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Regulation of Captives: Who? Why? What Next?

Michael Mead | August 1, 2005

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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.

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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