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Vermont reciprocals.

The United States' premier domicile is home to a growing number of reciprocals, self insurance mechanisms that provide access to insurance or reinsurance for organized groups of insureds.

There's been a lot of talk lately about when the soft market might begin to take its toll on the formation of new captives. Well, at present, the captive concept seems to have more appeal than ever, despite plentiful commercial capacity and insurer-based services.

There are many reasons why captives still work and work well for large single and group commercial insureds. One of the quiet evolutions lending momentum to the captive industry is the development of Vermont as a domicile of worldwide importance and rank.

Since the passage of captive-enabling legislation over 20 years ago, Vermont has worked to establish itself as a captive-friendly environment. In 1998 it passed the 400 mark in number of captive licenses granted. Forty new captive licenses were issued, the second-highest number of captives formed in one year since Vermont's law was enacted.

In July, Vermont passed Act 100, permitting the formation of reciprocal captive insurers. The reciprocal structure is the oldest form of group insurance. (Lloyd's of London started in the early 17th century structured essentially as a reciprocal.) Reciprocals have been quietly playing an active role in how groups of insureds receive insurance contracts for many years. For example, many of the physician-owned professional liability insurers formed in the late 1970s and early 1980s were formed under existing reciprocal regulations.

A reciprocal is essentially a self insurance mechanism providing access to insurance or reinsurance coverage for a closely organized group of insureds. It is an unincorporated entity, an issue which causes some confusion among insureds and regulators alike. A reciprocal does not have shareholders, it has subscribers or members. Its board may be called something like a Subscribers Advisory Committee. It is managed by an attorney-in-fact who usually has broad-ranging administrative and executive authority over the affairs of the entity. The entity does not usually have bylaws, but may have governing rules.

Since the passage of Act 100, a reported four reciprocals have been organized in Vermont and several more are in various stages of feasibility or formation. The established benefits of group self insurance, the existing ease of setting up a company in Vermont and the advantages of the reciprocal concept all help to explain this steady rise.

If the reciprocal is also created as a Risk Retention Act company (under the Federal Risk Retention Act of 1986), insureds may be able to eliminate issuing carrier charges and associated frictional costs that can make group captive programs unreasonably expensive.

Reciprocals can be particularly attractive to tax-exempt insureds. (Three of the four reciprocals now licensed in Vermont are owned by tax-exempt health care providers.) The earnings of each subscriber to a Vermont reciprocal are allocated to a subscriber savings account. If properly constructed, a reciprocal can minimize, and possibly largely eliminate, federal tax on the amounts allocated to these special accounts. I stress the phrase "if property constructed." As with all captives, it's best to seek independent tax advice as part of a feasibility analysis. What is clear is that group captives, particularly those owned by tax-exempt parents, will start giving Vermont careful consideration as the captive feasibility process unfolds. Health care captives in particular, which have traditionally gravitated to the Cayman Islands or, more recently, Bermuda, may start forming on-shore.

This development couldn't come at a better time for the health care industry for another reason. Over the past two or three years, competing hospitals and hospital systems have been moving guardedly toward affiliations that mutually benefit each facility's long-range strategic plan. They may and probably will continue to compete within certain geographic areas, but can come together to purchase risk financing, risk management and related services to their joint advantage. A reciprocal is the ideal vehicle from which to launch such risk financing, group insurance and reinsurance purchase initiatives. The reciprocal structure is easy to establish and administer, and all subscribers are, by definition, equal, even though their programs may differ in size or complexity.

Vermont has prospered over the last 10 years by targeting groups of insureds eager to share risk and purchase related services in an innovative environment; by allowing reciprocals, the state proves that it remains serious about alternative risk financing.

A note on tax issues

The differences between onshore and off-shore domiciles have been narrowing. A domestically licensed captive will generally have all or most of its income subject to United States federal income tax. A captive formed off-shore in one of the more popular domiciles, such as Cayman or Bermuda, will not be subject to local tax, but if organized as a Controlled Foreign Corporation, will be required to report and generally pay tax on the captive's Subpart F income, even if it is not actually distributed to the captive's shareholders.

Formation facts

How are reciprocals formed in Vermont? The state permits the formation of so-called industrial insureds (group captives by another name). An industrial insured can be formed as either a stock, mutual or (since July 1998) reciprocal insurer. Once a feasibility study is completed and the determination is made to move forward, the following steps should be taken:

Subscribers to an industrial insured group reciprocal captive must meet the definition of an industrial insured. That is, each subscriber must procure its insurance by use of a full-time employee acting as an insurance manager or buyer; have aggregate premiums of at least $25,000; and have at least 25 full-time employees.

At some point in the application process, if not prior to it, it's important to meet with Len Crouse, Vermont's director of captive insurance, to get his reaction to the details of the proposed formation and to provide the department with a level of comfort with the concept and insureds in question.

Reserve the name of the reciprocal with Vermont's secretary of state and clear it with the Vermont Insurance Department to ensure that it will be available.

The Vermont Department of Banking, Insurance, Securities and Healthcare Administration will require that a formal application be submitted for the reciprocal. This application will include the reciprocal's business plan, as well as its plan of operation. The application and plan should contain the following principal elements:

* A completed application form on the department's original application stock

* A complete feasibility study

* A business plan in narrative form, including a description of the coverages, deductibles, coverage limits, and rates

* A five-year pro forma financial statement. Vermont reciprocal insurers are required to maintain at all times free capital surplus of not less than $1 million

* Biographical affidavits for all officers and advisory committee members

* A loss control plan

* A copy of the proposed power of attorney document

* A copy of the proposed Subscriber's Agreement and other organizational documents

Vermont has a reputation for rapid response and approval for well-conceived captive formations, and although most captives are approved by the department within 30 days, it's important to allow 60 days or more for the entire application, review and approval process to be completed. This is particularly true of reciprocals, which normally involve more work by legal counsel in the construction of subscriber agreements, governing rules and related documents.
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Author:Maglaras, Michael
Publication:Risk Management
Geographic Code:1U1VT
Date:Mar 1, 1999
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