Expert Commentary

Surplus Lines Insurance Taxation Remains Murky

We are all familiar with the "Law of Unintended Consequences," I think, but for those who aren't, this refers to issues that arise from changes, laws, and rules that were put in place without anyone seeing all the possible ramifications. And the issues bring challenges/problems/costs that were not contemplated.


Captives
October 2011

Enter the Nonadmitted and Reinsurance Reform Act of 2010 portion of the Dodd-Frank Act (Subtitle B). The goal was to clarify the incredibly murky, aggravating, and complicated system of surplus lines laws in this country. It does not appear to have succeeded.

Many of you will identify with the headaches of trying to comply with 50 monkeys who don't speak with each other and don't care what you have to do to obtain and maintain your surplus lines license and pay taxes. Several parties, especially the Council of Agents and Brokers, the National Association of Professional Surplus Lines Offices, and the Risk and Insurance Management Society, Inc., spent years and tens of thousands of dollars to get the federal government to impose a uniform, consistent system of taxation and reporting. Amazingly enough, they succeeded by getting it into Dodd-Frank.

There were celebrations all around. Things at long last would be orderly, consistent, and reliable. As of July 21, 2011, all states were to come together to institute a system in which surplus lines taxes would be applied consistently and uniformly across the country. The Congressional intent was to have the state legislators pass enabling legislation to allow the individual states to enter into compacts to determine the method of allocation of surplus lines taxes.

Hah! Congress did not REQUIRE compliance.

Background

By way of background, many captives are formed under domiciles' surplus lines laws, such as direct procurement and industrial insureds. They pay taxes, but it is not clear to whom they pay taxes: the state where the risk is located, the state where the surplus lines broker receives the premium, or the state with the largest exposure? How is the exposure measured? Must they pay in all states in which they operate?

Well, we're cookin' now. The Feds said, get your act together, states, and create a system in which taxes are paid in one state, and that state apportions taxes to other affected states. It seems simple, effective, and most un-Fed-like.

Several qualified professional organizations worked hard to create the Surplus Lines Insurance Multi-State Compliance Compact ("SLIMPACT") program. But the National Association of Insurance Commissioners (NAIC) wasn't involved, so it created its own system, the Nonadmitted Insurance Multi-State Agreement (NIMA).

So, what we now have is that 14 states (and the number can change by the time of publication of this article) have adopted the NAIC NIMA program, which declares that the home state collects and retains the taxes and may allocate to other states or not. The home state is where the insureds' executives make decisions, sometimes known as the headquarters or the home office. Nine states have followed the National Congress of Insurance Legislators program SLIMPACT, which holds that states may enter into a compact to establish a system of collecting and allocating surplus lines premiums and taxes. The remainder of the states have said, "Keep doing what you were doing, pay us our money, and if it changes, we'll let you know."

The Dilemma

You can see the problem. Who makes this call? What are the taxes? Can we choose the most favorable state? What happens if we are challenged? Are these compacts constitutional, as they may delegate revenue authority to the Director of Insurance (DOI), which is not usually constitutional? This is a huge issue for many states, and there are few available answers as of the time of this writing.

An example has occurred, however, that shows the power of the "Law of Unintended Consequences": A captive in a domicile with a tax of X redomiciled to a state with a tax of X – $750,000. Who wouldn't make that call? What happens? Are jobs lost or gained?

Then, to make it really fun, the new domicile has a law that says that if you haven't previously paid your tax, you have to pay all the back taxes and penalties. What? Now what is the number versus $750,000? Will this be enforced? The DOI does not have the authority to make that choice.

So, if the surplus lines broker makes the call, will his or her errors and omissions underwriter exclude losses under this law? If the lawyer makes the call, will he or she put it in writing? If the clients make the call and end up with a lot of fines and penalties, how happy will they be?

Recommendations

Once again, it is incumbent on captive owners to work closely with their professional service providers. I think that, in this situation, a frank discussion with the regulator is crucial. It might be a wise idea to pay some tax with some proviso somewhere, somehow, that it is paid in good faith under the laws as they are understood and with the best advice of counsel. I would consider a captive board resolution declaring the home state of the insured. And, I would write my congressman to ask for some help.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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