Section 831(b) Captive Insurance Companies: Why Policymakers have it all Wrong

• Author: Drew D. Estes
• Position: Drew Estes is a graduate of the University of Alabama School of Law and the University of Alabama Manderson School of Business. He is a portfolio manager at Banyan Capital Management in Atlanta, Georgia. This article would not have been possible without the encouragement and guidance of Dean Andrew Morriss.
• Pages: 723-753

SECTION 831(B) CAPTIVE INSURANCE COMPANIES: WHY POLICYMAKERS HAVE IT ALL WRONG DREW D. ESTES * I. I NTRODUCTION The financial crisis of 2008–2009 exposed the risks inherent in our complex and global economic system. In the wake of that crisis, U.S. policymakers have used a multitude of tools to bolster the faltering economy. 1 In spite of their efforts, the economy continues to underperform. 2 Copyright © 2016, Drew D. Estes. * Drew Estes is a graduate of the University of Alabama School of Law and the University of Alabama Manderson School of Business. He is a portfolio manager at Banyan Capital Management in Atlanta, Georgia. This article would not have been possible without the encouragement and guidance of Dean Andrew Morriss. 1 See, e.g., Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343, 122 Stat. 3765 (2008). The Act authorized the Treasury to “purchase . . . certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system.” Id. This legislation established the Troubled Asset Relief Program (TARP), which would purchase “troubled assets” from institutional investors. See id.; Jeannette L. Nolen, Emergency Economic Stabilization Act of 2008 (EESA), ENCYC. BRITANNICA, http://www.britannica.com/topic/Emergency-Economic-Stabilization-Act-of-2008 (last visited Mar. 1, 2016). The implementation of the Federal Reserve’s expansionary monetary policy started with the “purchase [of] large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets” in conjunction with a decision “to establish a target range for the federal funds rate of 0 to 1/4%.” 2008 Monetary Policy Releases, BD. GOVERNORS FED. RES. SYS. (Dec. 16, 2008), http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm. The Federal Reserve (1) “purchased $175 billion in direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks” between December 2008 to August 2010; (2) “purchased $1.25 trillion in mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae” between January 2009 and August 2010; (3) “purchased $300 billion of longer-term Treasury securities” between March 2009 and October 2009; (4) “purchas[ed] an additional $600 billion of longer-term Treasury securities” between November 2010 and June 2011; (5) “increased policy accommodation by purchasing additional MBS at a pace of $40 billion per month” beginning in September 2012; (6) “purchas[ed] longer-term Treasury securities at a pace of $45 billion per month” beginning in January 2013; and (7) reinvested “principal payments from its holdings of agency debt and agency MBS . . . in agency MBS” beginning in September 2011. Credit and Liquidity Programs and the Balance Sheet, BD. GOVERNORS FED. RES. SYS., http://www.federalreserve.gov/monetarypolicy/bst_ openmarketops.htm (last updated Dec. 16, 2015) (noting the vastness of the Federal Reserve’s expansionary monetary policy since 2008). 2 See What Accounts for the Slow Growth of the Economy After the Recession?, CONG. BUDGET OFF., Nov. 2012, at 1, 2, http://www.cbo.gov/sites/default/files/43707-SlowRecovery.pdf; Eric Morath, The Worst Expansion Since World War II Was Even (continued) 724 CAPITAL UNIVERSITY LAW REVIEW [44:723 There are bright spots within the economy, however, and the captive insurance industry is among the brightest. 3 The captive industry is comprised of captives, captive managers, and other professionals providing ancillary services to captives. 4 The core of the captive industry is comprised of the captive insurance companies, which are technically defined as “insurance or reinsurance entit[ies] created and owned, directly or indirectly, by one or more . . . entities, the purpose of which is to provide insurance or reinsurance cover for risks of the entity or entities to which [they] belong[], or for entities connected to those entities.” 5 In more simplistic terms, the typical captive arrangement includes one or more firms owned or controlled by a common parent entity, i.e., a corporate family, and the parent entity forms a captive to insure the risks retained by the other members of the corporate family, i.e., the captive’s corporate sisters or affiliates. 6 Instead of using a third-party insurer, the corporation creates its own wholly-owned insurer. Although now mainstream, this is not a new concept. 7 Innovative entrepreneurs have utilized rudimentary captive arrangements for well over a century. 8 Captive insurance as it exists today, however, can trace its roots to the 1950s when a man by the name of Fred Reiss set out to solve a simple Weaker, WALL ST. J. (July 30, 2015), http://blogs.wsj.com/economics/2015/07/30/the-worst-expansion-since-world-war-ii-was-even-weaker/?mod=WSJBlog. 3 See Issues Paper on the Regulation and Supervision of Captive Insurance Companies, INT’L ASS’N OF INS. SUPERVISORS, Oct. 2006, at 4, 4 [hereinafter Issues Paper], http://www.captiveglobal.com/files/documents/Application_Paper_on_Captive_Insurers-Nov2015.pdf. 4 See Robert E. Bertucelli, Captive Insurance Companies, CPA J., Feb. 2011, at 60, 61, http://www.elevatecaptives.com/userfiles/file/Captive_Insurance_Companies.pdf (providing a visual representation of a typical captive structure). 5 Issues Paper, supra note 3 , at 4. “Reinsurance” refers to insurance provided to an insurance company. See Reinsurance, INVESTOPEDIA, http://www.investopedia.com/terms/r/ reinsurance.asp (last visited July 3, 2016). 6 See Bertucelli, supra note 4, at 62. 7 See Issues Paper, supra note 3 , at 5. “There are instances as early as 1782 of mutual insurance companies being formed by members of a particular industry to provide insurance coverage.” Id. 8 Id. “The concept of forming an insurance company to insure the risks of its owners can be traced to the infancy of insurance.” Id. The precursor of today’s group of association captives, captives owned by and insuring the risks of a particular industry’s participants, was formed as early as 1782. See id. A concrete example arose “[i]n 1860, in response to increased insurance rates, [when] a group of London merchants formed their own insurance company called Commercial Union.” Id. The first examples of pure captives, captives owned by and insuring the risk of their parent and affiliates, arose “[i]n the 1920’s [sic] and 1930’s [sic] [when] several major companies, including ICI, BP, Pilkingtons and Unilever in the UK and Lufthansa in Germany, had formed their own insurance companies.” Id. (continued) 2016] CAPTIVE INSURANCE 725 problem. 9 His clients needed protection from increasing insurance premiums that were threatening their companies’ financial viability. 10 Being the innovative businessman that he was, Fred Reiss formed the first modern captive, 11 and other firms have followed his example ever since. 12 Roughly thirty years after Fred Reiss’s creation of the first modern captive, the captive industry was still no more than a sleepy niche industry comprised of slightly more than one thousand captives. 13 Although commonplace among the world’s largest firms, captives were virtually unheard of among midmarket and small firms at the time. 14 Legal innovations drove costs down, however, and the popularity of captives began to rise. 15 As a result, the industry underwrote more than 10% of global premium income by 2002 and boasted more than 5,500 captives by 2005. 16 Although accurate data on the industry is hard to come by, the number of captives existing today certainly exceeds 6,000. 17 9 See id. (acknowledging that “[t]he modern concept of captive insurance companies did not develop into a real growth industry until the 1950’s [sic], when Fred Reiss, the widely acknowledged ‘father’ of captives took a special interest and initiated the development of the current industry profile”). 10 See id.; PETER J. STRAUSS, THE DEFINITIVE GUIDE TO CAPTIVE INSURANCE COMPANIES 5 (2011) (stating that Fred Reiss was prompted to take action after “one of Reiss’ largest clients[] saw its financial stability threatened by rising insurance prices”). 11 See STRAUSS, supra note 10 , at 5. “Instead of paying hefty premiums to buy insurance from a large insurance company, Reiss’ client would form a new insurance company . . . [that] would issue insurance to its parent company.” Id. The captive would then purchase reinsurance from Lloyds of London. See id. 12 See Issues Paper, supra note 3, at 6. 13 See id. at 4–5. 14 See Greg Taylor & Scott Sobel, A Closer Look at Captive Insurance, CPA J., June 2008, at 48, 48 (noting that the beneficiaries of captive insurance have historically been large corporations with 80% of S&P 500 companies using captive insurance); Bertucelli, supra note 4 , at 64 (noting that captives were “long favored” by Fortune 100 companies). 15 See Taylor & Sobel, supra note 14 , at 48. “With the enactment of favorable tax regulations and other legislation . . . captives are no longer just for large corporations.” Id. Robert E. Bertucelli, The Benefits of Captive Insurance Companies, J. ACCT. 53, 56 (Feb. 2013), http://www.pivotalcaptive.com/wp-content/uploads/2013/03/The-Benefits-Of-Captive-Insurance-Companies.pdf (noting that legislative innovations have created “the ability to operate a captive insurance entity at lower costs and using much smaller levels of risk and premiums, making it available to a broader spectrum of companies”); Jeff Simpson & Randall Beckie, Warning: Do Not Try This at Home! The Series Captive Insurance Company in Delaware Takes Cell-Type Captive Structures to Another Level of Flexibility and Premium Efficiency, CAPTIVE REV. (Apr. 2010), http://www.elevatecaptives.com/ userfiles/file/Series_Cell_Captive_-_Jeff_Simpson.pdf (discussing the efficiencies of the series limited liability company within the context of captive insurance). 16 See Issues Paper, supra note 3, at 50. 17 See id. (estimating...