Regulation of Captives: Who? Why? What Next?
August 2005
Captives are regulated in a manner different
from traditional insurers. A jurisdiction which is determined to establish itself
as a captive domicile must pass enabling legislation to recognize that a captive
is self-financing of risk. Today, as state versus federal regulation becomes
a hot topic, we will examine what this means for captives.
by Michael
R. Mead
M.R. Mead &
Company, LLC
The point of a captive is to finance one's own risks, and control your own
risk dollars to the extent that is possible. This central point means that regulation
of captives is inherently different from the regulation of a traditional insurer.
A traditional insurer is providing risk transfer to the general public, in the
broad picture.
Public versus Private Regulation Concerns
This difference in audiences is quite important. When insuring the general
public, the insurer must conduct itself with a view to matters that the captive
owner need not concern himself with such as discrimination in rates and forms,
availability to all qualified applicants, and participation in required pools.
Regulation of a traditional insurer therefore must consider the policy forms,
rates, claims personnel, reserving policies, distribution systems, and many
other factors. When regulating a captive for its limited audience, the owner,
the essential considerations become adequacy of finances and management competence.
While these are also a part of traditional regulation, they are more pronounced
in captive regulation.
A key element of difference is that traditional insurers must contribute
a set percentage of their revenues into various state-mandated funds for the
protection of the public. These include guaranty funds to pay claims in the
event of a bankruptcy by another insurer, funds for various support pools such
as second injury finds, fire marshal taxes, and what ever else needs funding.
Captives are usually exempt from these taxes and pool contributions.
The Commissioner Problem
Regulation of insurance for the past 60 years has been on a state-by-state
basis flowing from a Supreme Court decision, known as the Southeastern Underwriters case, which determined
that insurance regulation was not a federal function, but should be left to
the states.
Each state has an official charged with regulating insurance matters. Some
are elected, some are appointed. Some have adequate funding and staff, some
do not. Some are quite knowledgeable about both details and the bigger picture.
Some are not. Some are freestanding directors or commissioners, some are not.
Those who are elected by the public often have agendas directed toward personal
lines issues where the voter is more visible and impacted more directly by their
regulation. Those who are appointed may carry with the appointment the agenda
of the one who appointed them, which again may be more directed at votes than
insurance policy.
These inconsistencies of approach have caused considerable angst in the traditional
marketplace. If you are a multi-state or all-state insurer, the need to file
50 different forms and reports on all manner of issues is overwhelming, time
consuming, and costly. These costs are, of course, passed on the extent possible
so to do. But the time and manpower drain cannot be shared.
The Role of the NAIC
All of the state-by-state regulation is absolutely dependent on mutual interests.
What that means is that the Department in State A does not have the resources
to examine every insurer and its actions, so it must rely on the regulation
of the home state of domicile of each multi-state insurer. To assure themselves
of this reliance on shared interests, the National Association of Insurance
Commissioners (NAIC) publishes guidelines and then audits to determine if each
state is following the guidelines to an acceptable extent.
This is a very logical approach, and works well for the large majority of
traditional insurers. It does not work well in terms of an individual state
determined to develop its own standards and following them when they are convinced
that they are better alternative market regulators than the NAIC, which has
a different agenda. If the NAIC "pulls" the accreditation of a state for not
following the published guidelines, even when they do not apply to captives,
that state is largely out of business for licensing insurers and collecting
their taxes.
Is Federal Regulation the Answer?
Some view the current system as stifling commerce and preventing the introduction
of needed insurance products as the insurers must deal with 50 differing approaches.
This has developed into a call for federal regulation.
There is little federal regulation of insurance currently. There are federal
crop and hail and flood programs. And the federal terrorism program, TRIP, if
it continues beyond the end of the year. To introduce a new player would involve
some very complex and complicated moves. The obvious is where to place such
regulation in the federal pantheon of regulatory heavens. And who would be the
ultimate person in charge? How would this person be selected? What would be
their funding?
As you might guess, the state regulators are none too keen on federal regulation,
and have mounted some well-thought out arguments against such a move. State
regulators are a part of an overall association, the NAIC. This body has attempted
to be aggressive in addressing the concerns of the traditional market about
consistency of regulation and speed to market of new products. But 50 people
being 50 independent people with their own agendas, the NAIC's efforts are often
foiled by their own members.
Where Do Captives Fit?
So what does all of this mean for captives? As captives are by definition
very limited in their approach, and quite specific in their needs, the fear
is that their special niche will be overlooked or over regulated in a federal
approach. While it is far too early to mount an offensive in support of either
view, it is not too early to recognize the impact of any kind of decision about
regulation on captives.
The captive industry is large and diverse. The needs of one owner may be
quite different, if not in opposition, to the needs of another. Taxation is
a perfect example of these differences. Tax treatment of premiums and reserves
do not mean the same thing, nor or they handled the same way for all captives.
So, obtaining unanimity of approach is going to be difficult. At this point
there is no one voice for all captives and risk retention groups, though several
associations make the attempt. The reason for this is that since a captive is
self-finance, it is often the owners who mount their own defense to protect
their specific and unique regulatory needs.
Indeed, some associations work almost in opposition of each other due to
the differing agendas of their constituents. This diversity may work against
captives in developing a grand plan to address any threatened moves by either
the NAIC or the federal government, and it may well be that each owner will
have to go it alone. Nonetheless the effort will have to be made as the political
side of things will push their own agenda.
While the owners and associations move on unaware or unorganized, however,
the NAIC moves on with a view to gaining the high ground. Some regulatory "suggestions"
are making the rounds of various state departments of insurance that could be
interpreted as being very harmful to captives and risk retention groups. Some
of these "suggestions" would go a long way toward closing the gap between traditional
carriers and captives. This would be disastrous, so the time is now to organize
and create one, or more if necessary, game plans to get out the logic of self-finance
and control through captives.
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