Regulatory competition, captive insurance in the US market

Lots of attention gets paid to offshore captives, but there is a vibrant market for captives inside the United States as well.  

 That competition is linked to the offshore market – it is competition from jurisdictions like Cayman and Guernsey that helps drive U.S. market leaders to innovate. Similarly, the competition from the market leaders in U.S. states helps push continued innovation in offshore jurisdictions.  

Not surprisingly, the domestic competition provokes criticism from the losers about unfair competition, just as offshore competition provokes protectionist criticism from onshore interests.

One prominent example of such criticism is the New York State Department of Insurance’s June 2013 report, “Shining a light on shadow insurance: A little-known loophole that puts insurance policyholders and taxpayers at greater risk.” Using the term “shadow insurance” for out-of-state captives, the report argued that “Insurance companies use shadow insurance to shift blocks of insurance policy claims to special entities – often in states outside where the companies are based, or else offshore (e.g. the Cayman Islands) – in order to take advantage of looser reserve and regulatory requirements.” 

The New York regulators argued that states (and OFCs) competed for insurance managers’ business by allowing them to be undercapitalized or engage in other risky behavior that offered opportunities for greater profits. In short, the New York regulators saw captives as a means to shift risk from insurers back to the insured and to taxpayers, who the regulators argued would have to pick up the pieces if an insurer collapsed and its under-capitalized captive failed to make good on the policies.

It is not surprising that New York regulators might not like other jurisdictions’ success at captive insurance – New York has been unsuccessful in attracting much captive business to the state, despite having a statute authorizing captives since 1997.  We looked at captives across states and several aspects of states’ captive regulatory regimes to see if we could explain which states had succeeded.

The first U.S. captive statute was passed in 1972 by Colorado, and other states slowly began to introduce similar statutes. However, just nine did so by 1992. Thereafter the number of U.S. captives began to increase, with the number of captives doubling by 2000. This growing market led 12 more U.S. jurisdictions to pass captive laws between 2001 and 2008 and another four have entered the market since then.

Success is not uniform – the most successful have almost 600 captives; the least, none. We examined the history of each state’s statute and spoke with regulators in insurance departments in an effort to determine what separated the winners and losers.

Jurisdictions compete for business by providing an attractive regulatory environment. Critics of regulatory competition often claim that “attractive” is a synonym for “poorly regulated,” but we think the evidence suggests the opposite. Across U.S. jurisdictions, the most successful are those that regularly amend their statutes to keep up with the competition. An example is the introduction of protected cell companies. After Guernsey created the concept, 15 U.S. jurisdictions followed suit in the next five years.

Vermont’s creation of branch captives spread to four more U.S. jurisdictions within a year and then rapidly to additional ones. What we found was that successful jurisdictions regularly amend their captive statutes. One market leader, Hawaii, has made an average of 1.36 material amendments per year – an impressive level of legislative attention to a specialist law. 

StateNumber of Captives*Initial Passage   Amendments
Per Year*
Hawaii17919861.357
Utah39920081.167
Vermont58819810.939
West Virginia120040.900
South Carolina14720000.857
Arizona10620020.667
Montana15020010.615
Oklahoma1120040.500
Connecticut420080.500
Illinois119990.467
Rhode Island019990.467
Nevada15019990.400
Arkansas120010.385
Tennessee3019780.361
D.C.13520000.357
Louisiana220080.333
Maine319970.294
Missouri4020070.286
Colorado419720.214
Kentucky12820000.214
Delaware55019840.200
Alabama2620080.167
Nebraska220070.143
New York6219970.118
South Dakota1219960.111
Florida019820.063
Georgia019880.038
Kansas119880.038
Virginia019860.000
Texas320130.000
Oregon720120.000
New Jersey1520110.000
North Carolina520130.000
Michigan1220090.000

* Data collected between February and July 2014.

Most of the top jurisdictions average more than one material amendment per year. Further, all of the U.S. market leaders have adopted at least two of the three major recent innovations (protected cell, branch, and special purpose captives); most have adopted all three.

This is consistent with the general competition for corporate charters, where part of Delaware’s advantage has been that its legislature regularly updates the Delaware General Corporate Law.

Just passing statutory language is not enough to succeed, however. We also found that jurisdictions that created a public fund dedicated to regulation and marketing of captives were more successful. All of the most successful jurisdictions, and most of those that came close, had such funds. It does not surprise us that a commitment to the industry is linked to success. In general, regulatory competition is an important force driving jurisdictions around the world to innovate.

As Profs. Erin O’Hara and Larry Ribstein argued in The Law Market (Oxford University Press 2009), “Parties, in effect, can shop for law, just as they do for other goods. Nations and states must take this ‘law market’ into account when they create new laws.” Buying your law from an up-to-date jurisdiction that has shown commitment to the area is a sensible strategy.

The market for corporate charters is one that the evidence suggests is beneficial. The stock price of companies reincorporating to Delaware rises (or at least does not fall), suggesting that investors do not see Delaware as engaged in a “race to the bottom” that allows managers to loot shareholders.

The explanation for the mechanism by which a managerial choice translates into shareholder welfare is in the disciplining effect of capital markets. The question in captive insurance markets is whether or not there is an equivalent mechanism.

The New York state regulators argued that insurance company managers will not look out for shareholder welfare in their use of captives.

As an example, they suggested that the use of conditional letters of credit (i.e. letters of credit that provide credit only if certain conditions are met), two-step transactions in which risk was transferred by a New York insurer to another insurer outside New York and then to a captive controlled by the original insurer, reliance on hollow assets such as letters of credit with a parental guarantee, and naked parental guarantees of the captive’s losses were all means by which an insurance company could weaken the insurance provided while enhancing the insurance company’s profits.

The insureds would not notice because the captive transaction would occur out of their sight.

Is such a story plausible in light of the vigorous competition among U.S. states seeking captive business? We think not, particularly given that a key to success is keeping a statute up to date. It is implausible that state legislatures would be annually engaged in a scheme to defraud insurance policy holders in other states, and the regular passage of significant amendments to captive statutes demonstrates regular attention to the area.

Even if the legislative leadership were in the pocket of nefarious insurers, someone in the legislature would be motivated to blow the whistle. Moreover, investment in promoting the industry appears to be important to a state’s success.
 

This would not be necessary if the industry were merely looking for a location for a scam. Further, the insurance industry is so heavily regulated that it is implausible that regulators in all of the successful states would be willing to go along with defrauding policy holders in others.

Rather than a “shadow” industry, we think the vigorous regulatory competition among U.S. jurisdictions for the captive insurance business is evidence of a vibrant market for law and confirms the O’Hara-Ribstein thesis. 
 

 

SHARE
Previous articleEuropean financial privacy in peril
Next articleInvolving customers in water regulation
Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

T. +1 (216) 272 9187
    +1 (217) 244 3449
E. amorriss@law.ua.edu 

LinkedIn: Andrew Morriss
Twitter: @andy_morriss
Research: See my research on SSRN
Blog: Offshore Green
 

Drew D. Estes

Drew D. Estes
JD/MBA Candidate
Class of 2016
The University of Alabama School of Law


T: +1 (662) 549 4222
E: drew.estes@law.ua.edu
W: www.law.ua.edu
 

 

University of Alabama

The University of Alabama is a student-centered research university and an academic community united in its commitment to enhancing the quality of life for all Alabamians.

Founded in 1831 as Alabama's first public college, The University of Alabama is dedicated to excellence in teaching, research and service. We provide a creative, nurturing campus environment where our students can become the best individuals possible, can learn from the best and brightest faculty, and can make a positive difference in the community, the state and the world.

The University of Alabama family has always expected great things. After all, we are our state’s flagship university — the Capstone of higher education.

The University of Alabama will be the university of choice for the best and brightest students in Alabama and a university of choice for all other students who seek exceptional educational opportunities. The University of Alabama will be a student-centered research university and an academic community united in its commitment to enhancing the quality of life for all Alabamians.

 

The University of Alabama School of Law
101 Paul W. Bryant Drive
East Tuscaloosa,
AL 35487


T: +1 (216) 272 9187, +1 (217) 244 3449
E: amorriss@law.ua.edu
W: www.law.ua.edu