There are three, at least, major threats/opportunities for captives as we enter a new year. These immediate three are 1) changing state regulations, 2) changing U.S. Federal regulations and 3) technology.
In order to fully understand the regulatory situation it is necessary to provide some background. Insurance companies, including captives, are regulated in the U.S. by the 50 individual states and five territories. They regulate insurance companies licensed to headquarter their businesses in their states/territories, and any and all insurers choosing to set up operations in their state, though that state may not be their state of full licensure. If licensed or admitted, forms and rates are approved by the regulators and taxes are lower than for non-admitted insurers, for which there is a separate tax.
The underlying law for this, versus Federal regulation, is the South Eastern Underwriters Association Supreme Court case of 1944. This ruling found that the Sherman Act gave regulatory authority to the individual states for insurance.
Each individual regulator, in his/her territory, reigns supreme, under the legislation and government of that territory. One cannot compel another to do things their way. Only their individual state legislators, by passing laws, can tell the insurance regulators what to do. And they must do only what they are told to do by their legislators.
The reality is, many insurance regulators are appointed by their friends in government, or elected on pro-personal lines issues, and don’t really know much about insurance or regulation. To do their jobs they must turn to others. The others to whom they turn, in addition to their own staff, are other regulators who may be seen to have some knowledge, and to the staff of their trade group, the National Association of Insurance Commissioners (NAIC).
There are trade-offs for using the knowledge of others. The other regulators will want to trade votes on issues important to them, in return for imparting knowledge to the asking party. Some of those issues are inimical to captives.
Staff may know nothing of captives. The NAIC staff, most of whom are very knowledgeable and competent, have their own agendas for giving help. These “returns” may also be inimical to captives, as NAIC is mostly opposed to captives. Why? Captives don’t pay them any money for taxes or data service.
In addition to the NAIC, there exists a group, the National Coalition for Insurance Legislation, (NCOIL). This group is comprised of state legislators, those who actually make the laws, who are focused on insurance. They don’t usually regard the NAIC highly, and often work counter to them. However, they are not as well staffed so don’t get much publicity or notoriety. But they do make the laws, not the NAIC. The NAIC develops and promotes model laws, written to support their views, often quite helpful, which each individual regulator must persuade its legislative bodies to pass. Some do, some don’t.
So, the situation is one where a very competent staff at the NAIC is working with a few knowledgeable regulators to promote their individual agendas in the face of a Federal government which has its own agenda, and the Europeans and their agendas, neither of which give consideration to the NAIC. A battle by highly paid, knowledgeable people for their jobs, against less well paid, in the Federal government anyway, and not as knowledgeable people who have the bigger sticks.
Not good for the consumer. Why is this important to captives? The Federal Insurance Office Executive Director, a former NAIC member, has said openly that captives represent the best place for the regulators to stand their ground together. Why? There is no one of size and strength to speak for captives. There is no one in the Federal government who knows or cares about captives. So, have at it. Will NCOIL not intervene? Not likely. While they understand the issue they have no staff or time to take this on.
So, there is, at this time, very, very little Federal regulation in force. The issue began to boil when the European insurance groups decided that they would not/could not deal with 55 regulators. So, with whom could they transact?
The Feds have pushed their toes into the arena through the Department of the Treasury and the Federal Insurance Office, most notably. They have even signed agreements with some European regulatory groups, even though the Feds have no regulatory authority. They have made the conscious decision to ignore the NAIC.
This has caused the NAIC to invigorate themselves. The most common way to do so is to introduce more studies, committees and model laws. Again, captives are conveniently at the center of much of this activity.
Many successful captive domiciles have knowledgeable, active regulators who work hard within the NAIC to educate their peers and to advance captives while resisting anti-captive regulations. They need to be identified and supported.
Finding a way by which the NAIC and its members can interact with foreign governments is going to be challenging. Much of those types of actions are forbidden under the U.S. Constitution.
Beyond NAIC issues there is the issue of state taxes. While captives are generally at a tax advantage, some U.S. states levy a tax on insurance purchased out of state by in-state businesses. This so-called non-resident tax is usually 4 percent of premiums, which can be a large amount. Some captive domiciliary states have apparently, to some observers, threatened this levy to get captive owners to become licensed at home, regardless of the other reasons for selecting a domicile.
This tax can be compounded in some jurisdictions by a surplus lines tax, applied to business written outside of the traditional admitted lines of coverage. This can also be in the 3-5 percent range. Not all states charge these taxes but the economic challenges faced by all U.S. states have driven the review and application of these existing taxes, which may not have been considered in the past.
Federal regulation is growing through the Treasury Department’s interest in pursuing new taxes. It sees that some insurance goes outside the U.S., while being owned by U.S. taxpayers. Maybe they are not paying their fair share. Information must be captured and taxes imposed.
At this time about the only Federal regulation of insurance is on terrorism and flood, some on agricultural crop. Not much tax income on those. So, many within the Federal government are seeking new ways to regulate, i.e., tax.
This approach is a bit easier than quarreling with the NAIC since the offshore jurisdictions have no presence or say inside the U.S. But since these jurisdictions have all kinds of treaties in effect, the Feds can force them to submit information about the U.S. citizens with money there. Witness FATCA.
The main protagonist is of course, the U.S. Internal Revenue Service. They bring their own position to the table. They regulate. They do not legislate. They administer the laws on the books. They often choose which ones to regulate, and to what extent.
The IRS, like many functions of the U.S. Federal government, suffers from under staffing and under funding. There are only so many projects that they can take on. So, they have developed lists of those areas in which they will concentrate. When published, it became known to all as the Dirty Dozen. Captives, under the 831(b) exemption, made the list. This means that, all other issues aside, staff and funding will be devoted to this area.
The well-known 831(b) exemption is just that: an exemption to the Federal tax. It has nothing to do with state regulations. One must apply for this exemption, to the Secretary of the Treasury. Once granted, it cannot be withdrawn, except with permission of the Secretary. One must qualify annually. Most are familiar with its qualifications, and the fact that they were “expanded” this year, for companies with annual premiums up to $2.4 million.
Not always known is that this exemption was put in place to help small, farmer oriented mutual insurance companies located in rural areas throughout, mostly, the upper Midwest of the U.S. Their association, the National Association of Mutual Insurance Companies (NAMIC), is the promoter and “keeper” of the exemption. NAMIC knows nothing of captives. This situation causes a real disconnect, into which the IRS is pleased to jump.
Most captive users of the exemption have no idea from which it comes, who promotes it, who keeps it alive and well, and why it exists. Not knowing who provides this exemption, and why, can put the captive user at a disadvantage, if their purpose is to follow the law and its intent. This is what puts the IRS at an advantage. They know the purpose and intent, and they know the legislators who sponsor the laws.
All of these Federal areas of insurance interest, the IRS, Treasury and others, cause challenges because a) they have no regulatory authority, and b) those with regulatory authority are at the individual state and territory level, so that there are 55 of them. Getting 55 entities to agree on anything is impossible. This is the point that frustrates the Europeans. They want to deal with the “one” person in charge. In the U.S., there isn’t one.
There is no clear end to the Federal regulatory conundrum, especially in a major U.S. election year. No substantive action will be taken by Congress, and the next action will be driven by the new president, whoever that may be.
The technology impact will be felt in many ways, not the least of which is the reduction of jobs required to complete tasks. An estimate by a noted consulting firm has predicted that up to 25 percent of administrative jobs will soon be made unnecessary by advancing technology. That is both bad news and good news.
Certainly losing one’s job is terrible, but most of us are aware of the overall shortness of supply of qualified people in our industry. Who better to add to your staff than someone that you have already employed? Just move them around.
Yes, it will require in some cases considerable re-training, but not in the essentials of your business, like who your company is, what it does, how it works etc.
How do captives get affected by all of this consternation? Captives for decades have enjoyed a widespread lack of knowledge about their affairs, and worked to keep that ignorance going. With a U.S. push for new tax revenues those days are rapidly going away. The initial response is to tax captives first, then try to understand them.
The internet has done many things to change the insurance world, but those changes will be deemed minor compared to what is coming. In the past, insurance has been a significant laggard in regard to advancing electronic technology. Computers took a while to replace typewriters. Computers took a while to replace paper files, and still have not everywhere. Much mobile activity remains telephone usage, not substantive data exchange and handling.
One way to look at these coming developments is to put them into two categories: cyber risk and data banks. Much has been written on both of these subjects, but little on how they will affect captives.
The main impact is to cover cyber risk in one’s captive. This is often seen as a handy and appropriate coverage, as such coverage that is available in the traditional marketplace can be highly priced and full of coverage holes. There is a reason for that. Actuaries cannot define the risk, therefor they cannot price the risk. That applies to captives, also.
If your actuary cannot price the coverage to be written in your captive that should tell you that trouble is on the horizon. At a minimum that situation means that you may well not have enough cash on hand to pay claims. Or even enough capital to pay claims and satisfy regulators.
Beyond funds you may not have available to your captive the claims expertise necessary to adjust the loss. These claims are new, as we’ve said. The claims expertise may not be available anywhere.
But the scary looming exposure is not just cyber liability per se, but its immediate cousin and working partner, data banks. The risk is not just about the cost to cover a hacker infiltrating a client’s data base. How about your own?
Extending the warning to data banks, it is becoming clear that many, many captives, by their very nature, hold vast amounts of information about their parents, and their parents’ partners. They often hold far more information than the traditional marketplace may hold about their policy holders. This is a monumental, company breaking exposure. All of the information required for traditional underwriting, sitting in piles of paper and stuffed into file drawers in endless rows of cabinets, has suddenly been recognized as holding vital, important, even crucial information. It may not have seemed so when gathered, but to the enterprising hacker it is a gold mine.
Because the captive is often a completely separate entity, with outside management, audit and accounting, it can be overlooked by one’s in-house IT staff. And yet it holds tons of vital information. It must be contained and secured, and all in management must see and recognize the exposure. Today, many do not.
As carriers, and others, convert these piles of paper into electronic files, they can be accessed from the internet, not always legally. The mere conversion to the internet has caused some carriers to overlook the actual information contained in their files. The conversion itself is a monumental task. Reading the stuff while doing it is out of the question. But hackers do so read it.
The value of these data banks is growing exponentially. The protection is not.
New structures such as bank-chains will cause the rapid advancement of captives into the world of higher technology. As companies set up their financing, and even captives set up bank-chains, the exposure is not measurable. “You can’t manage what you can’t measure.” These, and other structures like bank-chains, are not new ideas; they are concepts in place and working now. Again, since many captives are “isolated” by outside management and service providers, they may not see the interconnectedness of their information and not install good barriers.
A signal fact of captives is their innovation. This innovation has led to new coverage, new administrative techniques, new claims procedures and new financing structures. This newness has sometimes blown past the captive basics. Even today, in many captive owning companies, not all know what a captive is, and how it is done. They don’t know how much information is stored in the captive’s vaults and how much in tax can be levied by your favorite domicile. But captives are getting more attention, and so more practitioners must recognize this and address it.
The threats are real, but so is the innovative skill of the captive profession. With some heightened attention to detail captives will meet these threats and move to a higher plane.