Friday, June 14, 2013

What Is the "Shadow Insurance" Industry?

     Over the last month, international tax planning and captive insurance -- two areas of law and tax planning typically shrouded in mystery -- have come to the forefront of the news cycle.  Unfortunately, both areas are typically poorly reported on not because of journalistic negligence or incompetence but due to the sheer complexity of the topics at hand.  Tax law is typically only taught in detail at the graduate legal level and captive insurance is not taught at all.  Moreover, the legal issues involved with captive insurance span a very broad swath of law including contracts, business entities, estate planning, tax planning, and insurance – three of which (estate planning, tax law and insurance) are in and of themselves legal specialties.   

     Recently, superintendent of the New York State Department of Financial Services began an investigation into the use by large insurance companies of captive insurance companies.  The purpose of this article is to provide the reader with a basic explanation and outline of captive insurance – what it is, how it came about and the current state of the law.  In addition, at the end I’ll talk a bit about the recent New York regulatory situation.  I’d be remiss at this point if I didn’t engage in a bit of self-promotion by stating that if you’d like to learn more you can purchase my book U.S. Captive Insurance Law or visit my firm's website.  At minimum, it will cure you of your insomnia.

            A captive insurance company is an insurance company owned by the insured.  The case law defines a captive as a “wholly-owned insurance subsidiary.”  While it may seem like insurance is always available, it can actually be harder to get than you’d think.  For example, if you own property in an area prone to being hit by hurricanes you’ve probably discovered that insurance coverage is very expensive.  Here are two additional real-world examples: due to the large amount of tort litigation in the 1970s, product liability coverage was impossible to get and in the mid-1980s, Congress amended the risk retention act allowing doctors to form risk retention groups because medical malpractice coverage had become extremely expensive.  Both of these industries are obviously important to the US economy, but their inability to procure insurance threatened their economic viability.  

            Even though companies started using captives for legitimate business reasons, the IRS had their doubts about this concept due to a very important technical legal reason: they were concerned that for tax purposes the captive was a “reserve.”  The key difference between a reserve and an insurance company is payments to a reserve are not deductible while insurance premiums are.  This key tax issue obviously meant there was a great deal of money riding on the legal outcome of captive litigation, which can be chronologically divided into four: periods: the reserve cases from the early 20th century, the early captive cases in the 1950s, the initial IRS victories from the late 1970s to the Humana case in 1987 and the IRS losses from Humana to the UPS case in the early 2002.  By the time of the UPS case, the writing was essentially on the wall that courts would accept certain types of captive structures.  At this point the IRS issued two Revenue Rulings which are essentially statements from the Treasury Department outlining how they will treat commonly occurring transactions.  In these rulings the IRS provided two legal safe harbors for captive insurance, essentially stating, “if you’re going to do this, here’s how you should do it.”

            While captives are typically associated with offshore tax planning, they are now an “onshore” phenomena: over 30 states have a captive insurance statute allowing for the formation of a captive in their jurisdiction.  While Colorado passed a statute in the early 1970s, Vermont’s statute passed in the late 1970s has become the de facto US model code or industry standard.  Some of the bigger captive jurisdictions are Vermont, Delaware and Utah.    

            So, let’s sum up so far.  Captives started in the 1950s because of deficiencies in the insurance market.  While the IRS challenged these structures for legitimate legal reasons, they were arguing against a historical tide.  Now, when properly structured and run, a captive insurance company is a valuable risk management tool used by over 5,000 US companies.

            Now let’s turn to the more recent events to see what’s going on.  The following excerpt is from Bloomberg:

Carriers in New York had $48 billion in “shadow insurance,” according to the report from Benjamin Lawsky, superintendent of the New York State Department of Financial Services. Lawsky has been investigating since July transactions that life insurers conduct with subsidiaries, known as captives.

Insurers use the captives to decrease the amount of capital they’re required to hold, Lawsky said in the report. The department said 17 New York-based firms use such transactions, without identifying them. The captives, which are typically based in other jurisdictions, are sometimes capitalized with letters of credit or intra-company guarantees, which can leave the parent responsible for claims if losses mount.

In essence, this is a question about capital and capital requirements.  According to the Third Edition of Barron’s Dictionary of Finance, capital is the “difference between the company’s asset and liabilities.”  This value protects the interests of the company’s policy holders in the event it develops financial problems.”  Ideally, capital should be in cash or a cash equivalent for fast access in the event it’s needed.  But while all US states allow a captive to use a letter of credit for capital, the real issue is the reserves backing the LOCs.  Under Basil II, the US requirement is 10% while for an offshore bank it’s between 1%-3%.  It is the difference in the reserve requirements among issuing institutions that has New York concerned.  And if a captive is backed by a personal or corporate guarantee you’ve potentially got bigger problems.

            So let’s play this out in a catastrophic situation.  Large US insurer has shifted some liabilities to a “web” of offshore captives.  While these captives are capitalized with letters of credit, the capital backing those letters is less stringent.  As a result, in the event a wave of liabilities hits the company, the possibility of capital being depleted increases.  This is the nightmare scenario concerning the New York authorities.

The issue here is not the use of a captive insurance company; it’s the capitalization of the captive that is concerning the regulators.  Captives are now an accepted and often used risk management tool.  However, this case does highlight the need (as with any financial tool) to use them correctly.  And it also shows that once again, New York state and its various institutions appears to be the real regulator of US markets while the FRB and SEC sit on the sidelines.