Selecting a Domicile

This article is provided by Strategic Risk Services. Contact details for the company can be found at the end of this article. The past few years have seen a proliferation of US states passing captive insurance laws. With more than half of US states having captive insurance laws and new offshore domiciles developing, the selection of a domicile has become increasingly difficult. In this quarter's newsletter we examine the critical factors that should drive the selection of a domicile. Some of these factors restrict options to either onshore of offshore, while others are a matter of choice between individual domiciles. US Federal Regulations: certain classes of US business can only be written offshore. These restrictions typically apply to lines of coverage or captive structures that require Federal approval or require a Federal regulation. The government is limited in jurisdiction and hence will only grant the rights under the regulation to US domiciled insurers. Examples of programs subject to Federal regulation include: ? Risk Retention Groups: the Federal Risk Retention Act only applies to group captives which are domiciled in the US. ? Employee Benefits: captives insuring ERISA benefits must obtain or qualify for an exemption to the prohibited transaction rules of ERISA. This requires approval by the US Department of Labor. In its guidelines for approval under the EXPRO process, the Department of Labor requires that the captive or a branch of the captive be domiciled in the US. This situation only applies to benefits which fall under the US ERISA regulations. Non-ERISA benefits can be insured both onshore and offshore and captives have been insuring non-ERISA benefits for many years. ? TRIA: as the deductibles under this program are based on the insurer's total premium, captives have been able to access the TRIA pool at a lower attachment level than commercial insurers. Access to TRIA is limited to US domiciled insurers requiring a captive to be domiciled onshore If a prospective captive is considering using one of these regulations, either nowor at some point in the future, it would favour selecting an onshore domicile. An onshore branch can also be used to allow offshore captives access to some of these Federal Programs. Third Party Business: US states have created specific regulations for captive insurance companies, distinct from commercial insurers operating in their states. To create this separation between captives and commercial insurers, the states have had to limit the activities of the captive principally to the risks of its owners. A limited amount of third party business is allowed, but regulators will want it to be incidental and controlled by the owners of the captive. Captives in offshore domiciles operate under the general insurance laws of those territories, not necessarily specific captive laws. While there may be different classifications and capital requirements for captives underwriting the risks of its owners to third party business. The same insurance laws will accommodate both. Any captive writing a significant amount (<20%) of third party business will probably be limited to an offshore domicile. Local Captive Regulations: while the differences between captive regulations, particularly onshore, have reduced over the past few years, there are still some significant differences between the local regulations and their application. Capital requirements are a key issue. While most domiciles (other than Bermuda) use judgement in assessing the amount of capital that is required versus a formula approach, there is wide disparity from one domicile to another on what is considered reasonable. Capital requirements can be driven by other considerations, such as the need to post capital to a fronting company. However the regulator is likely to require "free and clear" capital at least to the minimum capitalization levels applying in the domicile. Generally minimum capital requirements are slightly lower than those applying onshore. Investment restrictions in the local regulations can also be important. This will include the willingness of the local regulator to allow loan-backs to the captive's parent(s). This issue is not exclusively a local regulatory issue. The tax implications of using loan-backs will also factor into this decision. One other aspect of local regulations that should not be overlooked is the requirement for local Director's meetings. Most onshore domiciles require an annual meeting of the Board in the state. Some offshore domiciles, such as Bermuda, have waived this requirement, although meetings may still need to take place outside the US if the captive does not want to be subject to US taxation. Consideration should be given to the willingness of Directors to travel to the domicile annually for these meetings. This can be an issue for some groups which are used to periodic meetings in different locations. Taxation: there is often a misconception that captives domiciled offshore will not be subject to US income tax. Income from offshore operations will be consolidated into the parent company's taxable income either directly as part of an affiliate group filing or through the Related Party Insurance Income provision. Indeed many offshore captives choose to take a 953(d) election and be treated as a US entity for tax purposes. This avoids having to pay Federal Excise Tax on premiums paid to the captive. From an income tax perspective, offshore captives can actually be at a disadvantage to onshore captives, due to the dual consolidated loss provision. This provides that net operating losses from offshore companies can not be used to reduce the taxable income of other members of an affiliated group. This provision applies whether the captive makes a 953(d) election or not. The other taxation issue to consider in selecting domiciles is the level of premium tax. Many domiciles will apply a tax on premiums paid to the captive. Tax levels are relatively low, usually less than 1% of the premium, and often capped. However, it does provide for some cost differences between domiciles. Most offshore domiciles, and some onshore, do not apply premium taxes, but impose an annual fee instead. Infrastructure: a key differentiator between the newer and more established domiciles is the quality of the infrastructure. This applies to both regulators and service providers. It is important that the domicile has experienced regulators who understand captives and who are available to answer a captive owner's questions. There should be a consistent track record of captive regulation in the domicile so captive owners can understand not only the regulation but how it is applied in the domicile. This can be a challenge for newer domiciles which are just getting started. High turnover of regulatory staff should be viewed with caution as it can create inconsistencies in the application of the regulations. The reputation of the domicile is also important. Several of the newer domiciles, in their quest to attract new business, have provisions that allow owners more latitude. In many cases this leads a captive to take more risk (operating, tax, regulatory) than they would have in one of the major captive domiciles. The latitude can have negative implications for the reputation of the domicile. Offshore operations have come under scrutiny in the couple of years and it is important for captive owners to have legitimate reasons for domiciling in these locations. The established offshore domiciles have a longer history of regulating captives than other domiciles and can use this regulatory scrutiny to their advantage. Others have built up a strong reputation in certain areas such as the Cayman Islands in healthcare, which has allowed the domicile to earn a strong reputation in this niche. Onshore, the reputation of the domicile's regulators becomes extremely important for risk retention groups. These groups will need approval from individual state insurance departments to operate in those states. Domiciling in a state with a strong regulatory reputation will help with those approvals. Coupled with the quality of the regulatory infrastructure is that of the service providers. The older, more established domiciles will have service providers experienced in managing captives. In addition, Bermuda has benefited from the presence of a strong commercial insurance market, which allows risk managers to couple captive meetings with insurer and reinsurer meetings. Some offshore domiciles such as Vermont are attempting to attract specialist captive reinsurers to their states to provide a similar one stop service environment. Logistics: The final issue to consider in domicile selection is the logistics of the domicile. While this is often seen as the domicile's tourist appeal, there are some serious logistical issues to consider. These will include time zone differences between the insured(s) and the captive, the quality of the communication infrastructure in the domicile, and the ease of getting to and from the domicile. Will you get the input of senior management if it requires a 3 day trip to a remote location with no cell phone coverage for a single board meeting? Conclusion: Like all other aspects of captive feasibility, domicile selection is dependent on the unique characteristics of the captive and the business to be underwritten. Each captive owner must review these characteristics and make their own determination. It is also not a one-time decision as the factors behind domicile selection change over time. A re-examination of the domicile should be included in periodic strategic reviews of the captives operations. About SRS SRS provides underwriting, management and wholesale brokerage services in the alternative insurance market. They design, implement, manage and grow captive and ART programs on behalf of corporations, groups and insurance companies. SRS is an approved manager of captive insurance companies in Arizona, Bermuda, Cayman Islands, South Carolina & Vermont. Through a wholly owned subsidiary SRS is also licensed as an insurance broker in Bermuda. For more information on SRS, visit them at www.strategicrisks.com. Contact: info@strategicrisks.com