Captive regulators stress importance of appropriate monitoring

MIAMI – With captives under increasing scrutiny, captive regulators must be vigilant in ensuring that the captives they oversee are properly monitored to prevent any efforts to impose additional standards or requirements.

“As captive insurance regulators, we need to take responsibility for what we’ve created,” Sandy Bigglestone, director of captive insurance for the Vermont Department of Financial Regulation in Montpelier, Vermont, and a 2018 Business Insurance Women to Watch, said on Friday at the World Captive Forum in Miami, which is sponsored by Business Insurance.

“We need to take accountability for what we’ve created and we can’t just license a captive insurance company for any purpose other than insurance and we have to have monitoring going forward to make sure the reputation of our companies as well as any of the domiciles and jurisdictions have a good reputation,” she said.

Ensuring captives meet economic substance requirements was a key topic of conversation. Under the economic substance doctrine, a court can reject claimed tax benefits if it determines there is no business purpose to a transaction besides favorable tax treatment. The Paris-based Organization for Economic Co-operation and Development issued guidance in 2018 on economic substance.

Certain European domiciles such as Ireland have previously required such substance to be demonstrated in part by having local employees in the jurisdiction.

But organizations outsource services all the time and captives are no different, Ms. Bigglestone said.

“We understand that a manufacturing company is not in the business of running an insurance company, so they seek the services of a Vermont-approved management company,” she said. “That works really well.”

“As an organization, you need to have oversight of those contracted services,” she continued. “You need to have board oversight. The discussion as it continues will be interesting. It could be good for captives. Certainly, if standards need to change then they will naturally change to comply with what needs to be complied with to meet economic substance arguments.”

Vermont requires a resident director who can be a captive manager or local counsel, she said. “It’s of the company’s choosing, but it does solidify doing business in Vermont and whether the OECD, they’re not as far as I know any authority, but we all need to be cognizant of what’s going on and what recommendations are being made.”

The National Association of Insurance Commissioners has no specific standards applicable to captives such as how captives should be staffed and likely would not implement such a standard, said Steve Kinion, director of Delaware’s Bureau of Captive and Financial Insurance Products in Dover, Delaware.

“I don’t think that will happen,” he said, adding, however, that licensing of captive managers could come into play.

“Captive managers are not regulated,” he said. “There is no specific licensing system. There is no standards system by which we can say this is a good captive manager that meets the requirements and this is not. It’s very, very subjective. When it comes to substance, I can see potentially a captive manager licensing system … I’m not advocating for that, but that’s one thing I can see.”

A new code of conduct for captive managers was recently released to  guide them in ethical business practices and address some of the criticisms directed at them and perhaps stave off a formal effort to regulate their activities.

Dominic Wheatley, CEO of Guernsey Finance, cautioned against those advocating for the United States to follow the European regulatory model.

“Don’t forget the European model regulates captives in exactly the same way as any other insurance company,” he said, noting that companies have to meet minimum capital requirements to secure passporting rights. “Be careful what you ask for. I think in principle to have a captive framework that applies equally across all 50 states … is a fantastic idea. What it overlooks is the commercial reality that you have a lot of states competing for business and one of the ways they compete is by having more flexible regulation. Speak to your regulators and try to get them to agree amongst themselves … but don’t go down the European model because you’ll find it makes lot of your captives just not economically viable.”

For example, Delaware in 2018 adopted legislation to allow for conditional licensing for captives. Of the 46 licenses issued in the state last year, 30 were conditional licenses issued to a captive insurance applicant on the same day as the application submission.

Conditional licensing is only available to 30 captive managers who have been vetted in terms of their previous success managing captives in Delaware and the domicile applies a “know your customer” rule, Mr. Kinion said. Captive owners must sign a state of compliance and proof of minimum capital must be provided to obtain the conditional license, which is good for six months.

In requiring the compliance statements, Delaware considered the criticisms of tax court judges that “captive owners themselves were not fully engaged” in two major cases, he said. In Benyamin Avrahami and Orna Avrahami v. Commissioner of Internal Revenue, in which the Internal Revenue Service successfully alleged that the 831(b) for a jewelry business in Phoenix that ostensibly covered insurance risks charged unrealistic premiums and did not meet risk distribution requirements for captives, and Reserve Mechanical Corp. v. Commissioner of Internal Revenue, in which a U.S. Tax Court judge found that the captive “was not operated as a bona fide insurance company, and there was no legitimate business purpose for the policies that Reserve issued for the insured.”

But Ms. Bigglestone noted the importance of the licensing process in setting up a successful captive and questioned the immediate need for such a license and whether it created any legal issues.

Conditional licensing can be summarily revoked back to the date of issuance, which would annul policies issued during that timeframe, Mr. Kinion said. A benefit of allowing for conditional licensing is that the entity may need to have its license established on a specific date for such purposes such as a joint venture, merger or new product launch.

“Will other states follow? I don’t know. That’s a great question, but it’s a question I don’t know the answer.”