The subject of captive insurance companies (CICs) and tax law violations has been the topic of much discussion over the past year. Matters such as Phoenix 2010 Revocable Trust v. Artex Risk Solutions, Inc., and similar class actions have brought this issue to the forefront of the industry’s mind.
But while the discussion regarding CICs and IRS compliance (or lack thereof) grows more cacophonous, a less raucous discussion is taking place regarding compliance, entity governance and the risk of running afoul of state captive insurance regulators, should they choose to increase their scrutiny or impose new rules.
Ironically, even as the country is moving in the direction of anti-regulation, recent developments in the risk reduction group (RRG) market are causing regulators to increase their vigilance.
The Demise of Spirit Commercial Auto Risk Retention Group
In early 2019, a Nevada court placed Spirit Commercial Auto Risk Retention Group into permanent receivership, citing insolvency and hazardous financial conditions.
Industry experts have called the demise of Spirit a potential “black eye on our industry,” particularly in the eyes of regulators. This could easily invite increased scrutiny and cause unease in the marketplace. It may also discourage states from licensing new risk retention and captive insurance entities.
The issues with Spirit and other RRG failures could also trigger greater scrutiny from the National Association of Insurance Commissioners (NAIC).
The NAIC previously worked with the states to adopt a universal set of regulations addressing issues of potentially improper relationships between entity directors and managers or vendors. The regulations also sought to limit material relationships with service providers such as management, legal advisors, auditors and anyone else providing professional services for a fee.
Complying with CIC Regulatory & Governance Requirements
In addition to complying with the regulatory requirements of the domicile, CICs are typically subject to some level and type of corporate governance, depending on the unique circumstances of the entity.
At minimum, a CIC’s board of directors has a duty to ensure that the entity remains compliant and manages risk in such as way that the company delivers good financial results. Staying on the good side of state regulators is also important.
It’s also critical that the board faithfully represents the interest of shareholders. It is doubtful that the board of Spirit Commercial Auto RRG was upholding their duty of care, based on the eventual outcome.
What This Means for CIC Transaction Participants
Today, this discussion might have no direct repercussions on captive transaction participants. However, should regulatory scrutiny increase, RRGs and CICs may be forced to further embrace best practices of governance and compliance.
Fortunately, most CICs are doing the right things to distribute risk and provide the intended benefits. Those that are not may be forced to take action that ultimately results in higher administrative and operational costs. It may also mean less freedom to engage in the activities that make CIC transactions attractive to participants.
Just as tax compliance issues can pose a threat to individuals involved in CIC transactions — along with their lawyers, accountants and wealth managers — unsuspecting individuals may find themselves embroiled in a messy legal matter if promoters and captive managers fail to exercise the proper operational diligence.
If you or your clients are involved in a captive insurance company transaction that you suspect may be cause for concern, contact Cantley Dietrich today to learn more.