April 26, 2004
MEDICAL MALPRACTICE CAPTIVE INSURANCE COMPANY
By: Janet Brierton, Associate Legislative Attorney
You asked for information on captive insurers. In particular, you asked (1) why a hospital or medical practice would establish a captive, (2) how a captive is created, (3) if a state can regulate captives, and (4) if any federal laws limit a state's ability to regulate captives.
The Office of Legislative Research is not authorized to give legal advice and this memorandum should not be interpreted as such.
In the face of increasing medical malpractice premiums from traditional commercial insurance companies, health care providers, including hospitals, HMOs, and physician practice groups, have sought alternative insurance sources. One such source is a captive insurance company. According to A.M. Best, there are nearly 5,000 captives worldwide providing liability insurance to a wide range of industries. Towers Perrin-Tillinghast reports that medical malpractice insurance is currently a major stimulus for the creation of captives.
In a captive insurance company, the insureds have direct involvement and influence over the captive's operations, including underwriting, claims management, and investments. This direct involvement often means that the insured can reduce its insurance costs (i.e., premiums). However, as a self-funded mechanism, if a captive does not properly plan and reserve for losses, the parent organization's financial position can be significantly impaired.
There are two basic types of captives: (1) a pure or “single-parent” captive and (2) a group captive. In a pure captive, a parent company (e.g., a hospital or medical practice) forms an insurance company to insure its own risks. In a group captive, multiple, non-related organizations form or participate in an insurance company to insure risks common to the group.
To form a captive, a hospital or other health care professionals need to select a domicile in which to incorporate. Captives have several options when selecting a domicile. A captive may incorporate: (1) on-shore in a state with legislation that permits captives (e.g., Vermont); (2) in any state if forming as a risk retention group (RRG) captive, a type of captive authorized by federal law; or (3) off-shore in a country that permits captives (e.g., Bermuda, Cayman Islands, Ireland). A captive must comply with the laws and regulations of its domicile.
States can regulate captives to varying degrees depending on the domicile and type of captive formed. According to the National Association of Insurance Commissioners (NAIC), there are 23 states that permit captive insurance companies to domicile in their jurisdiction: Arizona, Arkansas, Colorado, Delaware, District of Columbia, Florida, Georgia, Hawaii, Illinois, Kansas, Kentucky, Maine, Montana, Nevada, New York, Rhode Island, South Carolina, South Dakota, Tennessee, Utah, Vermont, Virginia, and West Virginia. These 23 states regulate the captives through their captive insurance company laws, which generally include provisions on: captive formation, minimum capital and surplus requirements, taxation, financial statements, reporting, and investments, among other miscellaneous requirements.
Connecticut currently lacks legislation that would permit the regulation of non-RRG captives, whether domiciled on-shore or off-shore. However, the General Assembly has the authority to pass such legislation. Several of the medical malpractice bills raised this session include provisions regarding the regulation of captives, including sHB 5669 (File 540). However, the captive provisions proposed in sHB 5669 appear to conflict with federal law with respect to RRGs.
A RRG captive that domiciles in Connecticut must comply with all state insurance laws and must submit a plan of operation or feasibility study to the insurance commissioner (CGS § 38a-251). In contrast, Connecticut is limited in its ability to regulate a RRG captive that domiciles on-shore but outside of Connecticut because of the federal Liability Risk Retention Act of 1986, which enabled the creation of a RRG (15 U.S.C. § 3901, et seq.). (In general, captives that domicile off-shore are not RRGs under federal and state law.)
The federal act permits the domiciliary state to regulate a RRG. After the RRG becomes licensed in the domiciliary state, it can operate nationwide, provided it registers with each state in which it plans to solicit or write insurance. The act preempts non-domiciliary state laws from applying to the RRG, with certain limited exceptions. All states, including Connecticut, have adopted legislation based on the NAIC Model Risk Retention Act to regulate the formation and operation of RRGs to the extent allowed by federal law.
Connecticut's Risk Retention Group Act requires non-domiciliary RRGs to provide the insurance commissioner (1) information regarding its domicile licensure, (2) its plan of operation, and (3) a registration statement that designates the commissioner as agent for service of legal process in the state (CGS § 38a-252). The non-domiciliary RRG must also file (1) its financial statement and (2) a copy of each financial examination and audit performed on the RRG (CGS § 38a-253). Because of the federal act, Connecticut cannot mandate that a RRG become licensed in the state before it does business here.
The following documents are enclosed: A summary chart of state captive insurance laws from NAIC; the federal Liability Risk Retention Act of 1986; the NAIC Model Risk Retention Act; and an Annals of Health Law article, The Captive Medical Malpractice Insurance Company Alternative.
The following web sites provide additional information on captives: www.captive.com and www.captiveguru.com.
CAPTIVE INSURANCE COMPANY
Under Connecticut law, a “captive insurer” is an insurance company owned by an organization whose exclusive purpose is to insure the risks of that organization and its affiliated companies, or, in the case of groups and associations, an insurance organization owned by the insureds whose exclusive purpose is to insure risks of the member organizations, group members, and affiliates (CGS § 38a-91(2)).
Benefits of a Captive
In a captive insurance company, the insureds have direct involvement and influence over the captive's operations, including underwriting, claims management, and investments. This direct involvement often means that the insured can reduce its insurance costs (i.e., premiums) by eliminating third party commissions, profits, and overhead. Common benefits of forming a captive are the ability to: (1) control premium and capital investments, (2) design loss prevention and claims handling policies for specific insurance needs, (3) reduce the impact of the insurance industry underwriting cycle, (4) reduce regulatory requirements, (5) have direct access to the reinsurance market, (6) provide broader coverage than may be available in the commercial market, and (7) provide a self-funding mechanism for claims, which may have tax benefits.
Disadvantages of a Captive
Captives also present certain disadvantages. For example, a captive must cover all claims if it is not backed by reinsurance. As a self-funded mechanism, if a captive does not properly plan and reserve for losses, the parent organization's financial position can be significantly impaired. Captives are not protected by state guaranty or insolvency funds. In addition, forming a captive may require a substantial capital outlay for start up and maintenance costs.
Finally, although tax planning is generally not considered a primary objective in setting up a captive, tax laws need to be considered carefully. The Internal Revenue Service does not define insurance and has generally not granted favorable tax treatment to captives. However, court decisions continue to shape tax consequences for captives. For example, Carnation Company v. Commissioner of Internal Revenue ruled that a parent company could not take a business deduction for claim reserves because there was not sufficient evidence of shifting risk from the parent to the captive (71 Tax Ct. 400 (1978)). In Humana v. Commissioner of Internal Revenue, the Sixth Circuit Court of Appeals held that subsidiaries of a U.S. parent company paying premiums to the parent's captive could deduct the payments as an ordinary business expense (881 F.2d 247 (2001)).
TYPES OF CAPTIVES
There are two basic types of captives: (1) a pure or “single-parent” captive and (2) a group captive. In a pure captive, a parent company, which is not engaged in the insurance industry, forms an insurance company to insure its own risks. In a group captive, multiple, non-related organizations form or participate in an insurance company to insure risks common to the group.
From these two basic types, other varieties of captives have evolved, including: (1) an association captive, (2) a “rent-a-captive”, (3) a sponsored or “protected cell” captive, and (4) a risk retention group. An association captive is formed by a group of unrelated entities from the same industry or trade who have common insurance needs and similar risks. They join together for the sole purpose of forming and owning a captive insurance company. A rent-a-captive structure allows insureds, for a fee, the opportunity to use an established captive, saving them the time and costs of setting up their own.
A sponsored captive expands upon the rent-a-captive model. In a sponsored captive, unrelated companies pool their resources to form a captive insurance company. They spread costs among all participants, each of which places its assets in a protected cell. If one participant exhausts its funds, it cannot touch another participant's assets. As a result, each participant is protected from losses suffered by the others, but enjoys the benefit of having a group share operational costs.
A risk retention group (RRG) is a captive structure created under the federal Liability Risk Retention Act of 1986, which is discussed in more detail below. A RRG must be chartered (i.e., licensed) in one U.S. state, which regulates it as a captive insurance company. The RRG may then operate nationwide, provided it registers with each state in which it intends to operate. Businesses or people with similar types of risk may form a RRG.
FORMING A CAPTIVE
To form a captive, a company needs to select a domicile in which to incorporate and follow that state's statutory requirements for formation. When forming a captive, the company generally works closely with the domiciliary jurisdiction's regulatory authority.
In general, the company will complete a feasibility study; devise a plan of operation; select staff to manage and administer the captive (internal staff or external consultants), including attorneys and accountants; apply for and obtain a certificate of authority or license in its chosen domicile; make the necessary capital contribution; and enter into a reinsurance agreement. The reinsurer will cover a portion of losses after claims reach a certain threshold.
The feasibility study is a cost-benefit analysis of establishing and maintaining a captive. It analyzes such things as historical loss data, projected losses, potential tax benefits, and investment options for premium dollars.
To form a captive, a hospital or other health care professionals must select a domicile in which to incorporate. The captive must comply with the laws and regulations of that jurisdiction.
Captives have several options when selecting a domicile. A captive may incorporate: (1) in a U.S. state with legislation that permits captives (i.e., “on-shore”); (2) in any U.S. state if forming as a risk retention group (RRG) captive, a type of captive authorized by federal law; or (3) in a Caribbean, European, or Asian country that permits captives (i.e., “off-shore). According to A.M. Best, U.S. captives are most frequently domiciled in Bermuda, the Cayman Islands, Vermont, and Hawaii.
Captives generally encounter less regulation from off-shore jurisdictions, which appear to have fewer premium, capital, and surplus requirements. Captives may also experience favorable tax consequences when domiciled off-shore. However, the taxation of captives is complicated, requiring advice from legal and accounting staff.
Direct or Fronting Company
A captive can be set up in two ways. The first is to write the risk directly and reinsure some portion of the risk to a reinsurance company. The second is to write the risk through a fronting company (i.e., a commercial insurance company licensed to write insurance in the United States). The “front” issues the policy to the insured and may insure some portion of the risk. The front cedes the remaining risk to the captive, which becomes the reinsurer.
Using a front will cost more than writing the risk directly, because the captive pays the front some portion of premium. The captive will also relinquish some control to the front.
Despite the added costs, there may be advantages to using a front. According to James A. Christopherson, author of The Captive Medical Malpractice Insurance Company Alternative (5 Annals Health L. 121 (1996); copy enclosed), health care professionals may prefer using fronts because (1) they feel secure knowing that the insurance company is regulated in the United States and (2) if the insurance company fails, they will usually be protected by the state's insurance guaranty fund. In addition, captives set up with a front may pay less tax than direct-written captives.
However, according to Marsh & McLennan, a captive management consultant, fronts are expensive and can be difficult to obtain. As a result, more groups are looking to form RRGs, which do not require the use of a front. By forming a RRG, a group regains control over their insurance dollars and claims handling, and can operate nationwide with limited state regulation.
STATE REGULATION OF CAPTIVES
States can regulate captives to varying degrees depending on the selected domicile and type of captive formed. All captive domiciles, on-shore or off-shore, require some form of annual financial statement filing from captives. Most also require audit and actuarial reviews. A few, including Vermont, require periodic on-site examinations of captives. Off-shore jurisdictions generally subject captives to fewer and less onerous requirements. States typically do not seek to regulate off-shore captives.
According to the National Association of Insurance Commissioners (NAIC), there are 23 states that permit captive insurance companies to domicile in their jurisdiction: Arizona, Arkansas, Colorado, Delaware, District of Columbia, Florida, Georgia, Hawaii, Illinois, Kansas, Kentucky, Maine, Montana, Nevada, New York, Rhode Island, South Carolina, South Dakota, Tennessee, Utah, Vermont, Virginia, and West Virginia. These state captive insurance laws generally include provisions on: captive formation, minimum capital and surplus requirements, taxation, financial statements, reporting, and investments, among other miscellaneous requirements. A non-RRG captive cannot domicile in Connecticut because Connecticut lacks the enabling legislation.
Enclosed is a chart prepared by NAIC that lists a summary of the captive insurance company laws by U.S. state. Regulation of a RRG captive is discussed in more detail further below.
According to Christopherson, most captives form off-shore because (1) off-shore domiciles require lower capital levels; (2) the captive can avoid U.S. reporting requirements and state regulation; and (3) the captive can achieve certain tax benefits.
According to John Purple from the Connecticut Insurance Department, an off-shore captive can write business in Connecticut. The captive is regulated by its off-shore domicile and not by the department. Mr. Purple explained that captive insurers are considered sophisticated buyers who generally seek advice from management consultants, lawyers, and accountants in the formation and operation of the captive. As a result, they are typically viewed as not requiring significant regulation. He also noted that this is not unique to Connecticut, but is the standard nationally.
FEDERAL LIABILITY RISK RETENTION ACT
Federal law restricts state regulation of risk retention groups. The Liability Risk Retention Act of 1986 enables the creation of a RRG, a risk-bearing captive formed under state law (15 U.S.C. § 3901, et seq.). The act permits the domiciliary state to regulate an RRG. The RRG can then write insurance directly nationwide, provided it registers with each state in which it plans to do business. But, the federal act preempts non-domiciliary state laws from applying to the RRG, with certain limited exceptions.
Non-domiciliary states may, among other things: (1) charge premium taxes on business written in the state, (2) require the RRG to comply with the state's unfair claim settlement and deceptive trade practice laws, (3) permit the state's insurance commissioner to examine the financial affairs of the RRG under some circumstances, and (4) require the RRG to provide a notice to the insured that (a) the state's insurance laws and regulations do not apply and (b) insurance insolvency guarantee funds are not available should the RRG fail.
The act also enables the formation of a purchasing group, which is an entity that buys liability insurance on behalf of group members to cover the group's common risks. A purchasing group is not a captive but is made up of members in a similar business or trade. The act preempts state laws that would prohibit the creation or operation of a purchasing group. It also requires purchasing groups to register with the insurance commissioner of each state in which it intends to do business.
Christina Mancini, CEO of Captive.com, LLC, believes that RRGs and purchasing groups are the most common insurance alternatives used by hospitals and health care professionals for medical malpractice liability coverage. According to Ms. Mancini, by using a RRG, health care professionals better control their cash flow and manage their risks.
NAIC Model Act
All states, including Connecticut, have adopted legislation based on the NAIC Model Risk Retention Act (copy enclosed) to regulate the formation and operation of RRGs and purchasing groups as permitted and to the extent allowed by federal law. According to the Connecticut Insurance Department, there are currently nine RRGs registered in Connecticut (six are domiciled in Vermont, one in Illinois, one in Montana, and one in South Carolina) and approximately 400 purchasing groups. However, the department does not have sufficient data to determine what subset of these RRGs and purchasing groups are for hospitals and health care professionals.
Connecticut Risk Retention Group Act
A RRG captive that domiciles in Connecticut must comply with all state insurance laws and must submit a plan of operation or feasibility study to the insurance commissioner (CGS § 38a-251). However, because of the federal act, Connecticut cannot require a RRG to become licensed in the state before it does business here.
Connecticut has limited regulatory authority over non-domiciliary RRGs. They must provide the insurance commissioner (1) information regarding its domicile licensure, (2) its plan of operation, and (3) a registration statement that designates the commissioner as agent for service of legal process in the state (CGS § 38a-252). The non-domiciliary RRG must also submit (1) its financial statement and (2) a copy of each financial examination and audit performed on the RRG (CGS § 38a-253).
All RRGs, whether domiciled in Connecticut or in another state, must pay premium taxes on business written in the state (CGS § 38a-254). All RRGs must also provide a notice to the insured that the state's insurance laws and regulations do not apply and insurance insolvency guarantee funds are not available should the RRG fail (CGS § 38a-255). Any RRG that does not comply with Connecticut's RRG requirements is subject to fines and penalties, including revocation of its license and its right to conduct business in the state (CGS § 38a-264). In addition, the insurance commissioner is authorized to adopt regulations regarding RRGs (CGS § 38a-266).
MEDICAL MALPRACTICE CAPTIVE — REGULATION OPTIONS
Although Connecticut does not have a law that permits captives to domicile and be more fully regulated here, the General Assembly has the authority to pass such a law. As noted above, federal and state law already permit RRGs and purchasing groups to operate in Connecticut, subject to certain regulation.
Options for regulating non-RRG captives include, but are not necessarily limited to, adopting a law: (1) permitting or requiring on-shore captives to domicile in Connecticut before conducting business in state; (2) requiring a captive to register with or be licensed by the insurance department; (3) requiring a captive to name the insurance commissioner as agent for service of legal process; (4) requiring a captive to file copies of financial reports and audits performed by the domiciliary jurisdiction; or (5) subjecting the captive to examination by the insurance commissioner.
sHB 5669 — Summary
Sections 15 and 16 of substitute House Bill 5669 (File 504, February Session 2004) provide for the regulation of captives. The bill prohibits captive insurers from insuring a health care provider or entity in Connecticut against medical malpractice liability unless the captive has obtained a certificate of authority (COA) from the insurance commissioner. It does not require a COA for a captive insurer duly licensed in Connecticut to offer such insurance. The bill establishes a $175 fee for each certificate issued.
The bill requires any captive insurer seeking to obtain a COA to apply to the commissioner, on such form as she requires, specifying the line or lines of business that it is seeking authorization to write. The captive insurer must file with the commissioner (1) a certified copy of its charter or articles of association, (2) evidence satisfactory to the commissioner that it has complied with the laws of the jurisdiction under which it is organized, (3) a statement of its financial condition together with whatever evidence of its correctness the commissioner requires, and (4) evidence of good management in such form as the commissioner requires. The bill also requires the captive insurer to submit evidence of its ability to provide continuous and timely claims settlement.
If the commissioner finds that the information provided is satisfactory and the insurer complied with all other requirements of law, the bill authorizes her to issue to such insurer a COA, permitting it to do business in Connecticut. The COA expires on the first day of May following the date of its issuance, but may be renewed without any formalities, except as the commissioner requires. The bill requires the commissioner to adopt regulations specifying the information and evidence that a captive insurer seeking to obtain or renew a COA must submit and the requirements with which it must comply.
Under the bill, the failure of a captive insurer to exercise its authority to write a particular line or lines of business in Connecticut for two consecutive calendar years may constitute sufficient cause for revoking its authority to write those lines of business.
The bill authorizes the commissioner, for cause, after notice and a hearing, to suspend, revoke, or refuse to renew a COA. She may also impose a fine of up to $10,000. She or her designee may hold the hearings. The bill mandates that whenever anyone other than the commissioner acts as the hearing officer, the person must submit to the commissioner a memorandum of findings and recommendations upon which she may base a decision. The commissioner may, if she deems it in the public interest, publish in one or more state newspapers a statement that she has suspended or revoked the COA of any captive insurer to do business in Connecticut.
The bill requires the applicant to pay all expenses the commissioner incurs in connection with the authority and duties the bill establishes with respect to a captive insurer.
Any captive insurer aggrieved by the commissioner's action in revoking, suspending, or refusing to reissue a certificate of authority, or in imposing a fine may appeal to Superior Court. The appeal must be filed in the New Britain Judicial District.
sHB 5669 — Analysis
The proposed regulation of captives appears not to take RRG captives into consideration, which, under federal law do not have to be licensed in Connecticut in order to operate in the state. As a result, the bill conflicts with federal law and related state law with respect to RRG captives (See 15 U.S.C. § 3901, et seq. and CGS § 38a-250, et seq.).
The bill requires non-RRG captives to apply for and receive a COA before doing business in the state. This means the captive needs the insurance department's permission to operate in Connecticut before writing medical malpractice liability insurance in the state.