Tennessee Overhauls Captive Insurance Law To Become National Leader
Feb 1, 2012
Types of Captives: Lines of Coverage
Tennessee Governor Bill Haslam signed a comprehensive overhaul of Tennessee's captive insurance law in June. It put Tennessee at the forefront of captive insurance domiciles and permits cutting-edge captive formations. Tennessee had been one of the first domestic captive insurance domiciles when it first enacted its captive insurance law back in 1978. But the law had not been changed prior to June and had not kept up with industry changes. Interestingly, prior to being signed by Governor Haslam, the law received unanimous approval in both houses of the Tennessee General Assembly, indicating Tennessee's renewed commitment on a bipartisan basis to captive insurance.
Much has changed in the captive insurance industry in the last 30 years, although the fundamentals remain the same. Accordingly, in addition to traditional single-owner captives, group captives, industrial insured captives, and risk retention groups that have been permitted in Tennessee for years, the law now permits the formation of protected cell captives. This includes incorporated cells, branch captives, and special purpose financial captives (SPFC's). The updated law also now authorizes employee benefits risk and worker's compensation (for companies who otherwise qualify as self-insureds) to supplement the standard property and casualty insurance coverages offered by captives (including professional liability, general liability, errors and omissions, director's and officer's, and commercial property coverages). It also allows captives broad reinsurance and excess insurance authority. Unlike other leading domiciles, the new law also permits branch captives for risks other than employee benefits.
Background and Advantages of Captives
Simply put, a captive is an insurance company formed by a business or a group of businesses to insure its (or their) own risks (hence, the term "captive"). In other words, the owners of a captive are also the policyholders. The captive insurance concept has been around since at least the 1960s or the 1970s, but growth in this industry has accelerated dramatically since the late 1980s. Currently, it is estimated that as much as 50 percent of the business insurance marketplace risk is underwritten by captive insurance companies or other alternative risk transfer vehicles in some form. In addition to off-shore captive domiciles such as Bermuda, Cayman, British Virgin Islands and Barbados, the leading U.S. domiciles include Vermont, Hawaii, South Carolina, Kentucky, Montana, Utah and Arizona.
The primary benefit that captives offer is to help companies gain control of their insurance destiny. Captives also can provide significant federal tax advantages depending on the structure utilized. Generally, in order to qualify as an insurance company for federal tax purposes, a captive either must have sufficient risk transfer and distribution or insure enough unrelated risk. For a single owner or pure captive, risk distribution can be accomplished pursuant to a "brother-sister" arrangement whereby the subsidiary captive provides insurance to its brother and sister corporations. The IRS safe harbor for this arrangement requires at least 12 separate subsidiary corporations, with each one having no less than 5 percent nor more than 15 percent of the premium or risk. Depending on the structure and the specific facts of a given scenario, it may also be possible to achieve insurance tax status outside of these safe harbor parameters. In order to qualify for federal insurance tax treatment on the basis of insuring unrelated risk, the IRS safe harbor requires that the captive provide at least 50 percent of its insurance to unrelated parties—referring to companies who are not affiliated with or under the same control as the owners of the captive. Case law also has permitted federal tax treatment as an insurance company with unrelated business percentages as low at 29 percent. Thus, the industry for years has used the 30 percent threshold as a rule of thumb for potential favorable tax treatment, with the IRS standard of 50 percent as the definitive safe harbor.
In addition, there are also potential state tax advantages to captives, who pay significantly less premium than self-insured entities or traditional insurer alternatives. The annual premium tax rates under the new Tennessee law are consistent with those of the other leading captive domiciles and range between 0.4 percent and 0.3 percent for direct written premiums, and 0.225 percent and 0.150 percent for reinsurance. The minimum annual premium tax for any captive is $5,000, and the maximum is $100,000. Generally captives may only underwrite direct risk in their state of domicile. Any other risk reinsured by a captive must be "fronted" or insured first by a fully admitted carrier, resulting in the payment of state premium tax at the regular rate.
Overall, single-owner or pure captives tend to be used by larger companies and can be a very effective risk management tool for Fortune 500 and other large corporations (generally those with at least $1 million in applicable premiums). However, captives are potentially a viable option for smaller companies as well. Group captives and risk retention groups can be very effective for any companies that may belong to trade associations or otherwise have similar or related risks.
Procedure for Obtaining Licensure of a Captive
The new law has permitted applications to be submitted since July 1, 2011, and captives to be licensed since Sept. 1, 2011. The first captive licensed under the new law is a subsidiary of the Hospital Corporation of America (HCA) that was licensed on Sept. 1, 2011. Ultimate authority for licensing captives is vested in the Commissioner of the Tennessee Department of Commerce and Insurance, Julie McPeak. For information on application forms and how to apply for licensure as a captive in Tennessee, contact Assistant Commissioner for Insurance Larry Knight at the Department. It is recommended that all applicants have a detailed business plan and that they meet first with officials at the Department before filing an application. The Department is also in the process of establishing a new captives section or division and hiring a new senior director of captives, who likely will be in place by the time this article is published.
Passage of the Bill
Commissioner McPeak, who was previously my colleague at Burr & Forman LLP and was appointed by Governor Haslam in January to serve as Commissioner of the Department, played the pivotal leading role in preparing the legislation and advocating for passage of the bill. The new law utilizes portions of similar laws from many of the leading captive domicile states, including Vermont, South Carolina, Kentucky, Montana, District of Columbia, and Hawaii.
About The Author
Kevin M. Doherty is an attorney and partner at Burr & Forman LLP, and he assisted Commissioner McPeak and the Department in drafting the new law.
Kevin Doherty is a partner at the law firm of Burr & Forman in Nashville, Tenn., where he serves as head of the firm’s Insurance Group. Doherty’s experience concentrates on insurance regulatory law, with particular emphasis on captives, risk retention groups, self-insurance funds, and other alternative insurance vehicles. He is the founder and current President of the Georgia Captive Insurance Association, Inc., as well as Chairman of the Board and President of the Tennessee Captive Insurance Association, Inc. Kevin is admitted to practice in Tennessee, Georgia and New York.
