Choosing a Captive Domicile: Key Considerations

While there are numerous considerations when contemplating a captive, one of the most important and impactful will be the domicile in which the captive is formed and licensed. Selecting a domicile will be one of the first issues to consider when forming a captive and will determine many of the parameters that will guide the success of the company and increase the value that the captive has to its parent.

There are many domicile choices, and the list is growing as more states and countries seek the economic benefits that come with building a solid infrastructure of supporting financial services.

When deciding on a domicile, it is imperative to appraise the following to ensure that the company is positioned for success.

• The regulatory environment
• Capitalization, taxation, and fees
• The local captive community
• Onshore/offshore implications

The Regulatory Environment

The regulatory environment of a domicile sets the tone for every other consideration from licensing to ongoing operations. The key differences in captive laws should be considered, as the overall regulatory climate varies widely from domicile to domicile.

As traditional insurance policy renewal dates approach, the time needed to form a captive is often on the forefront of an owner's mind. Competition between domiciles has dramatically reduced the amount of time required to gain regulatory approval, thereby reducing the time it takes to form a captive.

Also, certain jurisdictions have underwriting limitations and require that rates and policy forms first be submitted for approval; others specify that only certain types of coverage may be written; still, others prohibit the writing of "unrelated" business except through reinsurance pools.

The acceptance by fronting companies and reinsurers is often influenced by where a captive is located. Naturally, reinsurers and fronting insurers prefer domiciles that offer the most growth potential for their operations, such as those with the most captive-friendly regulatory environment.

Becoming familiar with the regulatory environment will greatly enhance a captive owner's ability to choose the domicile that is right for their captive.

Once a list of potential domiciles has been created, prospective captive owners should familiarize themselves with the licensing process of each, as different domiciles will review the license application, process, and business plans in various ways.

The licensing review process is handled differently in each domicile. Here are some of the main ways that domiciles review licenses. Many domiciles will use a combination of these.

Regulatory Review

A prospective captive's business plan is most likely to succeed if the captive is formed in a domicile with regulators that can understand the proposed program and possibly provide constructive comments. Among other considerations, regulators should not require captive insurers to hold the extraordinary amounts of capital required of an insurer that sells insurance to the general public. However, regulatory requirements and other domicile-related details vary significantly with the jurisdiction selected.

Review by Panel of Experts

Some captive domiciles rely on a panel of industry "experts" to review a captive's initial business plan. The review board is generally composed of insurance, legal, accounting, or actuarial professionals who may also be principals in captive management firms. Those structuring innovative risk financing programs, therefore, must consider whether a captive domicile's application review process reveals too much information to business competitors.

Review by Paid Actuarial Consultants

The preferred alternative may be to select a captive domicile where paid actuarial consultants conduct the license review process. In these domiciles, a higher level of scrutiny may be given to the business plan's assumptions. Successful captive domiciles have regulators and professional reviewers that approve or reject a license application based on sound business sense and experience in insurance company operations.

The regulatory environment must be sophisticated and flexible, and good regulators will employ a principle of proportionality in their approach, along with a thorough understanding of risk exposures, risk management, and risk financing.

Understanding Capitalization, Taxation, and Fees

After vetting the regulatory environment, it is necessary to turn a keen eye on the quantitative elements to take into consideration, namely, capitalization, taxation, and fees. Understanding the following concepts will give a captive owner a very good idea of what to anticipate in dealing with regulators.

• Capitalization requirements. Refers to the minimum initial amount of money required to commence operations. These requirements vary widely from jurisdiction to jurisdiction. Some locales allow part of the capitalization to be in the form of letters of credit.
• Surplus requirements. The minimum written premium-to-surplus ratio allowed by captive domiciles varies significantly (e.g., from 1:1 to 10:1, depending on the location). A lower minimum premium-to-surplus ratio means less money (surplus) will support a higher volume of insurance written. This is especially important at the early stages of a captive's formation when funds may be limited.
• Investment restrictions. Certain jurisdictions prohibit various types of investments; others mandate specific maximum percentages of funds that can be placed in a given investment vehicle, while others have more or less restrictive definitions of what constitutes "admitted assets."
• Reporting and auditing requirements. Stipulate the types and frequency with which reports must be filed with local regulatory authorities. Some domiciles require much more frequent and detailed reports than do others.
• Loss reserving requirements. A few domestic domiciles require captives to post-loss reserves based on minimum loss ratios. For example, captives writing workers compensation insurance may be required to post initial loss reserves of no less than 65 percent of written premiums.
• Income and local taxes. Domiciles vary with respect to the taxability of total written premium, underwriting income, and investment income. Some domiciles even offer certain tax credits. Also, the need to pay federal excise taxes, a key financial consideration, varies from jurisdiction to jurisdiction.
• Government fees. Many domiciles levy an annual assessment on all captives operating within their jurisdictions.
• Formation costs. Include items such as a stamp tax (for offshore domiciles), registration fees, and incorporation expenses. In the aggregate, these amounts can vary considerably, which significantly affects the cost of forming a captive and making it operational.

Assessing the Local Captive Community

Turning from many of the public sector considerations in choosing a domicile, it is also important to look at the private sector and how the captive industry is represented and supported. In the very best domiciles, there exists a harmony between captive regulators and service providers. Open communication and a positive relationship among the many professionals that support the industry indicates a community that is focused on creating and continuing a domicile in which captives can flourish. A thriving local captive community also illustrates the overall investment that the captive industry has made in a domicile.

Determining Onshore/Offshore Implications

The final element to take into consideration is whether to domicile a captive onshore or offshore and the impacts and implications this will have. In the past, onshore domiciles were generally stricter than their offshore counterparts, but this is changing as major US domiciles are more aggressively trying to attract captives to their states. While there are pros and cons of domiciling a captive either onshore or offshore, prospective captive owners and existing owners redomesticating a captive will benefit from taking time to articulate their guiding principles to determine which will prove most beneficial.

Although the considerations mentioned here are not exhaustive, they should, nevertheless, be helpful constellations to guide discussions. There must be an appropriate level of regulation to support a captive while simultaneously providing elasticity to the actual owners of the risk to allow them to engage in creative actions that can give them an edge over their competition. There is no one-size-fits-all, and a balance must be struck. The right captive domicile will assist in maintaining this balance by applying an appropriate measure of regulation to the nature, scale, and complexity of the risk profile for the success of the captive while possessing a reasonable schedule of taxation and fees in a robust local captive community. The right domicile will be one that positions the captive to add both qualitative and quantitative value to the parent company.

This article is based on information in Chapter 11 of Captives and the Management of Risk, Third Edition, by Kathryn A. Westover, section IV. of Risk Financing by Steven T. Bird, and Chapter 5 of Construction Risk Management, all three published by International Risk Management Institute, Inc.