Paul H Phillips III
Ernst & Young

Regulatory permissions are partly the reason for an expansion in the US captive market, while the opposite is true in the EU, says Paul H Phillips III of Ernst & Young

What are you currently seeing in the US captive markets compared to in the EU?

Within the US, the captive market continues to expand at an accelerated pace while in the EU the market has been flat or contracting. One of the accelerators is clearly the favourable US Tax Court decisions that have added more clarity to the key criteria of risk shifting, risk distribution and what qualifies as an insurable business risk.

Additionally, it is important to note that within the US, the regulatory framework that governs insurance companies, including captives, resides at the state level. In this regard, while Vermont may be celebrating its 35th anniversary of having captive laws in its books, other states have recently been entering the market or modifying their insurance laws to further accommodate the captive industry. Accordingly, now 40 US states are competing for captive business. Thus, in the US, the expansion of the captive market is in part due to regulatory permissions.

This is in contrast to the EU captive market. Within the EU, we first started to see contraction due to the requirements of Solvency II, with various organisations re-examining the benefits of captive structures given internal hurdle rates, or the cost of capital and the increased capital requirements. Solvency II also introduced a fair amount of uncertainty into the environment, as the market seemed fairly confused regarding the actual applicability of the rules.

The confusion, and the contraction, within the EU has been compounded by the Organisation of Economic Co-operation and Development’s (OECD) base erosion and profit shifting (BEPS) project, as the market has reacted to statements and concerns raised regarding captives.

I should also highlight that while we have seen most organisations within the EU that own captives re-evaluate their use of this corporate risk management tool, many have decided to enhance the substance of their captive and increase the documentation of the corporate rationale for why their captive is appropriate. Accordingly, in both the EU and US captive markets, the volume of consultancy services is increasing, but for clearly different reasons in each market.

Beyond the regulatory environment, are you seeing any specific trends in insurance products?

Starting with the US market—we are seeing growth across the board and it’s difficult to pinpoint one particular line of business or even industry segment that is having a true break-out performance. However, I do see a few slight leaders in the pack.

With regards to lines of business, still focusing on the US market, we have seen a rise in product liability and product recall. Obviously, given the tort environment in the US, this is a natural product for companies that believe they have better experience than the overall industry, or who feel as if they are unfairly penalised in pricing due to the adverse development of claims of others, to explore placing this line into a captive.

We have also seen that in certain industry sectors product liability and recall coverage is not available to consumers, so a captive is a viable risk management alternative.

Perhaps most notably within the US, and expanding internationally, is the number of companies that we see examining different types of business risks and exploring whether such risk could be better managed in a centralised structure such as a captive insurance arrangement. I believe this is due, in part, to the residual value insurance (RVI) case and the clarification by the US tax courts on what may qualify as insurance. The other aspect that facilitates this is that many companies now have quite a bit of knowledge and data regarding their business risks.

This may have been captured as a result of enterprise risk management efforts, stress testing, succession planning or any of the other risk-based modelling initiatives an organisation may have executed.

This data may allow a company to analyse its experience and structure the transfer of such risk as pursuant to an insurance contract into a captive that is regulated as an insurance company. Accordingly, when big data is aligned to the RVI case, there are various opportunities in creating risk management, captive insurance and alternative risk transfer programmes.

Also, within the US we have seen an uptick in companies seeking to offer insurance to their customers for customer-based risks, such as extended warranty programmes. I can’t specifically call out the driver for this uptick, but I would suspect that it could be related to the increase in the premium threshold for electing small insurance companies to be taxed on investment income only under Internal Revenue Code Section 831(b).

This was modified late in 2015 to limit, or eliminate, the benefits of the election in certain situations where estate taxes may be at issue. However, in addition to the elimination of the perceived estate tax planning abuse, the premium ceiling for electing companies was raised from $1.2 million to $2.2 million, starting in 2017.

As this election was once popular in the producer-owned reinsurance space—dealer-owned extended warranty companies—I believe that that area of the market has re-emerged. Of course, the mere increase in the premium limit has many organisations re-evaluating programmes for otherwise self-insured risk.

Likewise, we do see some companies restructuring or taking other appropriate steps, including winding down, in reaction to the possible elimination of the benefits of the election.

I would be remise if I didn’t mention that within the US we also still see interest in employee benefits as possible placements within a captive, and lately this has included a focus on medical stop-loss programmes. Given the recent favourable rulings and the potential benefits of these programmes, they are often discussed.

In looking exclusively at the EU, I honestly cannot identify any real trends in products or specific sectors. Lately, the real efforts have been in assisting companies with substance or documentation concerns, such as transfer pricing considerations. However, historically, EU captives that I have been exposed to have EU pension risk transfers or other employee benefit type arrangements.

You mentioned risk distribution as a key criterion for qualification. How do you currently evaluate the matter?

The academic debate that we often have is: how many subsidiaries are needed in order to have risk distribution? This is due to the captive safe harbour rulings in 2002 (Revenue Rulings 2002-89, 2002-90 and 2002-91) that described the need for 12 or more subsidiaries, whereas no one subsidiary had more than 15 percent or less than 5 percent of the total premium or risk going into the captive.

The safe harbour ruling was also later clarified by the Internal Revenue Service (IRS) in Revenue Ruling 2005-40, where it articulated its position that the risk of an entity that is disregarded for tax purposes is the risk of its owner, and in the facts as presented, all risks transferred to an owner of 12 disregarded entities. As a result, distribution was deemed to not exist.

First, I would stress that all facts matter in evaluating qualification. But, if we are limiting such analysis to only risk distribution and assuming all other facts are good, my belief is that if the facts line up to the risk being shifted across the organisational structure, as opposed to coming down from a parent, than the number of subsidiaries is factually irrelevant to the actual risk distribution analysis. This is due to the US Tax Court statements in Rent-A-Center and Securitas, which emphasised risk distribution as being the analysis of statistically independent loss events.

Accordingly, technically one subsidiary, other than the captive, may be good enough for the risk being transferred from the subsidiary. Regardless of the technical or actuarially-based argument that the court has embraced, the IRS has not withdrawn or modified its prior revenue rulings.

Such guidance remains as authoritative pronouncements that must be evaluated, or weighed, against all relevant authorities in forming an opinion on a specific set of facts and circumstances. My view is that to be at a more-likely-than-not level of comfort, a taxpayer would need clean facts in all aspects and need at least two other subsidiaries, with no one subsidiary representing 90 percent or more of the total risk or allocable premiums going into the captive.

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