Demystifying the Dodd-Frank Effect on Captive Insurance Companies

captive insurance and dodd-frank actOn July 21, 2014, corporations, banks, and regulators marked the anniversary of one of the most impactful pieces of legislation the U.S. has seen in recent years. The Dodd-Frank Wall Street Reform and Consumer Protection Act, more commonly known as Dodd-Frank, was implemented to prevent the recurrence of events that prompted the financial crisis of 2008. Transparency, accountability and consumer protection are at the heart of the act and several regulatory groups were established to keep banks and corporations compliant. The Financial Stability Oversight Council (FSOC) was created to address the specific issues affecting the financial industry and the Consumer Financial Protection Bureau (CFPB) forged ahead to protect consumers from unregulated banks. Sub-prime loans doled out by “lone sharks” now had someone to answer to. But there was more to it.

Dodd-Frank includes verbiage relating to the world of taxation, licensing, and eligibility rules associated with the procurement of insurance from non‑admitted insurers across the 50 states, the District of Columbia, and five U.S. territories. This section was titled the Non-admitted and Reinsurance Reform Act (NRRA).

The legislation has brought dramatic changes for those procuring non‑admitted insurance for their organization from wholly owned captives. Four years later, prospective captive owners are still trying to make sense of their responsibilities and tax obligations. Are captive insurance companies expected to pay premium taxes to their respective domiciles? What about the operating company—who would ultimately be responsible for the tax burden, if any?

The draw for many business owners to form captives is multi-faceted. This alternative risk management tool provides them the ability to pay tax-deductible premiums to the captive and realize major benefits, such as broad insurance coverage for non-standard or otherwise excluded risks. Unfortunately, the general chaos caused by the law has given many captive owners a great deal of concern. It is why business owners looking to form captives must elicit the expertise of legal and insurance professionals as they could help navigate the complexities of Dodd-Frank.

Who Has Jurisdiction?

Prior to the passage of Dodd-Frank, insurance companies had an obligation to pay state taxes. The premium tax on the insured was included in the premium calculations without specific notice that the tax was being paid. Insureds purchasing non-admitted surplus lines insurance were assessed a premium tax that was collected by licensed insurance agents or brokers. The broker would remit the tax on behalf of the insured. Insureds that purchased insurance directly from non-admitted insurers, such as captive insurance companies were generally required to remit tax payments to the state directly, with no third party intervention.

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But on July 21, 2011, the bi-partisan Nonadmitted and Reinsurance Reform Act (NRAA) was added to Dodd-Frank—a provision that was intended to create certainty in the tax treatment and regulation of the surplus lines and in the reinsurance industry. It was to unify premium tax reporting on surplus lines insurance, such being state-licensed insurance brokers’ use of out-of-state/nonadmitted insurance companies to write generally unusual or large coverages (e.g., $50 million umbrella coverages) for clients.

The state–licensed brokers had to apportion premiums, file, and pay state tax in every state where the insureds did business, often requiring many tax filings. The NRRA gave sole authority to tax “nonadmitted insurance” to the home state of the insured, which is generally defined as the insureds’ principle place of business. The open definition of “nonadmitted insurance” in the federal statute led several states, including Texas, California, and New York to conclude that the NRRA granted them sole authority to tax independently procured insurance (including captive insurance) purchased by their home state insureds.

Essentially, they misinterpreted the application of the NRRA’s definition of “Nonadmitted.” It has been well-established that the writers of Dodd-Frank had no intention of including captives in this section of Dodd-Frank, as they would have met their tax obligation through their domicile. States quickly amended their independently procured tax laws to tax 100 percent of premiums on insurance acquired by their home state insureds. It is a real possibility that other states could follow in their footsteps.

The Case for Captive Insurance

There has been substantial resistance and controversy surrounding the Dodd-Frank Act. States created new captive insurance domiciles in an attempt to free new and existing captives from these tax obligations and to try to keep tax revenues in each state. But captives with operating companies in other states did not enjoy this protection. Captives domiciled in a state other than its parent company’s home state may expose the parent company to double taxation: a self-procurement tax on the corporate policyholder collected by the home state (under the NRRA) and a premium tax on the captive charged by the state where the captive is domiciled.

Delaware and other state regulators and captive associations formed a coalition to address issues of the NRRA with respect to captive insurance. The Coalition for Captive Insurance Clarity has been working to coordinate efforts in promoting corrective legislation to the NRRA since 2012. The objective is to address the misplaced reliance of certain states on the NRRA as an authority to tax captive insurance premiums.

In addition to the issues with the Dodd-Frank Act involving nonadmitted insurance, the National Association of Insurance Commissioners (NAIC), found issue with section 171 of the Dodd-Frank Act and the perceived ambiguity of banking capital requirements. The NAIC stated the U.S. Senate Banking Committee must consider amendments to the Dodd-Frank Act so that policyholders are not put at risk. The Senate attempted to heed those sentiments.

In June 2014, the ‘Collins Amendment,’ sailed through the Senate with unanimous backing. The bill, formally known as the Insurance Capital Standards Clarification Act of 2014, would revise section 171 of the Dodd-Frank Act. It would "clarify that the Federal Reserve Board can apply insurance-based capital standards to the insurance portion of any insurance holding company it oversees." Unfortunately, while it addresses the concerns of ambiguity under section 171 of the Dodd-Frank Act, the Collins Amendment did not address the NRRA in any capacity.

The Importance of Turnkey Services and Support

Under the Internal Revenue Code section 831(b), the formation and ongoing management of a captive must be overseen by experienced professionals that understand the insurance, tax, and legal aspects of the captive. Because the captive is a regulated insurance company, most business owners prefer to have a third party administer the captive on a turnkey basis that has developed familiarity with the issues, laws, and guidelines needed to ensure its success. For the same reason, regulators demand ongoing professional management. Dodd-Frank and general regulatory guidelines are still in flux.

Large corporations have shown their influence, paying reduced taxes in their home states. But Dodd-Frank has done little to solve the problems of the confusing multi-state premium tax regulations for captives and have probably made the situation much worse.

Many “captive managers” may be able to help with the formation of the captive, but his or her ability to support the client likely stops there. Legal and regulatory support is often disclaimed in the fine print, leaving clients to their own devices. By working with a true turnkey service, like Capstone Associated, Ltd. with its affiliated [The] Feldman Law Firm, future and current captive owners will be able to stay abreast of these changes and remain compliant on all fronts. The benefits of owning a captive are far-reaching and the adoption of captive insurance is growing exponentially. Navigating Dodd-Frank is a necessary part of the process that can certainly be done with the right people on your side.

This article was written by Steven D. Cohen, Esq, head of the tax department at The Feldman Law Firm, and Logan R. Gremillion, an attorney with The Feldman Law Firm and published by Captive Review Magazine in the September 2014 issue.

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