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Making the move onshore.

Making the Move Onshore

Three years have passed since the Tax Reform Act of 1986 and the Risk Retention Act of 1986 reduced the advantages of offshore captive insurance companies. Yet, whether to move a captive onshore is a difficult and complicated decision --one in which captives have received little help or encouragement from offshore captive managers and service providers. While some captives have opted to move to a domestic domicile with favorable legislation for them, a majority has adopted a wait-and-see attitude. Others have moved onshore and at the same time retained their offshore presence, a middle ground that, in the final analysis, may be the best solution.

Insurance Department Regulation

When deciding whether to domesticate, captive owners should review the factors that brought about the decision to go offshore and see if they still hold true today. Insurance departments in the United States have a reputation for burdensome regulation and bureaucratic red tape dictated on a state-by-state basis. They have traditionally applied the same regulations to a monoline single-parent captive underwriting parent company risks as to large multiline commercial insurers. Faced with the prospect of unsympathetic state regulators, companies wanting to establish captives had no choice but to consider the attractive regulatory environment offshore.

Today the situation has changed. Several prominent insolvencies in Bermuda and the Cayman Islands have made offshore captives less inviting. In addition, the emergence of well-run U.S. domiciles such as Vermont and Colorado, and more recently Illinois and Hawaii, has created competitive alternatives to offshore locations.

In Vermont, the leading onshore domicile, captives are welcome if they are well-conceived, adequately funded and soundly managed. The state recognizes the nature and purpose of captive insurance and applies different standards of regulation developed by risk managers. Rather than apply ratios developed by the National Association of Insurance Commissioners, when they are clearly inappropriate, Vermont relies mainly on feasibility studies and discussions with captive owners and managers. While the ground rules are dictated by statute, most regulations are applied on a case-by-case basis. Furthermore, regulators are often willing to discuss issues before they arise, a novel policy to redomesticating captives that are accustomed to dealing with unapproachable offshore finance ministries.

Other possibilities for setting up a captive have emerged in recent years. Colorado was the first onshore captive domicile and Illinois has a well-written law, despite its reputation for tough, inflexible regulation of traditional companies. Hawaii's law is a carbon copy of Vermont's, and with five new captives formed in 1989, the islands are developing as a legitimate domicile.

Good regulation is infinitely better than inadequate or no regulation. Risk managers with offshore captives undoubtedly prefer some guidance from regulators and managers before heading into third-party business, which in the past has led to serious losses and even insolvency for many captives. However, Bermuda and other offshore domiciles have been slow to react to the changing nature of captives, with Bermuda continuing to apply outdated solvency and liquidity ratios to captives.

There are several neutral factors that apply to onshore and offshore domiciles, such as freedom to invest, recognition of reinsurance and exemption from guarantee funds, joint underwriting associations and assigned risk plans. Financial reporting is not usually onerous in offshore or onshore domiciles, but association captives operating offshore must follow statutory accounting principles. Risk retention groups and single-parent captives operating in Vermont are only required to comply with Generally Accepted Accounting Principles.


With its 30 year history as a captive domicile, Bermuda has without doubt created a strong infrastructure to service its captives. However, the so-called Bermuda insurance market, created as an option to the domestic and London markets, is witnessing the flight of many actuarial firms and reinsurance companies, with the exception of financial reinsurers. Indeed, Bermuda is evidence that many risk managers are weighing their options in establishing a captive domicile. Vermont, on the other hand, has captive management companies, accounting and legal firms and banks in place to serve the needs of captives. The state is, perhaps, the only domicile to devote a separate department exclusively for captive matters, funded by 7.5 percent of the annual premium tax collected from captives.

Illinois and, to a lesser extent, Colorado also have strong infrastructures. These small onshore domiciles will find their niche, as the Cayman Islands did with medical malpractice captives, and Barbados did with Canadian companies. Colorado and Illinois are attracting more than their share of local risks. Hawaii will likely become a significant player for risks located west of the Rockies.

Some domestic captive management firms have hired certified public accountants with offshore captive experience. By coming onshore, these CPAs can combine their knowledge with the latest computer technology. They are often able to customize software that allows them to provide reports to clients in a matter of days after the close of a period. Many offshore management companies are incapable of this task because the hefty duties on imported computers have made the cost prohibitive.

There are other infrastructure factors that affect captive operating costs. Management and annual fees and audit, actuarial and legal costs are significantly lower in the states. Likewise, communications and travel expenses are lower, with the exception of Hawaii. Added to the costs of operating offshore, Bermuda has imposed a 5 percent payroll tax on captive managers as of April 1, 1990.

Having captive managers attuned to the risk management philosophy of the parent company is especially important because captives have become an integral part of the overall risk management program. Many offshore management companies believe that once a captive is operating no further assistance is needed to structure the insurance program. This policy reduces them to no more than glorified bookkeepers.

In terms of stability, domestic domiciles have the advantage over even the most politically stable offshore location. Indeed, redomesticated companies have found that reinsurance companies and third parties requiring certificates of insurance prefer the security of a U.S.-based captive as opposed to the equivalent offshore. Some participants have even expressed discomfort with the image generated from operating a captive in an "exotic" and perceivably unstable foreign domicile.

The issue of instability extends to employment. Bermuda and other offshore domiciles are often just temporary places of employment for expatriate account managers, auditors and other employees. Frequent personnel changes make communicating with parent company officials frustrating, especially when differences arise between management firms and auditors.

Income and Excise Taxes

Contrary to popular belief, taxes were never the driving force behind the reason for selecting an offshore domicile for single-parent captives; it seemed to be a more influential factor for group captives. To determine whether a captive should move onshore, the subject of tax deferral takes on added importance. No doubt, the Tax Reform Act of 1986 eliminated all tax deferral advantages for offshore single-parent captives and reduced them for group captives. Today offshore captive income is taxed in the same manner as income of captives domiciled in the United States.

The tax reform act ended the non-controlled foreign company status for U.S. shareholder group captives, eliminated tax deferral and resulted in the taxation of related person insurance income. In fact, the tax issues have become so complex that many offshore group captives retain counsel to show that there is still a tax advantage to being offshore. While some offshore tax advantages remain, clearly the days of abundant tax loopholes are over. Indeed, the Internal Revenue Service is watching these types of business transactions closely for any loopholes it may have missed.

Group captives are faced with a no-win situation with respect to sub-part F income. If they elect not to be taxed as a U.S. taxpayer, additional taxes must be paid by the individual participants. If they elect to be taxed as a U.S. taxpayer, the captive pays the tax and, as a result, may be drained of resources. Consequently, it may have to post a letter of credit representing 10 percent of previous year's gross premium as security, and the tax paid by the captive may turn out to be higher than the combined tax paid by the individual members. These disadvantages of election are partially offset by a relief from federal excise tax and the 30 percent withholding tax on U.S. source investment income, in addition to the availability of a three-year carryback of net operating losses, which also pertains to offshore group captives entering the fourth or fifth year of a claimsmade program. Apart from whether or not to elect, a bigger threat to group captives resulting from the tax reform act is the danger of the branch profits tax being assessed if the captive is held to be "engaged in a U.S. trade or business." In addition, state insurance departments have threatened penalties or suits against group representatives who have claims-handling or policyholder services for the offshore captives located onshore.

In the past the federal excise tax has only been an issue for group captives. Bermuda- and Barbados-domiciled captives recently lost their U.S. excise tax exemptions. This, combined with the recent decision of the U.S. tax court in Humana Inc. v. Commissioner, has made the issue a more important consideration. The 0.7 percent and 0.25 percent premium tax, which decreases for higher premium levels, for Vermont captives could be considered better than the 4 percent and 1 percent federal excise tax on direct premiums and reinsurance premiums going offshore. Until the Humana decision, which allowed deductibility of premiums for brother or sister companies of captives, the disallowance of the deductibility of premiums paid by single-parent captives resulted in their being treated as non-insurance entities. Therefore, the tax was not an issue. Yet, for captives taking advantage of the decision, the federal excise tax question is now relevant and will be even more so if the House Ways and Means Committee passes the proposal to increase the tax on reinsurance premiums from 1 percent to 4 percent.

Marketing and Administration

In addition to the changing tax climate, several other factors encourage redomestication. These take the form of marketing and administration for group captives and other pressing tax and regulatory issues for single parents. Offshore association captives and risk retention groups have always found it difficult to sustain the "critical mass" of insureds necessary to spread the risk, increase retentions and ensure survival. The soft market has dealt a further blow to the membership of association and group captives. Enticed by the short-run gains of low premiums, some members have returned to traditional commercial carriers. It has also become difficult for groups to maintain management offshore. Members and service providers must prove to state insurance departments and the IRS that the insureds came to the company rather than the inverse. Furthermore, the captive has had to overcome the perception of potential participants that a foreign-domiciled insurer is less secure than a domestic captive.

The Risk Retention Act of 1986 induced many group captives to consider abandoning their offshore domicile to take advantage of the exemption from federal security laws, state blue-sky laws and other insurance restrictions preventing non-admitted insurers from doing business in other states. Once a risk retention group is licensed in its domicile state,' brokers and agents can market the group without the added cost of a fronting company. The elimination of the costs and problems of fronting, a role that fewer admitted companies are willing to accept, gives the group captive more flexibility in determining its coverage and policy form, including unbundled services as part of the agreement. For certain lines of business, fronting will still be necessary, but fronting companies tend to be more receptive to a U.S.-domiciled captive. The combination of these marketing and cost advantages have already inspired 67 risk retention groups to operate onshore, despite a soft insurance market.

Mature single-parent captives that have generated substantial funds may wish to loan them back to their parent companies. Several foreign domiciles prohibit such loans or make them admissible only with special permission. For example, in Bermuda a loan to a parent does not qualify as an admissible asset for purposes of calculating the minimum liquidity ratio. Interest on such loans and U.S. equity investments is subject to a 30 percent withholding tax. Establishing a domestic captive eliminates the withholding tax requirement, and most regulators in onshore domiciles allow captives to make loans back to their parent companies. A regulation that encourages redomestication to Vermont is a port of entry rule which allows captives moving to the state from offshore domiciles to do so without having to pay a one-time premium tax on their portfolio transfer.

Before Closing Shop

Moving a captive onshore involves a lot more than closing shop and taking the next plane out. The captive must seriously consider the effect of its move on its contractual obligations and its untaxed retained earnings accumulated before the tax reform act. If the company has entered into third-party reinsurance treaties or has a fronting arrangement with an admitted company, it is required to obtain permission from these parties to novate the old agreements. Some domicile states have been sympathetic to offshore captives running off third-party business, but others such as Illinois specifically exclude redomesticating captives from bringing in such business.

The untaxed profits that offshore captives sheltered due to different definitions of sub-part F income which existed prior to the tax reform act are usually problematic because of the so-called toll charge the owners or parent are likely to incur when the captive is moved onshore. One way to bring a captive onshore is to establish a new U.S.-domiciled company to which all the assets and liabilities are transferred. Then the new company can issue shares to the shareholders of the old company in exchange for the transfer of assets. Another method is to use the shares of the offshore company as the principal asset to capitalize the domestic captive. In one instance, the offshore company can pay a dividend to the parent which is passed through to the new company as initial capital. The parent can later contribute the offshore captive stock as additional capital.

The offshore captive could include all or part of its loss reserves and unearned premiums in its portfolio for the new domestic captive and help alleviate the toll tax. In practice this has been one of the most common methods of redomestication primarily because of its simplicity and the fact that it avoids many jurisdictional problems. The redomesticating company must satisfy the onshore regulators that it is matching its actuarial valued liabilities with corresponding hard assets. However, this method should be as far-removed as possible, because the IRS could deem this a tax-avoidance vehicle.

Continuation Strategies

Rather than setting up a new onshore company, it is possible to have the offshore captive "continue" in the new domicile. Barbados, Turks and Caicos and the British Virgin Islands have passed legislation to allow this type of transaction. On the other hand, if a company wishes to transfer out of Bermuda but to "continue," it must do so by Private Act of the Legislature, which has been known to take up to six months.

Continuation has the advantage of enabling the existing contractual obligations to remain in force. Yet experience has shown that it is only successful when there is corresponding legislation in the new domicile. While Colorado and Illinois governments make reference to simplified redomestication rules in their legislation, no offshore companies have actually redomesticated using the mechanism.

Only one of these methodologies outlined so far addresses the toll tax problem. Remember, the offshore captive has only "deferred" taxation on its untaxed accumulated retained earnings, and even under the old rules the profits are taxed when they are remitted onshore. Still, it is possible for single parent captives to leave the offshore captive to write foreign risks or run off the existing book of business, while a new onshore captive is being set up to write new U.S. business. For groups or association captives, setting up an onshore risk retention act captive and keeping the offshore captive to act as a reinsurer or direct writer of lines, which is not permitted under the act, can combine the advantages of both locations.

The changing tax laws and regulations have omitted and reduced most of the historical reasons for locating a captive offshore. Yet, simultaneously, developments onshore are encouraging the establishment of captives there. In the last year alone, as the number of offshore domiciles have dwindled, the number of captives in Vermont increased by 17, bringing the total to 175. Illinois gained two new captives in 1989, bringing its total to eight, and Colorado and Tennessee each gained one, bringing their totals to 24 and 14, respectively. Indeed, the trend reveals that parent companies in search of a self-insurance program are moving to redomesticate their captives. For others who have not yet considered the move, or who are still weighing their options, benefits offered by operating captives in dual domiciles may in the final analysis offer the best of both worlds.

Michael T. Rogers is chief operating officer of Vermont Insurance Management Inc. in Montpelier.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:offshore captive insurance companies
Author:Rogers, Michael T.
Publication:Risk Management
Date:Sep 1, 1990
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