Developments in Vermont
Sixteen New Vermont Captives Licensed in 2014
In 2014, Vermont licensed sixteen new captives, including ten pure captives, two sponsored captives, two special purpose financial insurers, one association captive, and one risk retention group. Additionally, two new captives were redomesticated from Bermuda and Delaware. These additions brought the total number of captives operating in Vermont up to 581.
2015 Captive Legislation
The Vermont legislature has passed an annual “housekeeping” bill jointly proposed by the Vermont Department of Financial Regulation (the “DFR”) and the Vermont Captive Insurance Association. The significant provisions include:
- Required Number of Incorporators Reduced. Section 6006(c) of Title 8 was amended to reduce the number of incorporators required to organize or incorporate a captive insurance company in Vermont from at least three to at least one. The requirement that one of the organizers or incorporator be a Vermont resident was retained.
- Minimum Capital Requirement for Sponsored Captive Insurance Companies Reduced. Section 6004(a)(5) of Title 8 was amended to reduce the unimpaired paid-in capital and surplus requirement for sponsored captive insurance companies from $500,000 to $250,000.
- Definition of Capital and Surplus Expanded to Include Marketable Securities. Section 6004(c) of Title 8, which previously provided that a captive’s capital and surplus may be in the form of cash, certain qualifying trusts, or certain qualifying irrevocable letters of credit, was amended to permit a captive’s capital and surplus to be held in the form of “marketable securities.” The DFR is expected to issue a bulletin later this year interpreting the term “marketable securities.”
- Naming Convention for Incorporated Cells. A new subsection (d) was added to Section 6034a of Title 8 providing that incorporated protected cells will have their own distinct name or designation, which will include the words “Incorporated Cell” or the abbreviation “IC.”
- Clarification of Delinquency Provisions Related to Sponsored Captive Insurance Companies. Sections 6038 and 6039 of Title 8 were amended to conform to the NAIC Protected Cell Company Model Act regarding the segregation of a sponsored captive insurance company’s assets and liabilities.
- Adoption of Governance Standards for Risk Retention Groups. Vermont adopted portions of the NAIC model governance standards for risk retention groups. The new standards require that risk retention groups (i) have a majority of independent directors and an audit committee, and (ii) adopt a plan of operations, formal governance standards, and a code of business conduct and ethics.
2015 Limited Liability Company Legislation
The Legislature is considering substantial amendments to Vermont’s Limited Liability Company Act (the “LLC Act”) during the 2015 legislative session. The following proposed amendments may be of interest to the captive insurance community:
- Conversions. The LLC Act only allows for conversions of partnerships and limited partnerships into limited liability companies. The proposed amendments expand the type of conversions that may be done to include (i) the conversion of Vermont limited liability companies into other types of Vermont entities, and (ii) the conversion of other types of foreign organizations (other than foreign limited liability companies) into Vermont limited liability companies.
- Member Consents. The LLC Act allows for approval actions to be taken by written consent in lieu of a meeting of members, but requires that the written consent be signed by all members. The proposed amendments would allow for actions by written consent if signed by the number of members required to approve the action had the action been taken at a duly called meeting.
- Mandatory Buyout of Departing Member. The LLC Act requires that a limited liability company repurchase the interest of a dissociating member. The proposed revisions eliminate this requirement, though the members of an limited liability company remain free to include a repurchase provision in their operating agreement.
- Default Rule for Distributions. The LLC Act creates a default rule that, upon the winding up a business, the assets of a limited liability company will be distributed first to return capital contributions and thereafter in “equal shares.” The proposed revisions change this default rule such that remaining assets are distributed pro rata based on capital contributions.
Terrorism Risk Insurance Program Extended
On January 12, 2015, President Obama signed the Terrorism Risk Insurance Program Reauthorization Act of 2015 (“TRIA”) extending the federal terrorism insurance program through 2020. The new legislation provides for incremental increases to the trigger for reinsurance coverage under the program from $100 million to $200 million beginning in 2016, as well as increasing insurers’ co-pays from 15 to 20 percent and raising the federal government’s mandatory recoupment from $27.5 billion to $37.5 billion.
Insurers participating in the federal terrorism insurance program are required to submit to the Secretary of the Treasury information regarding lines of insurance with exposure to terrorism losses, premiums earned on coverage, geographical location of exposures, pricing of coverage, and certain other information.
In addition to renewing the insurance program, the law provides for the creation of the National Association of Registered Agents and Brokers (“NARAB”), which will be made up of state insurance commissioners and insurance market representatives. NARAB streamlines the licensing process for registered insurance agents and brokers and is intended to help insurance agents and brokers operate on a multistate basis.
Risk Retention Groups
Speece: Nebraska Supreme Court Rules that LRRA Preempts State Anti-Arbitration Law
In another victory for Risk Retention Groups, the Nebraska Supreme Court ruled that the Liability Risk Retention Act of 1986 preempts a Nebraska statute barring arbitration provisions in insurance-related agreements.
Speece involved a Nebraska-based chiropractor who had purchased professional liability coverage from Allied Professional Insurance Company (“APIC”), a risk retention group incorporated in Arizona. In 2012, Speece was sued by the State of Nebraska in connection with certain allegedly false Medicaid claims. A dispute then arose between Speece and APIC as to whether Speece’s related defense costs were covered under the APIC policy. Speece filed a declaratory judgment action in state court and APIC moved to compel arbitration. The trial court denied APIC’s motion, holding that a Nebraska statute barring arbitration provisions in insurance-related agreements was not preempted by the LRRA.
APIC appealed and the Nebraska Supreme Court overturned the trial court’s decision. Quoting extensively from Wadsworth v. Allied Professionals Ins. Co., a Second Circuit decision that we discussed here the Nebraska Supreme Court found that Nebraska’s anti-arbitration law was precisely the type of state regulation that the LRRA was intended to preempt because it had the effect of regulating the operation of the risk retention group by prohibiting a contract term (the arbitration clause) that was otherwise permissible under the laws of the risk retention group’s domicile. Accordingly, the Nebraska Supreme Court reversed the trial court’s decision and remanded the case to the trial court for consideration of whether the arbitration provision was unconscionable. In January, the trial court issued a decision finding that the arbitration provision was not unconscionable and ordering the dispute into arbitration per the terms of the APIC policy.
While the dispute in Speece is relatively narrow and state-specific, it may, along with Wadsworth, be indicative of a growing appreciation in the broader legal community of the regulatory structure created by the LRRA.
Federal Tax Matters
Securitas: Tax Court Allows Tax Deduction for Premiums Paid to a Captive
Following closely on the heels of its widely discussed Rent-A Center decision, the United States Tax Court, on October 29, 2014, issued a memorandum opinion rejecting an Internal Revenue Service (“IRS”) determination that certain amounts paid by subsidiaries of Securitas AB (“Securitas”) were not deductible as insurance premiums under Section 162 of the Internal Revenue Code of 1986 (as amended, the “Code”).
Securitas, a Swedish company, is the foreign parent of Securitas Holdings, Inc. (“Holdings”), a Delaware corporation that is the ultimate parent of a large number of United States-based operating subsidiaries (collectively, the “U.S. Subsidiaries”). As part of its expansion into the U.S. market in 2000, Securitas caused the U.S. Subsidiaries to acquire, among other businesses, Protectors Insurance Company of Vermont1 (“Protectors”), a Vermont licensed captive insurance company, and Centaur Insurance Company (“Centaur”), a defunct Illinois insurance company. In 2003, Protectors became a direct subsidiary of Holdings and, during 2003 and 2004, Protectors provided insurance coverage to certain of the other U.S. Subsidiaries.
In 2002, Securitas established Securitas Group Reinsurance Ltd. (“Securitas Re”), an Irish reinsurance company. For 2003 and 2004, Securitas Re reinsured 100% of the risks insured by Protectors.
Securitas’ intent in acquiring Protectors was to establish a captive insurance program for the U.S. Subsidiaries. However, an issue arose when Securitas realized that restarting Protectors could jeopardize Centaur’s eligibility for an exemption from federal income tax under Code section 501(c)(15), which limits the amount of premiums that can make up the gross receipts for an insurance company and certain of its affiliates. In order to address this issue, Holdings agreed to guarantee Protector’s obligations to the U.S. Subsidiaries under the 2003 and 2004 insurance policies (Protectors’ obligations to Securitas Re were not covered by the guarantee). As a result of this guarantee, Securitas took the position that Protectors did not qualify as an insurance company for federal income tax purposes during the relevant years. The intent of this position was to remove Protectors from the premium test under Code section 501(c)(15) and, therefore, to preserve Centaur’s tax-exempt status. No amounts were paid by Holdings on the guarantee.
Certain of the U.S. Subsidiaries (i) paid the premiums to Protectors for themselves and on behalf of the other U.S. Subsidiaries, and (ii) paid claims under the policies. Premiums were then allocated among the U.S. Subsidiaries and recorded as general ledger accounts payable to Securitas Re. Claims paid were allocated to the appropriate U.S. Subsidiary and recorded as general ledger accounts receivable from Securitas Re. The net balance due was paid to Protectors and Protectors paid the amounts due to Securitas Re, less a ceding commission. Premiums under the policies were reviewed by outside actuaries and determined to be reasonable.
The IRS concluded that amounts paid by the U.S. Subsidiaries were not deductible as insurance premiums under Code section 162 and asserted deficiencies of approximately $13 million for 2003 and approximately $16 million for 2004.
In order to determine whether the payments made by the U.S. Subsidiaries constituted insurance premiums for purposes of Code section 162, the Court considered four criteria: Insurable Risk, Risk Shifting, Risk Distribution, and Insurance in the Commonly Accepted Sense.
- Insurable Risk. The IRS did not dispute that various policies covered insurable risks.
- Risk Shifting. Because the Securitas program involved a “brother-sister” arrangement, the Court applied the balance sheet and net worth analysis developed in Rent-A-Center to determine whether risk had been shifted. The Court found that Protectors was adequately capitalized and the insurance program shifted the economic consequences of the covered risks from the U.S. Subsidiaries to Protectors and ultimately to Securitas Re. Importantly, the Court concluded that the Holdings guarantee did not preclude risk shifting because its primary purpose was to preserve the tax-exempt status of Centaur and no amounts were paid thereunder. Additionally, the Court confirmed that the use of journal entries by related entities to track the flow of funds does not prevent risk shifting.
- Risk Distribution. The Court concluded that the Securitas program satisfied the risk distribution requirement based on the hundreds of thousands of employees and thousands of vehicles that were insured.
- Insurance in the Commonly Accepted Sense. The court concluded the Securitas program constituted insurance in the commonly accepted sense as both Protectors and Securitas Re were adequately capitalized, organized, operated, and regulated as insurance companies by their respective domestic regulators, issued valid and binding insurance policies, set reasonable premiums, and actually paid claims.
While the Securitas decision largely covers the same issues that were addressed in Rent-A-Center, it remains important because it confirms the Rent-A-Center court’s holdings that (i) risk shifting can be achieved despite a small number of policyholders as long as there are sufficient risks for the law of large numbers to apply, and (ii) the presence of a parental guarantee, without more, is not sufficient to negate risk shifting.
Coca Cola: IRS Approves Retiree Benefits Reinsurance Arrangement
After years of delay, the IRS recently issued a Revenue Ruling approving the Coca Cola Company’s plan to use its South Carolina-domiciled captive, Red Re, Inc., to reinsure certain voluntary health benefits provided to Coca Cola’s retired employees and their beneficiaries.
Coca Cola proposed to structure its insurance program as follows:
- Coca Cola contributes funds to its voluntary employees’ beneficiary association (VEBA);
- The VEBA provides health benefits to the retired employees and their beneficiaries;
- Coca Cola and the VEBA have no legal obligation to provide the health benefits, and the health benefits can be cancelled at any time;
- The VEBA enters into a contract (“Contract A”) with a third-party life insurance company (the “Insurer”) pursuant to which the Insurer agrees to (i) provide noncancellable coverage, and (ii) reimburse the VEBA for claims paid by the VEBA;
- Insurer then enters into a separate contract (“Contract B”) with Red Re, a wholly owned subsidiary of Coca Cola, pursuant to which Red Re receives a premium and reinsures 100% of Insurer’s liabilities under Contract A;
- Red Re is adequately capitalized and Contract B is Red Re’s sole business;
- Neither Coca Cola nor the VEBA guaranteed any obligations under Contract B and the
premiums received by Red Re were not loaned back to Coca Cola or the VEBA; and
- Insurer’s participation in this arrangement is a condition of an exemption from the Department of Labor from certain of the prohibited transaction provisions of the Employee Retirement Income Security Act.
The IRS focused its analysis on whose risk was being insured by Red Re: Coca Cola, the VEBA, or the covered retirees and their dependents. Based on these facts, the IRS determined that the risks being insured by Red Re were attributable to the covered retirees and their dependents. The following facts appear to have influenced the IRS’s determination:
- Although the VEBA is the counterparty to Contract A, the insurance coverage is an economic benefit to the retirees because it relieves them of the expense of buying health insurance for themselves and their dependents; and
- Coca Cola and the VEBA do not have an obligation to offer health benefits to the covered retirees and their dependents and may cancel such benefits at any time.
Based on these factors, the IRS concluded that the risks under Contract B are insurance risks, and that Contract B constitutes “insurance” for federal income tax purposes. Furthermore, because Contract B is Red Re’s sole business, it constitutes more than half of the business performed by Red Re for the taxable year. Accordingly, the IRS also ruled that Red Re qualifies as an “insurance company” for the Federal income tax purposes.
This Revenue Ruling is important for a number of reasons. First, it confirms prior guidance from the IRS that the risks of a parent company’s employees (or former employees) that are insured by a wholly owned captive insurance company are third-party risks for purposes of the analysis of whether the captive is an insurance company for Federal income tax purposes. Second, the Revenue Ruling demonstrates the IRS’s willingness to look through multiple levels of insurance and reinsurance to identify the actual origin of the risk. Together with the Rent-A-Center and Securitas decisions discussed above, this represents a significant development in the analysis of risk distribution.
IRS Continues to Scrutinize 831(b) Captives
On February 3, 2015, the IRS published its “Dirty Dozen” list of tax scams for 2015. Unfortunately, captive insurance companies formed under Code section 831(b) (usually referred to as 831(b) captives or micro captives) were included on the list of legitimate tax structures that IRS believes are subject to abuse. Code section 831(b) allows the parent of a 831(b) captive to make up to $1.2 million in tax-deductible premium contributions to an 831(b) captive each year. Code section 831(b) also exempts the 831(b) captive’s underwriting income from federal income tax.
According to the IRS, “unscrupulous promoters persuade closely held entities” to establish scam 831(b) captives and “assist with creating and ‘selling’ to the entities often times poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums,’ while maintaining their economical commercial coverage with traditional insurers.” They also contrive to set annual premiums at an amount equal to “the amount of deductions business entities need to reduce income for the year; or, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision.”
While the propriety of the IRS’s focus on 831(b) captives is subject to debate, the description of practices that the IRS considers to be abusive is helpful in that it provides a crib sheet of how not to structure an 831(b) captive insurance program.
Interestingly, Congress does not seem to share the IRS’ dislike of 831(b) captives. A proposal that would have all but eliminated 831(b) captives by capping net written premiums from a single policy holder at 20% was replaced by a competing proposal that does not include the 20% cap and increases the maximum tax deductible limit to $2.2 million.
Given its concern about the potential for abuse discussed above, the IRS can be expected to weigh in on any modifications to Code section 831(b). DRM continues to monitor these developments and is happy to discuss the advantages and disadvantages associated with 831(b) captives.
IRS Opines that Foreign Currency Swap-Type Products Are Not Insurance
The IRS’ Office of the Chief Counsel recently opined that an arrangement in which a captive insurance company purported to insure certain of its affiliates from losses arising from foreign currency fluctuations is not insurance for federal income tax purposes.
The captive was part of a multinational conglomerate involved in the design, manufacture and marketing of certain medical, industrial, and commercial products. Because the conglomerate operated globally, its sales and purchases in currencies other than the U.S. dollar exposed the conglomerate to fluctuations in foreign currencies relative to the U.S. dollar, which had the potential to adversely affect its financial results. In order to mitigate the risks associated with these fluctuations, the captive entered into two types of contracts with certain other members of the conglomerate. The first type of contract protected the relevant members from losses related to a decrease in value of the specified foreign currencies relative to the U.S. dollar up to a stated coverage limit. The second type of contract (“Contract 2”) protected the relevant members against losses related to the increase in value of the specified foreign currencies relative to the U.S. dollar up to a stated coverage limit. There was no mention of any parental guarantee, premium loan back, or other feature of the arrangement that might be inconsistent with a bona fide insurance arrangement.
The IRS began its analysis of the issue by noting that “insurance” is not defined by the Code or the related regulations and that “the standard for evaluating whether an arrangement constitutes insurance for federal tax purposes . . . is, at best, a nonexclusive facts and circumstances analysis.” The IRS also noted that the case law that has developed around the issue often focuses on three elements: (i) an insurance risk, (ii) shifting and distribution of that risk, and (iii) insurance in its commonly accepted sense.
According to the IRS, the foreign currency arrangement failed the three-part test for insurance because it lacks insurance risk and is not insurance in the commonly accepted sense.1 Insurance risk requires a fortuitous event or hazard – essentially a chance event that the parties could not reasonably have foreseen. This is contrasted with business or investment risks, which are risks that a particular action will fail to achieve a desired economic result or investment return. The IRS reasoned that currency fluctuations are a business or investment risk, and not an insurance risk, because they are entirely foreseeable and, therefore, do not involve a fortuitous event. The IRS also concluded that the arrangement failed the “insurance in its commonly accepted sense” prong of the three-part test because the insurer’s payment obligation is triggered by the end of the contract — not by a casualty event.
While the Chief Counsel memorandum does not cover a lot of new ground, it is a helpful reminder of the IRS’ position that, in addition to risk shifting and risk distribution, an insurance arrangement must protect against a fortuitous event and must be triggered by a casualty event. The fortuitous-event requirement is currently being litigated in the U.S. Tax Court so there may be further developments in this area of the tax law.
Legacy Insurance Management Act
In another exciting development for Vermont, 2014 saw the enactment of the Legacy Insurance Management Act (“LIMA”). LIMA enables non-admitted insurers (foreign or domestic) to transfer closed blocks of commercial insurance policies or reinsurance agreements to purpose-formed Vermont entities. In exchange for the remaining reserves (and, potentially, other consideration ), these newly formed Vermont entities would assume all of the liabilities associated with the transferred blocks of insurance policies and reinsurance agreements.
LIMA-based transfers, which have the effect of a statutory novation, enjoy several advantages over traditional novations. First, in contrast to Part VII transfers under U.K. law, LIMA based transfers only require DFR authorization — judicial approval is not required. The elimination of the judicial approval requirement is expected to reduce transactions times and costs and enhance predictability. Second, investors will be required to establish Vermont-domiciled entities, but will not need to comply with the additional regulations imposed upon traditional insurance companies. Third, DFR, widely acknowledged as the “gold standard” regulator for non-traditional insurance regulation, will be responsible for supervising LIMA-based transfers and the subsequent claims-handling activities of the investors.
Industry professionals expect that LIMA-based transactions will be especially attractive to European insurance and reinsurance companies with U.S. long-tail liabilities and/or that are subject to onerous regulatory requirements. LIMA is the first legislation of its kind in the United States and represents another example of Vermont’s place on the cutting edge of the alternative risk management marketplace. DRM is excited about LIMA’s potential and happy to provide further detail on the mechanics of LIMA-based transactions.
1 The IRS also concluded that Contract 2 failed the test for risk distribution.