The origin of federal rules governing the use of employers' captive insurers to fund employee benefits risks goes back to the early 1970s.

At that time, federal lawmakers were in the final stages of drafting sweeping pension reform legislation.

Concerned about the potential for self-dealing, such as companies charging their employees excessively high premiums for benefits coverage such as life insurance or long-term disability, early versions of the pension measure would have barred employers from using their insurance subsidiaries to provide benefits to their employees.

Representatives of Sears Roebuck & Co., however, learned of the proposed ban and told congressional staffers such a provision would prevent the big retailer from using Allstate Insurance Co., then a Sears unit, to provide coverage to employees of Sears.

The Sears representatives said since so much of Allstate's business was not related to Sears, it would become clear if Sears employees were charged excessively high premiums compared with other policyholders.

The congressional staffers were sympathetic to that argument. As a result, that portion of the Employee Retirement Income Security Act was redrafted before final passage to allow employers to use their captives to fund their employee benefits risks, as long as at least 95% of the captives' business was unrelated to their parent companies.

While the 95% test allowed Sears to continue to use Allstate to provide coverage to its employees, several other employers were not so fortunate.

While the overwhelming majority of their captives' business was not related to the parent, the captives did not have quite enough third-party business to pass the 95% test.

Those employers lobbied the U.S. Department of Labor, which had regulatory jurisdiction over the issue, to ease the 95% test. Their efforts were rewarded in 1979 when the Labor Department said an employer could use its captive to fund its employee benefits risks, as long as at least 50% of its captive business was not related to its parent and the captive was licensed in a U.S. state.

Still, that ruling opened the door for captive benefits funding only a crack. That's because employers rarely have their captives take on so much outside business.

Captive benefits funding advocates did not give up the fight. They continued to press the Labor Department for alternatives to the 50% test.

In 1999, their campaign achieved results. Ivan Strasfeld, then the director of the Labor Department's Office of Exemption Determinations, said the department was willing to consider alternatives to the 50% test if the alternatives were in the best interest of employees.

“There could be other approaches. We are flexible if there are safeguards,'' Mr. Strasfeld said at the time.

Among other things, the department wanted to see that fronting insurers used by the captive to write the policies reinsured by the captive were “top-quality and highly rated,” Mr. Strasfeld said.

“The plan should be getting good-quality insurance at a fair price, taking into account reinsurance arrangements,'' he said.

In addition, the transaction had to benefit participants.

Mr. Strasfeld's guidance quickly became a roadmap for employers looking to fund employee benefits risks in their captives but unable to pass the 50% test.

A test case came soon after Mr. Strasfeld's comments.

Columbia Energy Service Corp., then a Herndon, Va.-based natural gas company, sought regulatory approval in 1999 to reinsure its long-term disability benefits program through the Vermont branch of its Bermuda-domiciled insurance subsidiary.

In its application, Columbia Energy closely followed the guidance laid down by Mr. Strasfeld. Among other things, the company detailed how it would sweeten participants' long-term disability benefits, using a top-rated insurer — Liberty Mutual Insurance Co. unit Employers Insurance Co. of Wausau — to issue policies.

Columbia Energy had to wait nearly a year for the Labor Department to rule. The company's patience was rewarded in August 2000 when the department gave preliminary approval to the arrangement. Final approval came a few months later.

Other employers soon followed. In 2002, agribusiness giant Archer Daniels Midland Co. asked permission — using what its risk management executives described as the Columbia Energy model — to use its Vermont captive to reinsure life insurance policies written by Minnesota Life Insurance Co. for hourly and salaried employees.

For example, ADM agreed to sweeten life insurance benefits and to use only insurers with a rating of at least A from A.M. Best Co. Inc. to issue policies, or an equivalent rating from another rating agency. Minnesota Life had an A.M. Best rating of A++.

In 2003, the Labor Department approved ADM's application. Over the next decade, more than two dozen other employers filed applications and received approvals to fund employee benefits risks through their captives.