Reflections from Cayman

CV-Issue-4-Dale-Fenwick

I came away from the 2104 Cayman Captive Forum pondering two significant issues. First, the short and long term effect of the Rent-A-Center (RAC), and Securitas Tax Court decisions. Second, the future of offshore captives due to the increased competition from emerging on-shore domiciles.

RAC and Securitas: Potential Implications

I am not going to regurgitate the published details of the RAC and Securitas decisions. You can read them in Prof. Cantley’s article in this issue of CV and elsewhere. I will, however focus on the implications, from a nontax expert perspective.

For years the ideal singleparent captive design has included 12-plus insured entities with none paying more than 15% of the total premium being collected. The RAC and Securitas decisions would seem to eliminate these requirements in favor of having a “statistically significant” number of independent exposures.

I’m not sure how many exposures are required to achieve “statistical significance.” This issue will probably lead to more disagreements with the IRS, but we should be able to get some guidance from our actuarial experts. The concept of only needing a statistically significant number of independent exposures reminded me of a vexing problem I have been unable to solve for a potential client.

The client has no subsidiaries, so the single-parent captive would only have one insured. But the client has more than 100 warehouses and wants to use a captive to fund the $1 Million windstorm deductible under their property policy. Since we have more than 100 independent exposures (the warehouses are on four different sites and are separated by 100-foot buffer zones), why would this captive not be an insurance company for tax purposes?

One of the most interesting aspects of RAC and Securitas is that both programs apparently started out with multiple subsidiaries, but after a series of corporate reorganizations both ended up with only a handful of insured entities. And the premium allocation amongst the entities was now quite concentrated with some entities paying more than half of the total premium.

But wait, the reorganizations had little or no effect on the number or nature of the underlying exposures. They still had the same number of employees, the same locations, the same vehicles, etc.… as before the reorganizations. So what changed? Only the ownership of the exposures. Wow. Then I started thinking… Imagine a traditionally designed captive. Say, 20 insured subsidiaries with each paying exactly 5% of the total captive premium. So far, so good. But what if the company decides it would be more efficient to merge several of the subsidiaries together? Overnight 20 subsidiaries become only 10. And a few months later, the 10 subsidiaries become only 5. See where this is going? What if the owner goes “all the way” to one insured entity which now owns the same exposures that were once owned by the 20 subsidiaries? Has anything changed?

And if we can go from 20 to 10 to 5 to 1 and still have an insurance company for tax purposes, why can’t someone else just start with 1 insured entity?

I posed this scenario to a couple of tax experts during the Forum. Both saw the logic in my analysis, but both were troubled by the “only one insured” outcome. Both suggested that there was something “statistically important” about having “at least two insureds.”

I ran the idea past one captive actuary and asked him the question, “What might make two better than one, from a statistical perspective?” He was unable to provide an answer.

If the Securitas decision is not appealed (at this writing there are still a couple of weeks left before the appeal deadline), 2015 could begin a new era for single-parent captives.

“For many years these premium taxes have been virtually ignored by not only captive owners but many state regulators as well. The increased visibility, combined with the need for most states to find new sources of revenue has made it dangerous for captive owners to continue to ignore these premium taxes.”

Competition from On-Shore Domiciles: Taxes Complicate the Decision

Let’s take a look at the second issue that came to mind in the aftermath of the conference: Will offshore domiciles be able to withstand the increased competition from on-shore domiciles?

We can thank the writers of Dodd-Frank for making nearly everyone aware of the need for the buyers of captive insurance policies to be paying state-imposed directprocurement taxes. For many years these premium taxes have been virtually ignored by not only captive owners but many state regulators as well. The increased visibility, combined with the need for most states to find new sources of revenue has made it dangerous for captive owners to continue to ignore these premium taxes.

And some onshore domiciles have seen another opportunity triggered by direct procurement taxes, most notably Texas and Missouri.

Both Texas and Missouri impose direct-procurement taxes of nearly 5%. However, both waive the direct-procurement tax if the policy is issued by a captive domiciled in state. Instead of the direct procurement tax, the captive pays a premium tax of approximately 0.5%. This results in a cost savings of $45,000 for every $1 Million of captive premium. As the average captive premium nears $2.5 Million we are talking about more than $100,000 per year.

Premium taxes and fees, which once were near the bottom of the list of captive domicile selection criteria, have suddenly rocketed to the top, or near the top. I now look first at where the captive policies are going to be purchased, and evaluate the financial impact of the direct-procurement vs. premium tax alternatives.

If the premium tax cost savings are significant, we then look at the regulatory environment of the onshore domicile. This is one area where offshore domiciles may continue to have an advantage, because some of the emerging onshore domiciles are much less flexible than their offshore counterparts when it comes to issues that many captive owners value.

Here are some examples:

One of my clients wanted to use ETFs as their primary investment strategy. The onshore regulator said no, despite the fact that 80% of the proposed portfolio was to be invested in Fixed Income ETFs. Why? Because ETFs are essentially mutual funds and mutual funds are, according to the NAIC, equities. Another client had been selfinsured for a particular exposure for several years. They also handled their own claims for this exposure. The onshore regulator insisted that a licensed adjuster needed to be retained if the exposure was put into the proposed captive. No offshore regulator would impose such a requirement.

Some onshore domiciles may simply not allow the desired ownership structure or the type of coverage proposed to be assumed by the captive. These type of issues are much easier to evaluate. If the onshore domicile says no to the proposed ownership or coverage, then the premium tax cost savings becomes irrelevant.

Finally, as more captives are domiciled in the state where their risks are located, it is likely that the captive will now be subject to unnecessary “consumer protection” regulations, such as the licensed adjuster requirement described above.

Offshore domiciles do continue to provide more regulatory flexibility, but one wonders how long that flexibility will continue to offset the premium tax cost differential?

It is certainly possible that the “cost” of onshore regulatory inflexibility could more than offset the “benefit” of lower premium tax costs in many cases. The cost/benefit analysis will almost inevitably be complicated.

About F. Hale Stewart JD, LL.M

F. Hale Stewart, Esq. is a partner at The Hale Stewart Law Firm.