Different strokes for different folks

For US-based corporations and organisations, there are numerous options available when considering the purchase of insurance, namely: buy traditional direct from an insurance company, access insurance via an association, join a group or establish ones own insurance company to access international markets.

For US-based corporations and organisations, there are numerous options available when considering the purchase of insurance, namely: buy traditional direct from an insurance company, access insurance via an association, join a group or establish ones own insurance company to access international markets.

Ultimately, the strategic drivers of insurance purchase are the same. However, making the decision on which alternative option is not easy.

The modern day US alternative insurance market emanated from the US liability insurance crisis during the mid-1980s. General liability insurance prices increased to an amount where it became uneconomic and began to affect business.

US Congress intervened by developing alternative insurance law. The Liability Risk Retention Act (LRRA) of 1986 is one specific piece of federal law that was drafted. LRRA specifically applies to general liability risk.

Below is a brief summary of alternative options available to US insurance buyers and differences in regulation, tax, governance and operations.

US alternative arrangements

Risk purchasing groups

There are approximately 900 risk risk purchasing groups (RPGs) in the US, the vast majority of which are registered in Illinois or Delaware. They are typically established as a not-for-profit, non-stock entity. Once registered in one US state, an RPG is free to offer insurance to its members across all states when registered in the state—an application largely standardised by the National Association of Insurance Commissioners (NAIC). Most states require an annual renewal update.

An RPG is typically established by an agent who establishes the RPG and pre-arranges a panel of insurance carriers to provide group discounted liability insurances to corporates or charitable organisations with common activities (one of the pre-requisites of the LRRA).

The relationship between the policyholder and the insurer is no different to purchasing insurance direct, ie, issuance of certificates and management of claims. The main benefit is a bulk discount on premiums plus a better understanding by the insurer of the specific RPG’s industry underwriting profile.

Risk retention groups

There are approximately 250 risk retention groups (RRGs) with reported gross premiums of around $2.5 billion. Vermont is the most popular domicile to establish these entities, and the largest industry users of RRGs are healthcare and professional services.

Unlike an RPG, an RRG retains a portion of insurance risk and reinsures with international markets, often the Lloyd’s of London market. An RRG is more likened to a captive from a federal and state regulatory perspective, ie, requirement to submit a business plan, be sufficiently capitalised and make annual financial statistical filings to the authorities. The main difference is that an RRG is only permitted to offer liability insurance and only within the US.

Similar to RPGs, an RRG is only validly formed when its members emanate from the same industry. An RRG is considered a mutual insurance arrangement.

Similar industry participants can be beneficial, as niche insurers understand the complex long-tail nature of the risk to competitively price premium, however, there is often a lack of product and geographical diversification. Evidently resulting in a larger capital charge.

Captive insurance companies

A captive is broadly defined as an insurer that only insures the interests of its group and subsidiaries. There are certain domiciles that allow a nominal percentage of a captives business to be unrelated. This exception is predominately in place for ease to overcome minor technicalities, such as joint venture arrangements or where a divestiture results in third party liability remaining with the captive.

In addition to a large number of captives being set up onshore in the US the LRRA also resulted in many insurance companies (and captives) establishing offshore, where lower capital and ease of doing business was a contributory driver. With continued scrutiny of corporate tax planning arrangements offshore tax benefit is a minor consideration when designing a captive insurance programme.

The main difference between captives, RPGs and RRGs is that a captive is permitted to provide insurance for different insurance classes, not just general liability. Although a captive can be capital intense, it offers greater control.

There is no federal law governing a captive’s treatment, unlike RRGs. This can often make it challenging for captive owners to navigate individual state disputes. For RRGs, disputes are often supported by associations, such as the National Risk Retention Association that represents its members (RRGs and RPGs) by acting as an amicus (or friend) to the courts to ensure that legal decisions in a state do not contradict federal law intentions of the LRRA.

Micro captives

In more recent times, there has been a significant rise in the use of 831(b) captives or micro captives. These are self-insurance arrangements that qualify for US tax exemption under an IRS code of 1986—this structure has been around a while, however, as smaller business’ demand more efficient ways to fund risk, they are increasing in popularity.

Notwithstanding their challenges to ensure the insurance arrangements are bona fide and pass risk transfer testing (ie, an insured event has to have a chance of occurring) to qualify, 831(b)s often prove efficient to fund short term risks, such as property, particularly in states where natural catastrophe insurance premium is uncompetitive.

Other arrangements

Protected cell companies, incorporated cell companies and segregated account companies are variances of micro captive where an insured is allocated a part ownership in the arrangement. These arrangements are typically used for very niche risks.

For US owners, the amount of collateral and security required and the appetite and cost of capital of the entity sponsor (as the cell owner is not necessarily the owner of the entity) often results in establishing a captive.

Regulatory

State insurance departments generally have a prescribed regulatory approach for each alternative. As a result of the LRRA, RPGs and RRGs are well defined in each state.

However, for captives there are still a number of states that do not have captive regulation and default to general insurer rules.

RPGs first form a legal entity in their domicile of choice. An application (generally following standard NAIC structure) is filed in the home state. Information included in this application includes: the type of liability insurance proposed, the name and NAIC number of the insurance company, a list of the RPG’s officers, confirmation of the insurance agent’s, and incorporation documents of the RPG.

An application form is then required in each state that the RPG wishes to provide insurance. The majority of states require the RPG to make an annual renewal filing so that the insurance department is informed of RPGs operating in their state.

RRGs differ from RPGs in both complexity and regulatory requirements as an RRG assumes risk. Many that form RRGs appoint an external manager to support initial registration and ongoing quarterly financial and regulatory reporting.

In addition to similar registration information required for RPGs, an RRG is also required to submit a plan of operation or feasibility study, the nature and amount of capitalisation and audited financial information on the RRG’s participants.

Unlike RPGs, an RRGs financial position is audited and insurance provisions certified by an actuary. An RRG is required to register in each state it will operate in and make annual renewal filings (similar to RPGs).

In the majority of cases, captives appoint an approved management firm in the home state unless self-managed. It is often more cost effective to appoint a captive manager as it has the infrastructure and qualified staff to ensure continued compliance, unlike RRGs, which often maintain a staff that not only manage insurances but also support administration services to the members of the RRG. State insurance department reporting requirements for captives is similar to that of RRGs.

Premium tax

There are significant variances in the treatment of state premium taxes. In general, an RPG’s premium tax liability is the responsibility of the insurer (typically surplus lines). There are instances where the agent or the RPG is jointly responsible to the state.

The Dodd-Frank Act included the Non-Admitted and Reinsurance Reform Act (NRRA) of 2010. This act improved the reporting and settlement process for surplus lines broker premium tax obligations (applicable to RPGs). The home state is determined and one tax filing made, however, the methodology for the home state to reallocate the portion of taxes due to other states is currently being agreed upon.

RRGs are authorised insurers under the LRRA and therefore pay premium taxes directly to the state based on premiums collected. This was an important clarification and exclusion in the NRRA.

The intention of the NRRA as it applies to captive insurers has caused differing views. There is generally an inconsistency in the treatment of premium tax.

Some believe that the NRRA was not meant to apply to captives, so one would assume that a captive should remit taxes in each state that the risk is located, whereas others consider that the NRRA does apply, in which case only one filing to the home state is required, similar to surplus lines brokers.

I suspect, either way, many states will welcome improved tax collection methodologies. After all, premium taxes contribute to local disaster recovery funds.

Corporate taxes

There is often a conflict between federal and state, and corporate, insurance and tax law for alternative insurance arrangements. Numerous clarifications have been sought over the years to harmonise this position, and over time over time, it has become a little clearer.

The LRRA clearly outlines the treatment of RPGs and RRGs. For RPGs, state business tax is less clear. Most RPGs are formed as non-profit, non-stock entities, which, by default, would indicate exemption from federal and state income tax requirements. However, looking further in to the underlying activities of the RPG, the vast majority may not necessarily fall within the exempt activities as defined in IRS code 501(c)(3).

This raises an interesting anomaly that may require RPGs to apply for a business ID and file income taxes in each state that they operate. It is clearer for RRGs that retain risk, as they fall within the definition of insurance and therefore file federal tax returns and are exempt from state tax requirements.

RRGs differ slightly to captive insurers that have challenges with passing IRS risk shifting/distribution tests to have premiums paid to a captive deductible as an expense. For RRGs, the position is simpler as members of an RRG (albeit part owners of the entity) share their risk with others therefore achieve tax deductibility.

Many captive owners consolidate the captive tax return with its parent, which allows the offsetting of any captive losses against group income.

Governance

There is real advantage to deploying a governance and management framework in any organisation. The framework should optimise the achievement of the strategy and protect the organisation from the adverse happenings. These principles apply to RPGs, RRGs and captives.

Governance rules imposed by state regulators can often alienate those to whom the rules apply. I believe that adopting a robust framework creates value for stakeholders by improving business operations.

By default, it is also likely to cover the requirements of many state regulators.

Many may wish to consider the following governance elements: