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By DAVE LENCKUS, who has covered the captive insurance industry for many years

Captive insurance regulators are a collegial group, passing along tips to one another about bad actors so no domicile gets burned and tarnishes the industry's reputation.

Yet, with states seeing captives as an engine of economic growth, regulators and domiciles also are competitive. So even the most mature domiciles modify their laws at least occasionally--and in some cases annually--not only to ensure adequate regulation but also to retain and attract facilities.

"We do talk to each other, and there is a friendly competition," observed Jeff Kehler, program manager, Alternative Risk Transfer Services, for the South Carolina Department of Insurance.

It's a competition, however, largely played out in obscurity. Captive insurance regulation is not well understood outside of the insurance industry, even by other governmental agencies. That sometimes leads to criticisms that captive insurance regulation is as substantial as carnival illusions created with smoke and mirrors.

For example, the Federal Housing Finance Agency roiled captive regulators late last year when it recommended limiting or eliminating captive insurers' eligibility to join the Federal Home Loan Banking System. The idea of captive insurers taking advantage of a decades-old federal law to join the FHLB, which would give parent companies a cheap source of capital, has been touted by Steve Kinion, director of captive and financial insurance products for the Delaware Department of Insurance. In its recommendation opposing the idea, the FHFA characterized captives as shell companies and questioned the adequacy of their regulation. (Read our story on this topic here.)

More recently, the New York Times in May published an article comparing an aspect of captive regulation to the "shadow banking system that contributed to the financial crisis."

Captive insurance regulators and industry experts, however, have said that the article focused on only around 1 percent of U.S. captives--those created by life insurers that want to tap excess reserves that regulations bar them from releasing. Those insurers, estimated at 15 to 20 in number, have plowed their excess reserves into captives and then raised capital by selling debt interests in the facilities--which actually do not bear any risk.

Those captives largely are based in Vermont and South Carolina, industry experts said.

The hundreds of the other U.S. captive insurers do bear risk, and regulators are balancing their rulemaking between provisions designed to ensure solvency and enticements to draw captive owners to their domiciles.

Even Vermont, the U.S. domicile with the greatest number of captives, continually modifies its captive law, on which many other domiciles have modeled their laws.

VERMONT'S RECENT RULES CHANGES

This year, Vermont began allowing protected cells to separately incorporate.

Cells in rent-a-captives--which typically attract unaffiliated middle-market companies that either cannot afford a single-parent captive or aren't sure captive insurance is right for them--previously had contractually separated their fortunes from one another.

But the strength of such contracts has never been tested in any bankruptcy court, captive experts noted. The theory is that, by allowing cells to incorporate and establish a legal separation from each other, a bankruptcy court supervising a failed cell could not compel other cells in the same facility to make the failed unit's creditors whole, captive experts explained.

Facility members also "don't have to worry" about being affected if another member runs afoul of tax law by failing to transfer risk, noted Arthur Koritzinsky, the Norwalk, Conn.-based managing director and U.S. captive advisory leader at Marsh Inc.

In a cost-saving measure for protected cells, Vermont also eliminated the minimum premium tax for them. Now, only the rent-a-captive facility itself is subject to a single minimum premium tax.

And the parent facility now can be owned by "qualified" and "sophisticated" entities outside of the insurance and financial institutions industries, noted Dan Towle, directors of financial services in the Vermont Department of Banking, Insurance, Securities and Health Care Administration.

Vermont also made permanent a five-year-old measure, initially intended as a 25th anniversary gift to captive owners, that waives the first $7,500 in minimum premium taxes during a captive's first year.

All of the changes indicate Vermont's competitive nature, captive experts said.

For example, the minimum tax relief measure for protected cells is in response to the approach that Delaware has taken with the series captives it has licensed since early 2010, acknowledged David Provost, Vermont's deputy commissioner of captive insurance. A series captive is a special purpose vehicle that only Delaware permits (see the story in that was featured in our print edition here).

"Vermont was just seeing some captives set up there that they would like to capture themselves," said Jason Flaxbeard, senior managing directors at Beecher Carlson Insurance Services LLC in Denver.

TENNESSEE'S NEW LAW

Tennessee, one of the nation's earliest domiciles, just overhauled its captive law. Nancy Gray, regional managing director-Americas at Aon Insurance Mangers in Burlington, Vt., noted it is modeled after Vermont's and South Carolina's.

The law, which went into effect July 1, has a couple of unusual provisions designed to catch the eyes of captive owners right away, captive experts said.

For example, it allows Tennessee-based companies to write workers' compensation coverage through their captives without using a fronting insurer.

"That's the first state to do that," said captive consultant and manager Michael R. Mead, president of M.R. Mead & Co. Inc. of Chicago.

It also allows life insurers to form securitization captives, where the insurers can park their Rule XXX reserves and then sell debt interests in the facility.

While there isn't a high demand for these facilities, which don't bear risk, they are an important capital-tapping tool for some life insurers, noted attorney Thomas M. Jones, a partner at McDermott Will & Emery LLP in Chicago. (They were, as mentioned earlier, also the kind of captive criticized in the New York Times piece.)

Tennessee's new law allows, as well, captives licensed in other domiciles to establish a branch or agency in the Volunteer State. Delaware also recently began allowing branch captives. The measure sets up both domiciles to compete with several others for companies that want to write employee benefits but currently are barred because their captives are domiciled offshore.

GARDEN STATE & OTHERS HOPE TO GROW TOO

New Jersey also enacted a captive insurance law this year. The law, which became effective in May, is modeled in part on Vermont's law.

But Aon's Gray noted that the law does not address the creation of risk retention groups. As a result, New Jersey-based RRGs would have to meet federal capital requirements, which generally are "more onerous" than those adopted by state captive domiciles.

In Nevada, pure captives have been relieved of some regulatory compliance costs under a captive insurance law revision enacted this summer.

Pure captives no longer face triennial examinations without cause. Ted Hall, president of CHSI Captive & Insurance Managers LLC in Las Vegas and a certified public accountant, estimated the change would save captive owners from $8,000 to $20,000 per examination.

"From a pure captive perspective, we're insuring our own risk," Hall said. "So, if it goes down, it's our own problem." Plus, the captives still must file audited financial statements annually.

Nevada also lowered the application costs and simplified reporting requirements for pure captives. For example, a captive applicant no longer needs CPA-produced pro forma financial statements because the actuary retained to establish coverage pricing already produces those statements.

"The thrust is to make Nevada a more attractive domicile for pure captives" and stop losing potential new facilities to Arizona and Utah, Hall said.

In Montana, one set of revisions is set to take effect Oct. 1. Another became effective earlier this year.

The upcoming changes reduce the capital and surplus requirements for direct-writing association captives to $500,000 from $750,000, and allow protected cells to incorporate.

The revision already in effect adopts the modifications on risk retention group oversight that were necessary to maintain the state's accreditation with the National Association of Insurance Commissioners.

SOUTH CAROLINA LOSES CAPTIVE COMMITMENT?

In South Carolina, there haven't been any recent captive law revisions. Some industry observers question the domicile's commitment to captives following a vaguely worded announcement from the state insurance department in July about an impending restructuring of its captive division.

Kehler, the state's captive regulator, said the coming changes have been designed to promote captive industry growth. Under the change, a deputy director in the South Carolina Insurance division will assume responsibility for the financial surveillance of captives so Kehler can focus on promoting the domicile and advising captive owners.

August 1, 2011

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