Morris, Manning & Martin LLP
Close tabs need to be kept on the NAIC to make sure that it is not overreaching and doing something that is adverse to the interests of the alternative market, says Skip Myers of Morris, Manning & Martin LLP
You have said previously that regulatory ‘mission creep’ has the potential to become a problem for US captive owners. Could you explain?
The US regulatory system is vastly different from the in European equivalent—we have 55 jurisdictions, 50 of which are states, and each of their commissioners belongs to the National Association of Insurance Commissioners (NAIC), which acts as the national standard-setting organisation. This brings states together but also creates conflict between them, which is a matter of some confusion to Europeans when they have to deal with the US. The International Association of Insurance Supervisors (IAIS) would much prefer to deal with one federal insurance regulator, but it has 50 to deal with, so it goes through the NAIC, which really has no power—except that it has the power to influence.
What happens is that the NAIC takes on an authority that it doesn’t have, and by mission creep I mean that, instead of dealing with straight-up regulatory issues, it tends to push the issues right to the edge. For example, since captives are regulated by each individual state, the NAIC takes on the role of trying to develop common standards. Sometimes that can be beneficial but, for the most part, it ends up invading upon the turf of states that have their own captive programmes—even in some non-US domiciles.
There is always mission creep in bureaucracies because they need to justify their existence—that is what happens and that is what makes it difficult. You need to keep close tabs on the NAIC and make sure it is not overreaching and doing something that’s adverse to the interests of the alternative market.
Is the mentality of the NAIC showing any signs of improvement?
In some respects, it has improved. There is more knowledge about captives now than there was five years ago. I do a lot of work with risk retention groups (RRGs), which are a form of captive that are the result of a federal statute that pre-empts state laws. Some of the states do not like them. The NAIC went through a five-year process that ended a year ago where it adopted accreditation standards relating to the regulation of RRGs and imposed them on the state of domicile itself.
That was a struggle, but through that process many states became more informed about what captives actually do and so on. Having said that, there are a number of states that still don’t understand. There are a number of regulators or state insurance departments that just want to do it their way and not take into consideration that these are captives and not regular commercial insurance. This is mainly due to a lack of experience, a lack of training and regular staff turnover.
Commissioners turn over every two years or even less and are appointed (instead of elected) in 80 percent of the states. It creates a dynamic where there might not be any institutional knowledge that endures. The NAIC is the place where there is institutional knowledge but it has a bureaucracy that is not accountable to any particular state, just its own leadership.
This issue has come up recently because there was a challenge to the leadership of the NAIC by one of the commissioners, Thomas Leonardi, who came out and said what others have thought— that there is too much cronyism.
Is this dynamic something that is likely to change?
I have been working in this industry for a long time and this is always the problem. It comes and goes in cycles and depends on who is in the position of power. The bigger states have more of a voice in the NAIC because they have more people to staff the committees and, as a result, they are more involved. They also generally have more technical expertise because they have bigger staffs and can afford it. States such as New York, California and Florida have a large input in how things go and also tend to not be very captive-friendly.
They accept captives unless it comes to their attention that a captive from, say, Vermont or Hawaii is doing business in their state as they define it. However, ‘doing business’ in the legal sense is not just having a risk in that state that gets insured by a single parent captive. However, owning property may be enough to raise attention. There are always going to be feathers that get ruffled, and you have to deal with it.
Now there is an idea that captives don’t pay enough tax. The truth is that they do pay a lot of taxes and even tend to pay proportionally more than traditional insurers. There is a study by A.M. Best on this that shows the extent to which captives pay taxes. The misconception comes from the fact that captives can afford the taxes because they don’t have the overheads that traditional insurance companies do. They don’t pay agents 17 percent, they don’t have the marketing expenses and they don’t pay the staff.
Marketing for a big company is generally 25 percent, but captives don’t have that expense—or certainly single parent and group captives. Some RRGs have marketing expenses, but, all told, these entities are designed to serve the company and the parents or their affiliates, not general parties.
Do tax reforms, such as those currently in the works in New York, have an impact on the industry as a whole?
As your readers may know, New York has this bill that’s in the legislature that would presume to give the state the authority to require an income tax return for any out-of-state captive. There could be a legal challenge to that because, under federal law, they may not have the nexus of doing business there.
You could challenge it, but it probably isn’t worth doing so because the cost of doing so might be too great—so it will probably be just more efficient to pay the income tax as there may not be much business there anyway.
The salient concept is that they are reaching out to get the extra tax dollars and, if other states did the same, then it could defeat a lot of the benefit of captives.
Where does CICA stand on these kinds of issues?
I cannot speak for the Captive Insurance Companies Association (CICA), but it has been quite proactive on these issues, and it has a broad portfolio of interests due to being domicile-neutral. The captives that are members of CICA are risk management tools (ie, ways to reduce your insurance costs), so the tax issues are really not so important.
There are companies that have captives that are in a domicile that has no income tax. In some cases, the allegation is made that this is a form of ‘transfer pricing’. It is a complicated question, but if all activity occurs on an arm’s length basis, then it is perfectly legitimate. It is generally the people who decide to try to push the envelope who cause the problems. The NAIC meeting is coming up soon, so we are waiting to see what might occur there.
The 831(b) micro captives are another important issue, as they are so easy to put together, and they can be flawed if not done correctly. If this is the case, then they are subject to challenge and that’s not good for the industry as a whole.
While some states don’t do them at all, some are big fans. The question is: do states have the staff to manage and understand them, and can they give them the risk management and actuarial analysis that is necessary to determine it’s a fair market, arm’s length deal?
The more there are, the harder they are to regulate. In the future, there may be tax issues for these guys and that’s not good for the industry.
We want the industry to roll along without regulatory problems, but that is unfortunately not likely to occur in a regulated environment. The pendulum never stops swinging in the middle, and there will always be over-reaction and under-reaction to these types of issues.
