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. INTRODUCTION

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 h ave been possible without the

encouragement and guidance of Dean Andrew Morriss.

1 See, e.g., Emergency Economic Stabilization Act of 2008, P ub. 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 th e 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 $1 75 billion in direct obligations of F annie 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 lo nger-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 Progr ams 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 Insura nce 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., F eb. 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 Pa per, 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 o f 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)