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Captives under Scrutiny

A mere decade ago, captive insurers were viewed by most regulators as a small, even exotic part of the insurance industry. Most were assumed to be offshore and aroused little attention. Now, captives have gone mainstream. A sizable, but undetermined, portion of the property casualty coverage is placed through, or issued by, captives. A good guess is 30% to 40%, but no one has been able to establish an accurate number. Thirty-nine states have some form of captive or self-insurance law. Captives are now part of everyday life for regulators and the result is more scrutiny.

The issues now on the agenda for captives are significant:

• XXX and AXXX Reinsurance Captives

According to Superintendent Joseph Torti (Rhode Island), 80% to 85% of life and annuity insurance is ceded to reinsurers. Much of the so-called “excess reserves” required by Rules XXX and AXXX are ceded to captive reinsurers or special purpose vehicles owned by the same licensed life and annuity companies which cede the risk. Because the amount of this risk is so large, any trouble collecting this reinsurance could have a major effect on the industry. Some regulators, even a few who approved these cessions, have criticized these arrangements. In some cases, the collateral for the reserves has been subject to parental guarantees, which tends to undermine the confidence which can be placed in the transaction. The NAIC is continuing its examination and has met some stiff resistance from the industry.

• Multistate Insurers 

The proposal to amend the preamble to the NAIC Accreditation Standards to treat captive reinsurers as “multistate insurers” (with some limited exceptions) was withdrawn at the last NAIC meeting in Louisville. A new proposal should be forthcoming (and may have already been issued by the date of publication of this Newsletter). The premise of this proposed change is that non-domiciliary regulators need to know how insurance issued in another state may affect the citizens of their state. The opposite point of view is that the regulators of the domicile have done their job and should be trusted by their regulator colleagues and that the transaction should not affect third parties, anyway. Some say the risk to the domestic captive industry is existential. If enacted and enforced, the proposed change could, ironically, drive much of the industry offshore and therefore beyond the authority of the regulators promoting it.

• Nonadmitted Risk and Reinsurance Act

Captives have been inadvertently drawn into the regulatory structure imposed by this federal legislation intended to streamline the reporting and payment of surplus lines taxes. It has shined a spotlight on the payment (or non-payment) of state self-procurement taxes, but, ironically, does not in any way alter either the application of them or their payment. While risk retention groups (RRGs) were able to get an exemption from the law during its formative phase, captives, because they are (generally) single state entities and therefore not doing business as a “non-admitted” insurer, did not even attempt to get an exemption. Now there is a group, the Coalition for Captive Insurance Clarity, which is seeking a legislative exemption on Capitol Hill.

• Insurance Company Income Taxation

The Internal Revenue Service is investigating several insurance pooling mechanisms and, in some cases, the captives that have utilized them to establish third party risk—which is essential for an insurer to get the benefit of insurance tax treatment. This investigation is presumably a response to the rapid growth of “micro-captives” as mechanisms to assist with avoidance of taxation in estate planning and wealth transfer. This process is in its early stages, but is likely to produce some dramatic results.

• Federal Home Loan Bank (FHLB)

Who would have thought that the FHLB would have anything to do with captives?  It appears that some captives, and at least one risk retention group, are members of the FHLB, which allows them to obtain federal funds at advantageous rates. The Federal Housing Finance Agency (FHFA), which regulates the twelve FHLBs, has proposed a rule that would exclude all captives from membership by defining “insurance company” to mean an entity which “has as its primary business the underwriting of risk for nonaffiliated persons.”

Why is this happening now? While there are numerous reasons for these kinds of actions, there are two primary motivators. First, regulation is always subject to the problem of “what’s worth doing is worth overdoing.” Reasonable minds can differ on the interpretation of statutes and regulations. Each of the above includes an element of “pushing the envelope,” which can be significant or insignificant issues depending on your point of view. Second, captives have been caught in the vortex of regulatory competition. As we have discussed before in this column, the National Association of Insurance Commissioners (NAIC), the Federal Insurance Office (FIO), and the International Association of Insurance Supervisors (IAIS) are jockeying for position and power. Add to the mix the position of the Organization for Economic Cooperation and Development (OECD) that captives may be used as a device to avoid taxation (“base erosion” in OECD parlance), and you have a tumult of regulatory action which at the same time can be challenging and conflicting in its goals and implementation.

What does this bode for the future of captives? Once you have been seen on the radar, it is hard to drop off. Captives can expect more of the same for the foreseeable future.

This blog was previously published on the Morris, Manning & Martin, LLP website.

Financial Services Firms Report Losing 27% of Revenue Due to Poor Reputation

Improving reputation remains a chief objective in the financial services industry — and rightfully so, according to a new study that reports firms saw an average of 27% of revenue lost in the past two years due to reputation and customer service issues stemming from the financial crisis.

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The 2014 Makovsky Wall Street Reputation Study found that 81% of financial service firms are still feeling major negative impacts on stakeholder perception, and over three-quarters of financial services executives say industry risk is the same or worse than in 2007.

Public perception, riskier markets, and regulatory actions are the biggest impediments to industry recovery, executives told the communications firm. The biggest drags on reputation come from negative public perception (64%) and regulatory actions (55%), they said. A majority agreed that the top emerging reputation risks are high frequency trading and cyber data breach.

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Further, four out of ten executives say their company’s reputation has already suffered due to recent cyber data breaches.

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Makovsky Wall Street Reputation Study

Trends and Predictions for Retailers

Last year, retail and consumer packaged goods (CPG) companies faced challenges stemming from evolving regulatory compliance, brand exposure, reputational risk and increasingly complex global supply chains. No doubt 2014 will prove to be a pivotal year for organizations to demonstrate their focus and commitment to strong governance, risk management, and compliance in order to truly emerge as leaders. Here is a look at some top trends that have influenced the industry, and a few predictions that will shape the year ahead.

2013 Key Trends:

Increased Volume and Complexity of Regulations. In 2013, the retail/CPG industry faced a flurry of new and amended regulations spanning environmental compliance, conflict minerals reporting, product safety, data privacy, anti-corruption, product packaging and labeling to name a few.

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Ensuring compliance and staying one step ahead of regulators requires that retail and CPG organizations establish more centralized and collaborative compliance programs.

Managing the Supplier Ecosystem. We saw that environmental, man-made, and human rights issues can threaten the financial stability and reputation of retail and CPG organizations. Establishing a unified view of the organization and its entire supplier ecosystem requires consistency and transparency, which can be achieved only through stronger due diligence, monitoring, and reporting processes.

Focus on Collaboration. In response to increased compliance mandates, and added complexity throughout the supply chain, internal business functions have begun converging and collaborating in new ways. A strong, compliant, and risk-aware organization brings together the right people, the right skill sets, and necessary resources against a shared vision, mission, and purpose.

2014 Predictions:

Rising Importance of Reputation. Non-compliance, fines, product recalls, bribery and corruption allegations, customer activism, factory fires, and health and safety issues have put many retail and CPG companies in the hot seat.

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These incidents not only play out over front-page headlines, but can spread virally across social media sites in a matter of minutes. In 2014, building and maintaining an organization’s reputation will become a matter of survival.

Complying with the Affordable Care Act (ACA). The ACA impacts retail companies that employ a significant number of temporary workers. According to the ACA, health insurance must be provided to full time employees who work at least 30 hours per week. In the retail industry, however, employees who work at least 40 hours per week have traditionally been considered full-time. Overcoming this discrepancy will require new policies and processes that will impact employees, human resources teams, and compliance executives alike.

Investments in Technology. As operations expand and supplier ecosystems become more diverse, organizations will be faced with new opportunities and new challenges. We will see organizations continue to focus on integrating the activities of multiple functions.

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Investing in new technologies and tools to help integrate quality customer service, regulatory compliance, supply chain governance and security can help organizations realize greater efficiencies, enhanced agility and improved business performance.