The US has worked hard to become a home to the captive insurance industry, and now as a whole is the largest domicile in the world having close to 3,400 captives licensed as of the end of 2019.
States such as Delaware, Vermont, North Carolina, Tennessee, Montana, Nevada, Arizona, Hawaii, and South Carolina are some of the largest in the US captive domiciles.
The US has seen a lot of growth within the captive insurance industry in recent years, however, there have been some challenges along the way. One of the biggest challenges includes continued scrutiny from the Internal Revenue Service (IRS) on micro captives, while some more recent challenges have occurred from the ongoing COVID-19 pandemic.
Although challenges are present, industry experts believe there is a bright future of growth within the US captive market.
Adam Miholic of Hylant, Peter Kranz and Jason Flaxbeard of Beecher Carlson, Spencer Poole of Venture Captive Management, Ryan Work of the Self-Insurance Institute of America (SIIA), and Jerry Messick of Elevate Risk Solutions discuss these challenges and more.
The IRS’ battle against micro captives
One of the biggest talking points in the US captive industry over a number of years has been the scrutiny received by the Internal Revenue Service (IRS).
The IRS is responsible for collecting taxes and administering the Internal Revenue Code, the main body of federal statutory tax law of the US.
The IRS’ specific target is micro-captives, which have made an appearance on the IRS ‘Dirty Dozen’ list of tax scams since 2014.
In 2016, the Department of Treasury and IRS issued Notice 2016-66, which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.
The IRS has recently won three court cases against captive companies. Following these cases, the service has decided to offer settlements to taxpayers currently under exam.
The IRS recently came under scrutiny from various people in the industry, including associations, after it sent out settlement letters at the start of the COVID-19 pandemic, a few days after the US officially went into lockdown.
The letter was sent to tens of thousands of taxpayers seeking information about their participation in micro-captive insurance transactions. After push back from the sector, the IRS extended the deadline for the micro-captive insurance filing positions from 4 May to 4 June 2020 because of the pandemic.
Adam Miholic, senior consultant, global captive solutions at Hylant, states that the IRS’ continued campaign against "transactions of interest" has “muddied the waters” around what is allowable under the current interpretation of insurance operations and accounting.
He says: “While tax should never be the primary driver of captive creation, the potential financial benefits that a captive could provide its owners are indisputable. The absence of a bright-line test in the US Tax Code that outlines specific requirements for the treatment of captive insurance companies continues to cause concern for the industry.”
The applicability and enforcement of various states’ self-procurement tax have been well documented over the past few months and years. Miholic explains with most of the high-profile cases ending in court or mediation, “this is clearly an area of captive regulation affecting the industry”.
On the IRS issue, Peter Kranz, executive managing director and captive practice leader at Beecher Carlson, suggests that it is not a domicile issue, but is a challenge in the industry overall.
Kranz says it is an area “we are glad the IRS is cleaning up because there seem to be abusive structures out there”.
He outlines that there is some concern by the leading tax experts in the industry about the approaches the IRS is taking and how that could ultimately be interpreted concerning all those captives that are doing things the right way.
Also weighing in on challenges around the IRS, Spencer Poole, chief compliance officer at Venture Captive Management, highlights that within the captive insurance market, the largest regulatory hurdle is the tax code.
Poole notes that the IRS still has not set defined criteria around risk distribution; the determination remains largely subjective.
Ryan Work, vice president of government relations at SIIA, also notes the IRS as a challenge, however, he views it as an “ongoing and unending campaign against 831(b)s”.
Work states that “this is yet another case of regulators not fully understanding or willing to be educated on how a captive structure operates from start to finish”.
“That, combined with overaggressive tactics and duplicative industry data requests, have created a perfect storm,” he continues.
CIC Services, a captive manager based in Tennessee, has lodged several lawsuits against the IRS and US Treasury in a bid to block Notice 2016-66. However, the firm has so far been unsuccessful.
However, in January, CIC Services noted that they wanted to bring the case to the Supreme Court of the US (SCOTUS) and in May of this year, SCOTUS agreed to hear CIC Services’ case against the IRS regarding IRS Notice 2016-66.
Reflecting on if this court case will change the IRS positions on micro-captives, Kranz says he doesn’t know if this case will “necessarily resolve them”.
He explains: “If I understand it correctly, throughout the process CIC Services have lost at every single level they have been at."
"Therefore, the likelihood of them winning at the Supreme Court appears to be very low. But you need to consider the facts and circumstances in that specific case.”
On the other hand, Work believes the case before SCOTUS can help clear up the IRS’ ability to engage in certain regulatory actions towards the captive industry, such as Notice 2016-66, as well as broader industries across the country, but he adds it will not solve wholesale the scrutiny of captive structures.
Work highlights that the captive industry is here and willing to engage and that they need the IRS to be open to having a forthcoming and honest dialogue about what appropriate federal regulatory guidelines would be. He points out that “Congress makes laws, the IRS is tasked with following them, not the other way around”.
On a different note, Kranz lays out his only hope that the IRS doesn’t overreach because a vast majority of the industry is made up of compliant structures, created for the right reasons.
He specifies his hope the IRS to focus on the issue in question.
“Frankly, as an industry, over the last eight to 10 years, we have been trying to self-police. So I think that the IRS push on entities will help clean things up, but I do not know if CIC Services will necessarily have a significant impact unless the Supreme Court rules that the IRS cannot enforce Notice 2016-66”, he adds.
He points out that the CIC Services case has a very specific set of circumstances, taking the matter to the Supreme Court about the IRS’ requirement to disclose certain transactions. Even if this is granted, this does not necessarily stop the IRS’ push to clean up non-compliant structures.
US regulation challenges
In terms of other US regulation challenges impacting the captive insurance industry, Kranz suggests that one of them is jurisdictions that are aggressively pursuing direct placement taxes and where in some cases they might not even have the legal authority to do so.
Kranz highlights that this is a factor that captives and their managers have to consider. However, according to Kranz, in a hard market, premium pricing is increasing so much that direct placement taxing is becoming a lot less of an issue.
Also discussing regulatory challenges, Poole notes the biggest challenge around regulation is the outbreak of COVID-19. ?
Poole says: “For any company, comprehensive compliance requires a cohesive network of internal and external professionals working in tandem, especially in the audit season. This crisis has been a stress test in many ways, as we’re finding new and different ways to work together, apart.”
Poole states from a coverage perspective, regulators in the US are pushing for indemnity where there was never underwriting intent. He notes that this is most evident in workers’ compensation and business interruption.
Jerry Messick, CEO of Elevate Risk Solutions, also echos COVID-19 and the challenges associated.
“I think captives will provide a very important role in providing new and creative solutions. One concern is making sure captives have adequate reserve strength should coverage be found for the pandemic, especially with insured/owners feeling cash pressure due to the economic conditions”, Messick says.
Introduction to PRIA
The ongoing COVID-19 pandemic continues to impact not just people’s lives but also the financial markets worldwide. In early June, the US introduced the Pandemic Risk Insurance Act of 2020 (PRIA), which aims to cover losses and protect the US economy in anticipation of a resurgence of COVID-19 and future pandemics.
The new legislation would create the Pandemic Risk Reinsurance Programme, which will be a federal programme that provides for a transparent system of shared public and private compensation for business interruption losses resulting from future pandemics or public health emergencies.
The bill was introduced by Carolyn Maloney, US representative for New York’s 12th congressional district and a senior member of the House Financial Services Committee (HFSC), alongside several stakeholders.
Commenting on the bill, Jason Flaxbeard, senior managing director at Beecher Carlson, says: “The bill is important because if you look at the amount of stimulus the government gave to their small business approaches, our economy burned through that in days.”
Flaxbeard explains: “The insurance industry has approximately $800 billion of available policyholder surplus and some anecdotal reports have indicated that if you make the insurance industry pay for all the business interruption losses caused by COVID-19, currently excluded in most policies, we would burn through that surplus in a couple of months.”
He notes that the insurance industry cannot pay for these losses, and therefore, there is a need to have a governmental backstop.
PRIA will follow the same structure as the Terrorism Risk Insurance Act (TRIA) and provides access to governmental funds when the insurance market is not available for the coverage, according to Flaxbeard. He adds that this provides a screening process for companies and takes out the application process. It also provides capital when it is needed and does so in a mechanism that allows the process to potentially recoup those losses.
Flaxbeard notes: “I think it is a good move, it’s needed, and it provides a backstop when there is no insurance available.”
In April, Work sent a letter addressed to Maxine Waters, a US representative for California’s 43rd congressional district and chairwoman of HFSC, on the proposal to create a pandemic risk reinsurance pool.
In his letter, he outlined that SIIA supported a federal framework for a Pandemic Risk Insurance Programme that would create a risk-sharing model similar to Terrorism Risk Insurance Pool (TRIP) that is between policyholders, insurers and the federal government.
Work states: “With the country not yet having emerged fully from COVID-19, PRIA will necessitate a much larger debate on the federal level as to the necessity for a future pandemic reinsurance programme and what that will look like as a means to help American businesses recover.”
He explains that PRIA sets up a pandemic risk reinsurance programme that will be triggered when aggregate losses for a covered health emergency exceed $250 million. If that limit is triggered, the federal government will take on an amount equal to 95 percent of insured losses that exceed the insurer deductible, with a cap of $750 billion.
Work highlights that it remains important that private sector insurance and reinsurance programmes, such as captives, remain an important tool for businesses in mitigating future pandemic costs.
“While I believe the HFSC and Congress generally, will have further debates and in-depth discussions on this topic later this year, it may take some additional time for COVID-19 recovery and lessons learned to truly understand if this programme will be enough to handle the risks and costs associated with future pandemics”, Work adds.
US outlook
Examining what the next year looks like for the captive industry, Poole expects to see a marked increase in the number of captives in the US.
Poole says: “What will be interesting is how each venue will differentiate itself from other jurisdictions to attract captives; whether this manifests in the form of decreased fees, amended capitalisation requirements or something else, I’m excited to see how the captive market evolves and the new opportunities it presents.”
Messick also expects to see growth, suggesting a 20 to 30 percent increase in new captive clients over the next 18 months, if not longer. He says: “We’re very optimistic about the captive industry.”
Miholic also highlights the trend of increased interest in new captive formations and he sees it continuing well into 2021, given the future outlook both locally in the US as well as the London and global markets.
He highlights: “As the environment and political landscapes continue to shift at uncanny speed, the traditional marketplace will still have issues keeping pace. While this is causing pain points with many insureds, the situation is highlighting the benefits that captives can bring to their parent companies. I also see increased interest and participation in cell companies across industries and company demographics.”
“The value placed on joining a pre-built facility with timing and cost efficiencies can be immeasurable during these times of uncertainty and capital constraint,” Miholic maintains.
Kranz says he expects to see captive domiciles continue to be flexible with their requirements (waiver of physical presence, electronic signatures, etc.). He suggests there will “dramatic activity” in the number of new captives and the programmes being set up.
He also notes that “the insurance marketplace is changing and doing so in a way that is going to put more risk on insureds”.
Kranz highlights that this is going to be a primer to the growth we’ve been seeing in the middle market for captives: groups and other cell structures.
“It’s not about trying to get some tax benefit – it is being driven by the fundamental repricing of the insurance marketplace”, he adds.
Also weighing in, Work says he is “amazed” at how rapidly evolving the industry is, suggesting that the next year will be an exciting one in this evolution.
He explains that state regulators and others are seeing first-hand the success of captive formation, with new domiciles looking to follow suit.
He also notes that in November, the US will see election results from the 2020 presidential election, which may very well impact the future of tax policy on several fronts, between Congress and the Administration.
“There are numerous issues to track, including a hard insurance market, election impacts, and a potential federal court decision, any one of which will have long-term implications across the industry”, he concludes.
