While captive-insurance experts contend that the market is healthy, with solid formations, they also note a variety of concerns, including Solvency II, the Dodd-Frank Act and fraud.

For example, Solvency II creates more capital requirements and governance standards, making it “onerous” for owners of captives domiciled in Europe, says Nancy L. Gray, regional managing director of the Americas for Aon Risk Solutions.

While this won't directly impact U.S.-domiciled captives, there are possible domestic ramifications “from the standpoint that you have a lot of U.S. parents that own a captive in [Europe] and are being faced with Solvency II implications,” Gray adds.

In fact, some with captives in Europe are closing them down, with the domicile of Dublin being “hit very hard,” says Gray, who recently spoke with an owner who was contemplating shutting down its European captive and expanding its U.S. captive, which is licensed for employee benefits.

Gray explains that one reason some U.S. companies have captives domiciled in the EU is to be able to write locally, because in the EU a local fronting company is required.

“But there are different ways of structuring it so they could have the local front without the captive,” she explains, adding that if “Solvency II—which is still evolving—takes away all the benefits of the local-front requirement, then it doesn't make sense to keep that captive operational.”

MARKET SWING, REGULATORY CONCERNS BOOST BIZ

Overall, Gray says the captive market, especially in the well-established domiciles, is seeing an increase in new formations. “It's actually going to be an excellent year in terms of new formations,” she says.

Some of this, she observes, is a result of risk managers who believe the market is going to harden.

They want a captive in place to deal with any capacity or hard-market conditions they might face—“especially on the property side, in case of a bad hurricane season,” Gray says.

Another issue, she says, is the Dodd-Frank Act and how that could potentially affect captives.

“There has been concern that Dodd-Frank would raise the profile of the self-procurement tax,” Gray says, “because not many companies are actually paying it—and states [might] start coming after captives for the tax.”

Gary Osborne, president of the USA Risk Group, is also paying close attention to the potential fallout from Dodd-Frank on the issues of surplus-lines taxes and self-procurement.

Some captive owners are concluding that “if the majority of their premium is in a state and it's a captive state, then the answer to some of those potential surplus-line/procurement-tax issues could be to [form a captive] in that state and just pay them their captive tax,” Osborne says.

THE IRS, CELL CAPTIVES & FRAUD

Jay Adkisson, partner with Riser Adkisson LLP and chairman of the American Bar Association Committee on Captive Insurance, observes that, overall, captives are doing well and that the IRS overseer of captives recognizes their legitimacy—“and that's a big step forward.”

He notes, however, a troubling trend he is seeing is in the area of cell captives and larger group captives—viewed as a low-cost alternative to standalone captives.

Cell captives, he says, have become more popular after the Internal Revenue Service came out with guidance last year. The IRS stated that a cell classified as a separate corporate entity will be treated like any other corporation, including the ability to make standalone tax elections.

While the IRS ruling gives a better idea of how it will treat them, “there are always unanswered questions, and people are, frankly, very much at risk,” Adkisson says.

Some captive planners warn that until sufficient case law has developed on the use of cell captives, they should be viewed with caution since their benefits at this time are largely theoretical.

While most captive planners think that cell captives “should work,” Adkisson says, they nonetheless express concern about the numerous unknown issues involving this new and untested form of entity.

The problem, he explains, is regardless of how the laws are drafted, “the truth is, we haven't had any court cases, so we don't know how they work.”

This has two ramifications, according to Adkisson: First, people in some cell captives are, “frankly, guinea pigs.” The second is the proliferation of scam captives—people using captives who basically take in insurance money and keep it.

Those engaging in a cell-captive arrangement need to consider that they may be “subjecting their claims to other people and risking whoever is running the company embezzling the money,” Adkisson says.

He points out that there have been problems in the past with reinsurance scammers, and that hardcore scammers are now entering the captive business “because they see it's a good way to run a disguised pyramid scheme. People put money in and they really don't know what goes on behind these companies.” A manager who says he has paid a claim, for example, may not have really done so.

As a result, those looking to enter into a group-captive arrangement, as opposed to owning their own captive, need to be careful.

“Any type of new business entity is like an earthquake zone,” Adkisson says. “You don't know where the fissures are until you've had a few major temblors. And you just hope that your house isn't on top of them as they are being discovered.”

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