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By Steve Tuckey

Captive insurance companies have existed in some form for many years. So they must contain some adaptive qualities that will come in handy if they are to survive the new regulatory universe arising in the aftermath of the great financial crisis of 2008.

In addition, the industry may soon face regulatory scrutiny that it has somehow become a "shadow banking" system, when those fears have such resonance in the wake of the nearly trillion-dollar bailout stemming from the financial crisis.

Two years ago, President Obama signed the Dodd-Frank regulatory reform legislation into law aimed at preventing another financial crisis. Lawmakers included the Non-Admitted Reinsurance Reform Act targeted at, among other things, taxation issues involving surplus lines companies, whose ranks may now include captives, by some definition.

Rob Leadbetter, Cayman Islands-based vice president of the USA Risk Group, has no doubt the captive industry will thrive and prosper, despite the uncertain regulatory climate. "Dodd-Frank is far reaching and the insurance industry is not being spared, rightly or wrongly, depending on who you talk to," he said. "Everyone will have to make some adjustments."

While Dodd-Frank may bring some expanded captive regulation, "at the end of the day, the influencers within the captive space will adjust, as they have always done, with the same kind of flexibility that have made captives the popular risk transfer vehicles they are today."

The NRRA tried to settle the thorny issue of how premium taxes incurred by surplus lines policies covering multistate risks should be collected and distributed. The law calls for the home state of the insured to collect 100 percent of the premium, while at the same time allowing states to set up compacts to codify a system of tax-sharing governed by where the risks are located.

So far, most of the states have settled for the home state collections systems, having been unable to reach consensus on the terms of any such compact.

Captives have unwittingly been dragged into the fray since the case could be made that they are nonadmitted insurers, even though the law was clearly aimed at surplus lines companies.

Chicago-based attorney Tom Jones, who specializes in captives, calls the whole controversy a "tempest in a teapot."

"It may affect where a captive is set up. But it is in no way a threat to the future of captives. It just has to do with to whom do you pay tax to, and how much," he said.

Arthur G. Koritzinsky, Marsh North American Captive Advisory Leader, said while the impact of the law remains unclear, it is already having an effect on where companies will locate their captives, and on companies opting to create new ones to manage some risks.

The Norwalk, Conn.-based broker said that for those companies located in one of the 32 states with captive infrastructures, a home-state captive would be advantageous "because it is pretty clear that the whole issue of the self-procurement tax goes away because you now have an admitted placement if it is in your home state."

States such as New Jersey and Connecticut that have had captive laws on the books for years have seen new formations in the aftermath of the NRRA passage, he noted.

As for Vermont and other states with well-oiled captive machines, Koritzinsky said "I don't think there is a panic or a rush to the doors."

But Koritzinsky said that companies with captives with large amounts of premium in nonadmitted placements might consider formations in other jurisdictions or look at forming multiple captives.

A number of companies have already taken such action in the past couple of years, he added

The whole issue centers on the so-called self-procurement as opposed to broker-obtained surplus lines policies tax that is in effect in about two-thirds of the 50 states. The NRRA says this tax should now be collected only by the home state of the insured rather than apportioned to different states based on the percentage of risk in each state, as was the case in the pre-Dodd Frank days.

In reality, the tax often went uncollected in many states and companies were unsure where the tax was or wasn't in effect.

But all that has changed with cash-strapped home states now eyeing a possible 100 percent collection. "So it is a big deal. I don't think states are in any kind of mood to give up taxes they are allowed to collect even though a lot of them are not," Koritzinsky said.

The issue can be resolved through an amendment to the NRRA at the federal level followed by conforming actions by the states, Koritzinsky said.

Daniel Towle, director of financial services for the Vermont Agency of Commerce and Community Development, said the lawmakers intended that the NRRA apply only to the surplus lines market and not captive insurance companies.

"Most captive insurer's informed tax consultants are advising a 'wait and see' approach and captives are staying put in their current domicile," he said. "We have seen a few consultants that are trying to encourage movement by captives but their interests appear to be driven by consulting fees."

A CHANGING ROLE

The practice of insurance companies themselves creating captives for the purpose of financing, as opposed to transferring risk, has raised concerns among regulators that policyholders, or other carriers themselves through guaranty funds, might end up on the short end of the stick if efforts to skirt reserve requirements end up backfiring.

The National Association of Insurance Commissioners has set up a panel that could result in more scrutiny on Special Purpose Vehicle Captives aimed at securitizing the risk of term and universal life insurance policies in particular after reserving requirements were bolstered in 2001.

A New York Times article in the spring of 2011 further raised the specter of a so-called "shadow banking" system stemming from these special-purpose captives, but industry experts downplayed the story, saying it sensationalized a trend that represents about 1 percent of the captive industry.

"I don't think regulators quibble at all with captives being used for risk transfer," said Tom Sullivan, Hartford, Conn.-based PwC partner and former Connecticut insurance commissioner.

"Where regulators have concerns is when the captive is being used to finance risks that are intended for underwritten liabilities, that is, those that have policyholder implications," he said. "This has piqued their curiosity and has led to deeper introspection."

The Times article cited the example of an AIG Vermont-based captive created to shelter the burgeoning liabilities of a North Carolina-based mortgage insurance unit so that "getting the claims off the books of the North Carolina company made it solvent again so it could keep selling all those policies."

"Vermont's confidentiality rules make it impossible to find out how MG Re (the Vermont captive) is juggling all that debt. AIG is liable, but for now the problem is hidden away," the article stated.

Sullivan said that he has heard from senior regulators that after the NAIC's special panel's white paper is approved there will be some sort of action taken by the body. "I don't think this is going away," he said.

A discussion draft of the NAIC panel's white paper implied that the entire issue of term and universal life insurance reserving requirements will be moot with the implementation of so-called Principle Based Reserving tenets in the near future.

But as a former regulator, Sullivan is not so optimistic. "I think there is a lot of support for PBR principles, but it is not unanimous. There are still some states not on board and they are big ones."

Richard Smith, president of the Vermont Captive Insurance Association, defended the use of captives to transfer third-party insurance risk.

"We understand the concern for the NAIC to review these transactions, but we think when the subgroup understands them better they will see they are very well regulated and safe. After all, these transactions have to be approved by not just the captive insurance regulator, but the home state insurance regulator as well," he said

STEVE TUCKEY has written on insurance issues for a decade for several national media outlets. He can be reached at riskletters@lrp.com.

November 1, 2012

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