Why is Delaware fertile ground for captives?

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No longer exclusive to the real estate industry, the selling mantra “location, location, location” means big money for the public sector as states compete for domestic and international captive insurance business. Delaware’s insurance laws, its Chancery Court system, and corporation-friendly environment make it the perfect location to form  captive companies.

The Alternative Risk Transfer (ART) market includes risk retention purchasing groups and captive insurance. Captive insurance coverage is ideal in cases where traditional insurance is either too costly or, due to the risks inherent to the business, difficult to obtain. Unlike conventional insurance, owners or participants of a captive pay premiums to themselves. Typical guidance suggests that this arrangement is only cost- effective if premiums previously paid to conventional insurers were in excess of $500,000 a year. Moreover, risk becomes the responsibility of the captive, as owners must contribute their own capital in order to cover claims, although reinsurance is available for excess claim payments through the conventional marketplace.

Today, while the majority of Fortune 500 companies utilize captive insurance to manage a portion of their risk coverage, its existence dates back to the early 16th century when it was utilized by the shipping trade traveling in and out of London. However, it wouldn’t be until some 400 years later when Ohio insurance broker Frederic Reiss would attempt formation of captive companies for his clients. With stringent U.S. regulations governing captive insurance, Reiss was forced to look to offshore opportunities. Growth within Bermuda’s financial sector made it a natural domicile for Reiss’s new venture. And in 1962, Reiss established International Risk Management Ltd in order to assist his U.S. clients.

Bermuda, the Cayman Islands, and Guernsey remain as highly popular offshore options for U.S. companies wishing to segment their risk. Many, but not all, U.S. states also offer captive insurance. However, regulations, taxation, and structure vary between domicile states. Captives are strictly governed by IRS regulations and the regulations of the state where they are domiciled. The federal tax code 831(b) is of particular importance as it discusses allowable premium deductions. Utilized primarily by small to mid-sized companies, 831(b) enables a captive company collecting premiums under $1.2 million annually to incur taxes on investments only.

These are some of the more common forms of captive insurance available in Delaware:

A Pure captive insures the risks of a single owner.

An Association captive comprises a group of owners within a shared industry. For instance, a trade organization may choose to form this type of captive. Risks of participants are pooled.

An Industrial Insured captive is a type of association captive but the captive must have more than 25 employees, with a full-time employee serving as an insurance manager. Premiums on all risks of at least $25,000 are required. Risks are pooled.

A Sponsored captive also comprises a group, but participants are protected from the risks of others by forming what are called protected cells. The sponsor does not need to share commonality with its members.

Risk retention or purchasing group is arranged through the conventional market, but shares a similarity with captives. Members are involved in the same industry and gain purchasing power as a group, ultimately negotiating a better rate. Growth within the shared economy has made this a popular option for risk management, with Airbnb recently having been approved in the state of Delaware. Delaware ranks first in the nation for purchasing group opportunities.

Delaware has two unique captive designations – the special purpose captive and the series LLC captive.

Special purpose captives were created as a means of allowing the insurance commissioner the ability to approve anything that wouldn’t fit the existing format of a captive. This provision facilitates the unknowns of future captive requests.

A series LLC captive is a special purpose captive and also a type of a sponsored captive in that it shields its participants from the risks of its members. As the shining star in the state’s varied portfolio of captive formations, this popular and flexible arrangement now insures 756 participants. Its phenomenal growth is attributed to a single change to the premium tax that Delaware collected from captive insurance companies shortly after Commissioner Stewart came onboard.

“The minimum premium tax [once] applied to every protected cell. The upshot was that no one was using it because they didn’t want to pay the minimum premium tax,” said Jeff Simpson, a director at Gordon, Fourmaris, & Mammarella, P.A. in Wilmington. The state needed a way to get around its own law, he continued. The series LLC was created. The sponsor paid a premium tax, but participants, known as series business units, did not.

While attractive, and certainly a catalyst in moving the state forward, the state’s insurance department has since revisited this provision. House Bill 15 recently went into effect and again allows for the collection of the premium tax from the individual series business units. The change, said Steve Kinion, bureau director of the state’s Captive and Financial Insurance Products, had been in the discussion stages since 2013, and has become an accepted reality in order to increase revenue. Similarly, the rate structure has changed with regard to the application fee, processing fee, and license renewal fee. In announcing the increases, the state’s Department of Insurance indicated that these fees had stayed the same for a decade. Projected revenue for fiscal year 2016 is now expected to be $6.4 million, $2 million higher than last year’s revenue.

Several other key provisions set Delaware apart: While many states require a multi-step process in order to license a captive insurance company, Delaware requires just one: an application for licensure as an insurance company. In many states a company must first receive permission, typically a certificate of general good from the insurance department. This is not a requirement in Delaware. Moreover, the entity does not need to be formed under Delaware state law. Additionally, Delaware allows captives with overseas participants the ability to use generally accepted accounting principles, facilitating reconciliation with their non-U.S. based parent companies.

(Sources include: www.naic.org/cipr_newsletter_archive/vol2_captive.htm;   www.captiveinsurancecompanies.com – IRS code 831(b) information; http://captive.delawareinsurance.gov/docs/pdfs/Explanation_HB15_20150710.pdf)

 

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