Choosing a domicile

Onshore or offshore jurisdictions; each has benefits

By Michael J. Moody, MBA, ARM

Risk financing for many corporations has changed significantly over the past 25 years. Most have moved from a “fully insured” basis to a more self-insured approach, and for some that means that they were forming captive insurance subsidiaries. Originally, captives were limited to the larger Fortune 500-type organizations. However, as the captive market has grown and matured, more and more mid-sized corporations have begun making captives a key element in their overall risk management programs.

Most owners come to the decision to form a captive after completing a detailed feasibility study. Typically, any captive feasibility study would include an analysis of several critical aspects, including such things as pro forma financial projections, presentation of the business case for the captive formation as well as an overall business plan for the captive operations. However, another extremely important aspect of the feasibility study should be the domicile selection, or where the captive should be licensed. In that regard, captives have two broad options available to them: onshore or offshore.

Here or there

Put simply, onshore domiciles are jurisdictions located within United States that have enacted special legislation specifically designed to encourage captive formations, while offshore domiciles are those jurisdic­tions outside the United States that have such legislation. Frequently noted onshore domiciles would include states such as Vermont, South Carolina, Hawaii, Arizona, Nevada, Utah and 25 or so newer states. Among the major offshore domiciles, Bermuda is at the top of a list that also includes British Virgin Islands, Cayman Islands, Barbados, and a number of smaller domiciles.

Any comprehensive feasibility study should include a detailed review of the pros and cons of onshore and offshore locations. Among those things that have been traditionally considered to be advantages of offshore domiciles is the fact that the regulations are typically far less onerous, particularly with regard to capitalization and surplus requirements. Other frequently cited advantages of offshore domiciles are flexibility, ease of entry, expense savings (lower operating expenses and governmental administrative fees) and potential tax advantages.

Onshore domiciles similarly have a number of advantages that are mentioned as reasons for their selection. Like the offshore domiciles, every one of the 30-plus U.S. domiciles has its own unique set of regulations; however, typical advantages that are frequently cited would include political stability and quality of infrastructure. Additionally, onshore captive domiciles have advantages with regard to issues such as the reputation and patriotism of the captive’s parent. This latter point became more important following the events of 9/11.

In addition, several specific situations will require onshore domiciles. One of the primary situations would be risk retention groups (RRGs) where the federal legislation requires that the RRG be formed in a single state, and then can do business nationally. Another specific situation that requires an onshore domicile is the usage of the federal terrorism backstop which requires an onshore domicile to access the federal coverage. And finally, one of the more popular trends in the captive insurance market today is placing employee benefits (primarily group term life insurance and long-term disability coverage) in a captive insurance company. In order to gain approval from the Department of Labor to use a captive, the parent must have a U.S. domiciled captive or use a U.S. branch of an offshore captive.

Strategic Risk Solutions (SRS), a major independent captive manager, has indicated that the following factors have been identified as the primary drivers for today’s growth in the number of domiciles.

• Differences in minimum capital and surplus requirements

• Differences in fees and tax structures

• Regulatory staff dedicated to captive business

• Regulator responsiveness and attitude

• Specific types of captives associated with domiciles

• Service provider activity

For the most part, these six factors can apply equally to onshore or offshore captive domiciles.

The more things change…

In the 1970s, when captive insur­ance companies first started to be utilized as risk-financing alternatives, the vast majority were formed offshore. The primary reason for this was that few, if any, U.S. domiciles had legislation that favored captive insurance company formations. Rather, most states had regulations that were designed only for traditional insurance companies. Once the states began noticing the increasing use of captives, they started drafting legislation designed for these new risk-financing options. More than 30 states now have passed specific captive regulations and the number of state domiciles continues to grow.

Major tax advantages have also generally been associated with offshore domiciles; however, over the years, onshore domiciles have taken specific steps to reduce those tax advantages. At this point in time, most experts consider the tax issue pretty much a “level playing field,” since the majority of offshore captives now make a 953(d) election for their captives. In essence, this means that they elect to be taxed as if they were domiciled in the United States.

Last year, the onshore captive industry had a “close encounter” of the IRS kind, via the consolidated tax return issue. And while the Coalition for Fairness to Captive Insurers did yeomen’s work in getting the IRS to back off from its consolidation position, the IRS left the matter unresolved. In fact, the IRS can readdress this issue at a later date. Unfortunately, this has left some single-parent captives concerned about future IRS involvement.

Further government regulations also have some captive owners concerned about onshore domiciles. Apprehension about tighter governmental oversight has come about primarily due to the recent shenanigans going on across the financial service industry. The insurance industry, along with most other financial service sector members, is now awaiting some serious new regulations that will be provided by the federal government. While there still is little known about any specifics that will be in the new regulations at the time this article is written, most experts agree that the new rules will likely be more onerous than previous ones.

But concern about additional government regulations is not new. Several years ago, prior to all the current troubles in the financial service sector, Ernst N. Csiszar, past insurance commissioner of South Carolina and past president of the National Association of Insurance Commissioners, shocked a convention crowd by stating that the majority of future captive growth would be offshore. Csiszar made this bold prediction during a session at the Captive Insurance Companies Association annual conference. He based this forecast on what he called “the serious threat to domestic captives that will come from changes to the U.S. insurance regulatory environment.” Csiszar noted the challenges being brought about because of the issue of national insurance regulation and states that regardless of how this issue ultimately would be resolved, it would likely result in less flexibility for captive owners. The current train wreck within the financial services sector seems to support Csiszar’s contention.

Conclusion

First and foremost, captive insur­ance companies have become an important part of many corporations’ overall risk management programs. As such, it can be expected that they will continue to see growth regardless of the insurance pricing cycle. Still, the selection of a domicile will continue to be a critical decision for the long-term success of any captive. Given the issues noted above, however, is it better to form a captive onshore or offshore?

Over the past 10 to 15 years, both onshore and offshore domiciles have worked hard to “level the playing field,” with regard to the advantages of each domicile. However, much of today’s captive growth is coming from mid-sized organizations. And most of these corporations are very concerned about overall cost. As noted in the SRS study, capital and surplus requirements and cost of fees and taxes are two of the primary drivers in selecting a captive domicile. Another factor that is frequently noted is flexibility, which would typically favor an offshore domicile. Additionally, most mid-sized organizations are not as concerned about an onshore domicile as a publicly held company would be. Taken totally, offshore domiciles would appear to be in a good position to attract new captive formations.