McDermott Will & Emery
It is incumbent on the captive industry to show that it can succeed without the heavy hand of regulation, according to Tom Jones of McDermott Will & Emery
What is the current state of the captive insurance industry, from a regulatory point of view?
I think there will be excitement over the next couple of years. This will be, to a lesser extent, on the federal tax side—although there are exceptions that have appeared recently (the taxpayer-favourable Rent-A-Center case, for example) and there will be another one in a month or two, I expect, called the Securitas Holdings & Subs case.
It seems like the real action is going to be on the state regulatory side, regarding the National Association of Insurance Commissioners (NAIC) and how it will treat, not just risk-retention groups, but group captives in particular. There will also be more of an attempt to regulate captives in a more rigorous fashion on a state-wide basis.
Captives have expected, and deserved, lighter regulation than the commercial insurance sector, and I think they have discharged their responsibilities pretty well to avoid trouble such as insolvency. I think it is incumbent on our industry to show that we can succeed without the heavy hand of regulation.
The burden of proof is probably on the captive world to show regulators that there is nothing to fear—we are not a shadow insurance industry that is going to cause some kind of systemic financial failure.
We’re entrepreneurial, innovative and practicing a manner of self-help, with the support of the commercial market, to reduce claims loss mitigation and patient safety in the healthcare world. Captives promote all these positive things and it is up to us to show our benefits.
So is there a possibility that the captive insurance industry’s image can change in time?
I don’t think there’s anything wrong with the image, per se. From the beginning we have been called alternative risk transfer, and the captive sphere has since become large enough that we have almost gone from being alternative to mainstream. The financial meltdown in 2008/2009 stimulated regulators to look at anything that was different in order to determine if it could be dangerous or injurious to the taxpayer. We were just unlucky enough to get caught up in that.
How are macro-economic events, such as the recent rise in US interest rates, affecting the captive industry?
The captive world continues to grow whether there is a hard market or a soft market, and there is a lot of capital available in the insurance industry—not only conventional insurance, but transformers that essentially change insurance risk into securities risk, so the capital markets can take it.
I do not see captives as being threatened by increasing interest rates in the same way that I do not see them being assisted by rates staying low.
Historically, there have always been jumps. For example, in 1993/1994, interest rates spiked up and the value of portfolios of bonds went way down—captives were technically underwater, but most regulators were patient. The situation reversed the next year and then everything was okay. For this reason, I am not too worried about this most recent economic environment.
Is the trend of new states popping up with captive insurance laws an inexorable one, in your opinion?
There are currently 35 states that have captive facilitating statutes, or at least want captives to form in their state. As a result of this, there is a push and pull at the NAIC—there are the pro-captive states and then there are the not-so-pro-captive states, and this often varies as to whether you are talking to the captive regulator or the regular insurance department.
In the end, it is hard for me to visualise all 50 states having the legislation. It is not impossible, as a majority of states have the law, but probably only two thirds are truly active in it. Many states are dormant in that they have the laws but do not do much with them, such as my home state of Illinois. That, for example, has one captive and no interest of getting any more.
Will this factor lead to states such as Vermont staying on top for the forseeable future?
States such as Vermont will always be important because they are pioneers. They have the infrastructure, the expertise and all the service providers—whether you are talking about captive management, legal, accounting or actuarial services.
They have an edge and they have an insurance department that understands captives. That gives them a little bit of a leg up, so to speak, but other states can develop the same level of experience over time. Some states that did not seem so likely to be successful, such as South Carolina, have proven many of the doubters wrong.
What macro trends affect your day-to-day environment?
One example is our federal healthcare reform. This has led to a lot of restructuring among hospitals and other healthcare providers—including mergers and acquisitions. This has lead to organisations coming together to have two or three captives, so my job is to try and meld the captives, usually by creating one larger entity. We are seeing a lot of consolidation in the captive industry because of what is happening at the parent level in healthcare.
These national trends affect everybody, but those jurisdictions that have a lot of healthcare captives, in particular the Cayman Islands, are especially affected because they have fewer but larger captives.
Construction is another industry that is a heavy captive user. They were doing great until 2008 and then there was the meltdown, which affected the mortgage market, and construction stopped—but now they are doing well again.
We see more cell captive structures around, too, whether it is in construction, healthcare or any other sector. There are more options available today. These days you can do a regular captive, a cell captive, a captive that has incorporated cells instead of regular cells, a not-for-profit captive, or limited liability companies. We have a great deal of tools in the toolbox so we work hard to ensure that we pick the right one for the right client.
WDespite the strength of the industry, are you still weary of the threat from the IRS?
I would say that, when you set up a captive and look at the structure, you take into account what the tax law is and hopefully you anticipate any ambiguities or vulnerabilities and attempt to minimise them. While you cannot say that our structures are bulletproof, we want them to have a high chance of success, should they be challenged.
Years ago, the IRS attacked the captive world with its proposed federal treasury regulations and, to make a long story short, the captive constituency responded quite actively—convincing the IRS to withdraw the regulation. The current scenario is a more NAIC or state regulatory threat. In the next year or two, all facets of the captive world will need to push back against any unnecessary regulations.
