are accredited by the National Association of Insurance Commissioners and maintain its solvency requirements. For example, the required premium-to-surplus ratio in most domestic domiciles is 3 to 1, while some jurisdictions require little or no surplus to support captive premium writings. The states' supervision of surplus may provide needed financial security for the investment of captive owners.
TED HALL is the president of CHSI Captive & Insurance Managers LLC.
November 1, 2007
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