Supreme Court to hear arguments in captive insurance case on December 1

Last Wednesday, the Supreme Court released its December arguments calendar. Included on the calendar was CIC Services v. IRS, a case we first blogged about in 2016.  Since then, our firm has been involved as counsel for an amicus party, the district court dismissed the case, the Sixth Circuit affirmed in a 2-1 decision, and the Supreme Court has granted certiorari.  The issue that the Supreme Court will hear oral arguments on December 1st is:

• Whether the Anti-Injunction Act, which prohibits lawsuits to stop the assessment or collection of taxes, also bans challenge to reporting and information-gathering mandates imposed by the Internal Revenue Service, when the violation of those mandates carries tax penalties.

The case has generated significant amicus attention at the high court, with a dozen amicus briefs being filed (10 in favor of CIC Services, two in favor of the IRS).  It remains to be seen whether the passing of Justice Ginsburg will result in an alteration of the oral argument calendar. 

Lawsuit filed to set aside IRS Notice 2016-66

Two months ago, without any prior warning or public notice, the IRS issued Notice2016-66 which defined a number of common captive insurance transactions as “transactions of interest.” The Notice is limited to captive insurers organized under 831(b). The IRS states that these “transactions of interest” have the “potential for tax avoidance or evasion.” It places reporting responsibilities on the captive insurers and the owners of captive insurance companies, as well as a number of other professions (including lawyers, accountants, actuaries, and captive managers), with stiff monetary penalties for non-compliance.

The Notice has generated a substantial amount of reporting and commentary in the captive insurance community. By imposing reporting requirements on any 831(b) which has used risk pools to achieve risk distribution, had loss rates of less than 70%, or been involved in related-party lending, the Notice applies to the vast majority of 831(b)s which have had operations for the last 10 years. Further, captives (and professional advisors) were given only until January 30, 2017 to comply with filing the new reporting requirements, which include retrospective reporting of transactions for the last 10 years. However, since the time that this lawsuit was filed, the IRS has issued 2017-08 which extends the reporting deadline until May 1, 2017.

Two days ago, on December 28, 2016, CIC Services, LLC filed a lawsuit against the Treasury Department and IRS. It seeks an injunction from the federal district court, which would prohibit the IRS from enforcing the Notice.

More specifically, CIC Services, LLC is a captive manager located in Tennessee.It claims it is entitled to an injunction because (1) the Notice is a “legislative-type rule” which was unlawfully issued without proper compliance with the Administrative Procedures Act (which includes a public notice and comment period) and (2) because the Notice is “arbitrary and capricious and ultra vires in nature” and lacks the proper analytic foundation required under the Administrative Procedures Act.

The thrust of this injunctive lawsuit is that the APA contains a four step process before an administrative rule can be put into place, and the Treasury Department and IRS did not give public notice and seek public comment before publishing the Notice.

It will be interested to see how this lawsuit proceeds in the federal court system. If CIC Services, LLC prevails on a temporary restraining order or early motion for a permanent injunction, the IRS will not be able to enforce the Notice.

Charlotte-area riots and looting could be covered by insurance

Businesses in Charlotte, North Carolina will most likely be covered by property insurance for damage caused by protesters. Additionally, some may be able to recover lost business income.


Over the last two evenings, Charlotte has been the site of protests as a result of the police shooting of Keith Lamont Scott, a 43 year old man. On Tuesday night, protestors blocked Interstate 85 near the UNC-Charlotte area, and looted a nearby Wal-Mart. On Wednesday night, the Uptown area near the Epicenter was the site of most of the demonstrations. The protests, and resulting police response, have caused business disruptions in various parts of Charlotte.


 Today, it is reported that many of the largest employers in the urban center of the city, including Bank of America, Duke Energy, and Wells Fargo have asked or permitted employees to work from home. Governor Pat McCrory has declared a state of emergency and requested the assistance of the National Guard.


Local news reported that a number of Uptown Charlotte businesses were damaged or looted during the violent overnight protests. These included the NASCAR Hall of Fame, the Charlotte Hornet’s team store, the Charlotte Convention Center, the United Way of Central Carolinas, the Bank of America headquarters, and several restaurants.


Property Insurance
Generally, businesses have a commercial property or business-owners property policy (sometimes called a BOP). The standard ISO commercial property and business-owners property policies have provisions that cover riot, civil insurrection property damage, and looting. This would include physical damage to a building, as well as merchandise that may have been stolen. Damage from fire will also be covered as a named peril.


On the other hand, photographs from social media and news reports show many shattered windows in Charlotte. Plate glass window insurance is usually offered as an add-on or additional insurance, and is not covered by many standard policies.


Businesses which are routinely in possession of someone else’s property – such as a shoe repair or auto repair shop – would likely need to have specific bailee insurance to cover the cost of replacement of a customer’s property which was damaged.


Business Interruption
If any curfew is imposed in Charlotte, or other restrictions on access to a business by either its customers or employees, the company may have a claim for business interruption or lost business income, depending on what coverages were selected. These policies typically provide require the insurer to pay for necessary extra expenses and lost business income as a result of a civil authority prohibiting access to the business.


The usual business interruption policy will only be triggered if there is sufficient physical damage to the business’s property such that the business must suspend its operations. Business owners should carefully read their policies however, as the trigger for business interruption may not begin for 24, 48, or 72 hours after the first civil authority prohibits access to their premises. Although the policy may not require an additional deductible prior to business income coverage being available, the 24 to 72 hour waiting period serves as a “time deductible.” Even once the business interruption coverage is triggered, it will not be retroactive to the date of the event. In other words, for damage caused on Wednesday night, business interruption coverage will not begin until Saturday night. As a result, some losses will not be recoverable under the standard policy. The business interruption during the first 72 hours could be covered by a captive insurer, however.


Often, this is a critical period of time for business owners immediately after a civil insurrection. During this waiting period, policyholders should take prompt repair measures to mitigate their damages even though lost profits will not be recoverable. Extra expense coverage, on the other hand, typically is triggered as soon as the first civil authority action.


Businesses with claims should immediately take photographs and put their insurance companies on notice. If claims are denied, there are typically internal appeals processes available to policyholders. If claims continued to be denied, business owners should consult with a knowledgeable insurance attorney about their options.

60 Minutes investigation of lawyers should caution the captive insurance industry, too

About two weeks ago, the popular Sunday evening investigative journalism program, 60 Minutes, aired a segment with Steve Kroft which purported to show “what happens when hidden cameras capture New York lawyers being asked to move highly questionable funds into the U.S.”  In short, CBS broadcasted video evidence that 15 out of 16 attorneys in Manhattan sat down to discuss legal strategies and techniques for a potential client – who purposefully hoisted a series of red flags - for laundering tainted, corrupt profits into the United States. The New York Times published a similar story.  Although the formation of a domestic or foreign captive insurer was never mentioned by name in either piece, both stories are a reminder of the importance of ethical conduct within the captive industry.

The CBS segment – largely shot with hidden cameras by the international non-profit Global Witness – showed German-accented man acting as a financial consultant for a potential client who was a mining minister of a west African nation. Global Witness was able to secure consultations with 16 lawyers in Manhattan, even though the consultations were set up by reading from a script purposefully designed to set off a number of red flags.

The representative of the potential client disclosed that the Mining Minister earned a salary similar to a teacher in the United States, but sought to transfer substantial sums – possibly over $300 million – into the United States in order to purchase real estate, a $10 million brownstone apartment, a Gulfstream jet, and commission a yacht. This money was “earned” by the fictional minister by awarding non-U.S. foreign mining companies favorable mining concessions in Africa.

Out of the 16 separate lawyers which were shown on hidden camera, only 1 attorney refused to continue the conversation with the potential client after a few minutes. Some of the attorneys seemed delighted at the prospect of the new client, and even began to discuss fee arrangements. The remainder of the attorneys, suggested 60 Minutes, gave general legal advice on the ways “that the suspicious funds could be moved into the U.S. without compromising the minister’s identity.” This included setting up a series of shell companies, both domestic and offshore or in European domiciles such as the Isle of Man or Lichtenstein, the use of straw men, the avoidance of large international (and regulated) banks, and the use of individual or small partnership money managers who are less concerned about corporate reputation. At one point, an attorney advised setting up a complicated transaction and then doing a test with an expendable amount of money – perhaps only $1 million – so that “if anything goes wrong, it’ll be painful, but it won’t be life threatening.” Another advised that it would be important to avoid banks and countries that are “vigilant about money laundering.”

The Global Witness report, and the accompanying 60 Minutes segment and NY Times story, are turning a bright light onto legal ethics. Only 1 out of 16 attorneys ended the consultation because of the red flags. Two others specifically told the potential client that, if they did go forward with the representation, “if [they became] aware that a crime was being committed, [they] have an obligation to report that.” That obligation stems from New York State Bar’s Rules of Professional Conduct.

Professionals in the captive insurance industry should always be aware of the same types of clients. In the investigation, the potential client even used the word “bribes” at one point, to describe how the funds were originally obtained. The red flags included:

• Government officials in the position to accept bribes;
• An intense desire for secrecy;
• No seemingly legitimate source of the income (recall that the potential client only earned a salary equivalent to a teacher in the United States, yet sought to purchase a $10 million brownstone);
• A requirement to move the money from where the corrupt proceeds were obtained (Africa) to where they can be enjoyed (the United States);
• The need for a number of financial intermediaries and professional assistance (rather than simply depositing the money into a large international bank).

 

Although there are no reported instances of captive insurance companies being used for money laundering, if the industry wants to continue building its reputation as a legitimate risk finance tool, it must remain vigilant about the potential for abuse. Towards that end, domestic state regulators typically already have the statutory authority to oversee the licensing and operation of captive insurers. Working hand-in-glove, captive professionals need to also be aware of the red flags raised above.

Similarly, the North Carolina Captive Insurance Association has adopted an aspirational Code of Professional Conduct. That Code has several canons of conduct which would apply if the fictional African mining minister or his representative appeared in your office. Canon 2 states that “[c]aptive professionals must not willfully violate any laws or regulations, in both their personal conduct and in their advice to clients. Captive professionals should be familiar with the laws of the domiciles where they advise clients and operate captives, as well as applicable federal law. Captive professionals should avoid conduct or activities that are reasonably certain to cause unjust harm to others.” Underlying this ethical canons is the commentary that professionals should conform their conduct to the policies, rules, laws, and regulations within the applicable jurisdiction; should not seek to aid, abet, or assist a client in the commission of a felony; and should not allow personal financial gain (the prospect of earning a large fee) from interfering with professional judgment and adherence to the law.

Most importantly, captive professionals should simply be aware that unscrupulous individuals are moving within the American economy and seeking professional assistance in the laundering of large sums of tainted money. No captive professional wants to be the focus of the next hidden camera investigation. For the good of individual professional reputations and for the good of the industry, professionals should be aware of the hallmarks of money-laundering, consider ethical codes of conduct, and apply common sense to any potential new client or proposed transaction.

North Carolina nears 100 captive benchmark

We are pleased to congratulate the North Carolina Department of Insurance, which recently announced that North Carolina’s captive insurance program now oversees nearly 100 captive insurance companies.

For 2015, North Carolina Department of Insurance approved 44 new captive insurance companies, bringing the total number of captives domiciled in North Carolina to 96. Additionally, certain of those captive are licensed protected cell companies housing 240 cells or series. In the prior year, 2014, North Carolina grew by 49 captives.

Insurance Commissioner Wayne Goodwin reported that "From the start, we have been committed to growing and continually improving the captive insurance program in North Carolina.” He continued by saying “I am proud that, in such a short time, we have become one of the fastest growing states for captive insurance in the country.”

With two great successive years of 44 and 49 formations, North Carolina is rapidly becoming a presence in the captive insurance industry. For comparison, South Carolina gained 20 captives in 2014 and 30 in 2015.

"Shadow insurance" captive life insurer class actions to be "heard in tandem" by Second Circuit

Yesterday, the Second Circuit issued an Order in Maria Del Carmen Robainas v. Metropolitan Life Insurance Co., 15-3504 (Dkt. 46) that the three pending XXX/AXXX life insurer class actions would be heard "in tandem."

Previously, as we reported last week, the Plaintiffs-Appellants in three cases (which were all dismissed for lack of standing at the District Court level), filed unopposed motions to consolidate the three appeals.

The three cases are:

• Yale v. AXA Equitable Life Insurance Co. No. 15-2665,
• Robainas v. Metropolitan Life Ins. Co. No. 15-3504, and
• Yarbrough v. AXA Equitable Life Ins. Co., No. 15-3553.

Under Federal Rule of Appellate Procedure 3(b)(2), separate cases can be joined or consolidated on appeal "[w]hen the parties have filed separate timely notices of appeal." This rule of appellate procedure does not give any guidance to a court as to the proper reasons for consolidation on appeal. The Advisory Committee note states that "In consolidating appeals the separate appeals do not merge into one. The parties do not proceed as a single appellant."

After denying the unopposed motion to consolidate, the Second Circuit explained that "the appeals will be heard in tandem." Thus, each appeal will remain a separate appeal, the parties will comply with the briefing requirements under the Yale, No. 15-2665 case. Both 'sides' of the case, can elect to file a single brief addressing all three appeals, and a single copy of that brief and its relevant appendix would then be filed in the other two cases. Finally, the Clerk's office will set all three cases for argument before a single three-judge panel.

By rejecting consolidation, each Plaintiff-Appellant is allowed to rely on unique differences in the pleading (the Complaint) in his or her case. The factual record for each appeal will be unique to that case. If the cases were consolidated under Federal Rule of Appellate Procedure 3, then the record/Joint Appendix would be unified. However, the Court's ruling that the cases will be heard in tandem allows for uniform consideration of the common issue(s) of law, while allowing the factual/pleading portion of each case to be independent.

Also noteworthy about the Order is that the Plaintiffs-Appellents' opening brief(s) "are due thirty days after the Supreme Court issues a decision in Spokeo, Inc. v. Robins, 742 F.3d 409 (9th Cir. 2014), cert. granted, 135 S. Ct. 1892 (U.S. April 27, 2015)(No. 13-1339).

Spokeo was argued on November 2, 2015. As a recent article by Lee Epstein, William Landes, and Judge Richard Posner, published in the Duke Law Review notes, the Supreme Court usually issues a decision within three months of oral argument, occasionally will a case take up to six months to be decided, and practically all opinions are released by the following June when the Court closes for its summer recess. The Best For Last: The Timing of U.S. Supreme Court Decisions, 64 D.L.J. 991, 993 n 5 (2015). So, it's likely that we will see the Spokeo opinion released in early February, at which point the opening briefs in these appeals will be due one month later. This briefing schedule gives both Appellants and Appellees plenty of time to find amicus party assistance if they desire.  At the absolute latest, the Spokeo opinion should be public by late June 2016 (which is the conclusion of the Supreme Court's October 2014 term).  

North Carolina 2015 insurance legislation update

The long legislative session has closed, 2015 is almost over, and now is a perfect time to summarize the main statutory changes to North Carolina's insurance law.

Captive Insurance - The first insurance-related bill to pass, S.L. 2015-99, made a series of technical corrections to the North Carolina Captive Insurance Act.  This bill contained a number of clarifying and conforming language changes.  It also gave the Insurance Commissioner discretion in setting capital and surplus limits less than $250,000 in certain special purpose captives, depending on the business plan and feasibility study (akin to the provisions already in place for pure captives).  The bill also provides for captive insurers to establish one or more separate accounts. 
Importantly, the bill gives the Insurance Commissioner the ability to waive the filing of an annual report if the captive complies with the annual audit requirement.  This provision will provide real savings for certain captive owners who use NC as a domicile compared to many other states.  The bill also gives the Insurance Commissioner the authority to provide exemptions to inactive captive insurers from filing annual reports, making premium tax filings, or paying premium taxes.  In essence, the captive is allowed to go 'dormant' for certain years, rather than being completely unwound or dissolved.  This provision is not intended to allow shelf-registrations of captives.

Insurance for mopeds - S.L. 2015-125 was hotly debated amongst many members of the bar (insurance lawyers, criminal lawyers, public interest lawyers, and personal injury lawyers).  Under this new legislation, mopeds must be insured, although they do not have to be titled and dealers do not have to be licensed (in the manner that automobile dealers are licensed). 

More specifically, various provisions were added to Chapter 20 and Chapter 58 of the General Statutes are changed.  If mopeds are to be operated on streets and roadways, they must be registered and they are only allowed to be registered if they are insured.  The North Carolina Rate Bureau will not be promulgating rates (neither liability, theft, or property damage) for mopeds.  Rates will be regulated through Chapter 58, Article 40 ("Regulation of Insurance Rates").  Moped coverage may be added to an automobile policy as a rider or endorsement.  Moped liability insurance cannot be ceded to a reinsurance facility. 

Technical corrections to various insurance statutes - S.L. 2015-146 provides various amendments to Chapter 58, the insurance chapter, of the General Statutes.  Periodically, the National Association of Insurance Commissioners (NAIC) meet to discuss insurance regulations.  These regulations are then sometimes codified as model acts or proposed statutes, which are then passed into law in each state.  S.L. 2015-146 contained various provisions originating from the NAIC, and passed to maintain accreditation by the NAIC, related to the governance of insurance company holding systems, risk-based capital requirements for life insurers, and corporate governance of risk retention groups. 

This bill will effect the mergers and acquisitions of domestic insurers.  It also gives specific outlines for the composition of the Boards of Directors of risk retention groups, including the requirement of a majority of the board members to be independent directors and contains other provisions to enhance the transparency of risk retention group board supervision and activities. 

Unemployment Insurance - S.L. 2015-238 made a number of changes to unemployment insurance.  During the recent recession, the State paid unemployment benefits by, in part, borrowing funds from the federal government (to the tune of $2.5 billion).  Unemployment insurance was overhauled in 2013 by the General Assembly, in part to collect funds to repay this amount.  North Carolina has quickly repaid the federal government and has been saving money in an Unemployment Trust Fund.  Pursuant to this statute, if the Unemployment Trust Fund reaches $1 billion by March 1, 2016, the currently-in-place 20% surtax on employers will be suspended. 

Principle-Based Reserving/Revision to Insurance Laws - Finally, S.L. 2015-281 amends Chapter 58 to require principle-based approach to life insurance reserving.  This should provide a more accurate valuation of life insurance reserves compared to the formulaic models currently used.  This bill also amends the standard non-forfeiture provision contained in N.C.G.S. 58-58-55 and provides some clarifying changes to laws regarding professional employer organizations, insurance company deposits, provides for a nine member advisory committee to be appointed by the Insurance Commissioner regarding continuing care retirement communities (which are under the supervision of the Insurance Commissioner in North Carolina), expedited health insurance external review, and an addition to N.C.G.S. 58-41-20 (the statute on notice of nonrenewals, premium rate increases, or changes in coverage).

NC legislative retirements present challenges for captive insurance industry

The North Carolina House of Representatives and Senate will undoubtedly see leadership changes in 2016 because several senior leaders and incumbents have already announced they are not standing for re-election.  Additionally, some of the lawmakers in Raleigh who were involved in the initial passage of captive insurance legislation in North Carolina in 2013 have stepped down from the legislature in the past two years.  The cumulative result is that the captive industry will have at least a half-dozen new faces on Jones Street in 2016 to introduce and explain captive insurance to. 


Notably, Senator Tom Apodaca, current co-chair of the Senate Standing Committee on Insurance and Chair of the Senate Rules Committee, has announced his retirement.  Additionally, Senators Bob Rucho (Mecklenburg), and Josh Stein (Wake County) have also announced they will not be standing for relection.  Josh Stein has announced he will be running for Attorney General.


In the House of Representatives, one of the original sponsors of North Carolina's captive insurance enabling act, Rep. Paul Tine (Dare County) will be stepping down.  Additionally, Leo Daughtry (Johnston County) and Paul Stam (Wake County) have both announce their retirement from the General Assembly as well.   


Each of these six lawmakers supported North Carolina's initial foray into captive insurance in 2013 and technical corrections bills in 2014 and 2015.  Their replacements - regardless of party affiliation - will likely have to be educated regarding the benefits to North Carolina and middle market businesses which the captive insurance industry has brought to the state. 

XXX/AXXX life insurer class action appeals likely to be consolidated

We previously reported how life insurers were successful in winning dismissal of two putative class actions filed in the Southern District of New York. 

Both cases challenged the use of certain Regulation XXX/AXXX reinsurance transactions issued to life insurers by life insurer-owned captive insurance companies.  Both of those cases were dismissed under Rule 12(b)(6), for a lack of standing, because the plaintiffs failed to articulate any personal injury or actual harm in their allegations against the life insurer defendants. 

Robainas has been appealed by the plaintiffs to the Second Circuit Court of Appeals.  In a related case, Yale v. AXA Equitable Life Insurance Co. (No. 15-2665, 2d Cir.), the Plaintiffs-Appellants have moved to consolidate their case with Robainas v. Metropolitan Life Ins. Co. No. 15-3504 and Yarbrough v. AXA Equitable Life Ins. Co., No. 15-3553.

The motion was unopposed, so it is expected that the motion to consolidate and adopt a uniform briefing schedule will be granted.

The motion to consolidate also notes that "the dispositive legal issue in all three cases may be significantly shaped by the pending decision in Spokeo, Inc. v. Robins, No. 13-1339, 2014 WL 1802228 (U.S.) cert. granted, 135 S.Ct. 1892 (2015), which involves the scope of Congressional authority to create Article III standing by virtue of a federal statute authorizing a private right of action."  Spokeo was just argued on November 2, 2015 so it is unlikely that we will see an opinion issued by the end of the year.

Each of these putative class actions alleged that the life insurer defendants violated New York Insurance Law Section 4226, which entitles policyholders of life insurance or annuities to recover a statutory penalty if the life insurer makes any "misleading representation" or "misrepresentation" concerning its financial condition or reserves.  The plaintiffs allegations - closely following the Shining a Light on Shadow Insurance report published by the New York State Department of Financial Services - that certain life insurers used captive reinsurance transactions under Regulations XXX/AXXX to artificially inflate their financial position.  What the Plaintiffs did not - and could not - allege was any concrete and personal harm or injury-in-fact which they had suffered. 

We will be watching these cases closely and regularly reporting on developments.   

Interview with Self Insurance Institute of America on NC's captive ethics code

The North Carolina Captive Insurance Association is the first state-level captive insurance association to create an aspirational code of conduct.  I was recently interviewed for an article in the Self Insurance Institute of America's monthly magazine on the topic. 

The NC Captive Insurance Association is the only captive insurance trade group dedicated to representing the interest of captive owners and captive insurance professionals in the North Carolina domicile.

The Association’s board established an ethics subcommittee composed of members who represent a variety of professional interests (accounting, actuary, captive management, legal, and insurance). At the direction of the board, the subcommittee drafted (and the board approved) an aspirational Code of Ethics for the members of the Association. We believe that this is a first-in-the-nation ethical code for the industry. The code is composed of ten canons of conduct, along with an explanatory comment after each canon.

The list of professional associations which have adopted ethical codes is nearly endless (but includes engineering, medicine, the law, psychological counseling, financial planning, commercial insurance, and countless others). However, to our knowledge, no state association has set out to describe the contours of ethical conduct in the industry; including conflicts of interests, best practices, and what is considered acceptable conduct. This aspirational code is designed to raise awareness of ethical issues confronted by captive insurance professionals.

Most professionals engaged in the captive insurance industry will likely read the code and realize that, consciously or subconsciously, they were already conducting their business affairs in that same manner. They attend seminars, stay up to date on industry trends, are diligent in attending to client matters, act as ambassadors for the useful business purposes of captive insurance, and avoid breaking the law or advising clients to break the law. The canons of conduct are not designed to impose onerous new burdens on the industry; instead, they highlight best practices that have already been widely adopted.

Other state associations may copy this code of ethics, or choose to create other similar rules of guidance. Either way, additional energetic and intelligent professionals will be thinking about these issues and how the industry can best address them. This dialogue is necessary as the industry grows, matures, and gains increasing recognition as a useful and valid tool of risk financing.

Ultimately, this code should be the catalyst for conversation. Both conversations within an office setting when potential ethical conflicts arise, as well as an industry-wide conversation between stakeholders and domiciles. By having a written code with certain boundaries of conduct, captive insurance professionals will be better equipped to spot potential conflict areas. The mere creation of a written code raises awareness of the issues which captive insurance professionals face, while its content provides guidance in those areas.

Hopefully, the adoption by the North Carolina Captive Insurance Association of a formal Code of Ethics will initiate a broader discussion within the industry on the appropriate conduct, appropriate client service, and the ethical operation and utilization of captive insurance. 

You can find the entire article here.

North Carolina's modern Incorporated Cell Captive statute should allay Fitch's fears

Recently, Fitch announced its new views regarding credit risks it believes may be inherent in protected cell captive insurance companies ("PCCs").  This questioning of the structure of PCCs is in light of Pac Re 5-AT v. AmTrust North America, 2015 WL 2383406 (D. Montana, May 13, 2015 ).

A protected cell company is a captive insurance company composed of (1) a “core” and (2) a number of “cells” which are established around the core.&nbs;Unless limited by statute or regulatory rule, there can be an unlimited number of cells.&nbs;The assets and liabilities of each cell are segregated from the assets and liabilities of every other cell, as well as from the core.&nbs;The PCC structure was designed so that the assets of each cell are only available to creditors of that cell.&nbs;  Once a PCC is established by a sponsor, the sponsor can then operate each cell as an independent insurance company.&nbs;Or, more commonly, the sponsor can operate the core and other, non-related companies can operate each cell as independent insurance companies.&nbs;The cell structure – and its shared overhead – permits smaller companies who do have the capability or desire to operate a single parent captive insurance company to obtain some of the benefits of captive insurance.&nbs;

In Pac Re 5-AT v. AmTrust, a contract dispute regarding a captive reinsurance agreement between a cell and its reinsurer (which was subject to arbitration) broadened into an issue of first impression regarding protected cell companies.   Originally, the dispute was between the reinsurer and the one single protected cell (Pac Re 5-AT a/k/a Cell 5) under the terms of the captive reinsurance agreement.  However, the reinsurer named both the cell and the core (Pacific Re, Inc., a Montana captive insurance company) as a party as well.  Pacific Re then sought a declaratory and injunction in federal court that it was not a party to the arbitration. 

On cross motions for summary judgment, the court applied Montana’s corporate law to its captive insurance enabling statutes (which established protective cell captive insurance companies).&nbs;

Stating that this was an issue of first impression under Montana law (and indeed, an issue of first impression under all domestic United States law), the court stated in pertinent part:

The statutory construction issue arises here because a cell is not a separate de jure legal entity, but has many de facto aspects of a legal identity.&nbs;It is clear that the liabilities and assets of a protected cell are segregated from the other cells and from the PCC, but it is also clear that a protected cell does not have a separate legal identity.  Each cell, in essence, operates as its own separate entity, but remains part of the larger PCC.&nbs;Though the statute does not contemplate that the assets of a protected cell will be used to satisfy the liabilities of any other cell, the cells are not entirely independent from the PCC.

The court went on to rule that:

 “A protected cell is not a separate legal person.&nbs;Without a separate legal identity, and absent a statutory grant to the contrary, a protected cell does not have the capacity to sue and be sued independent of the larger PCC.&nbs;The statutory language is clear, and the court may not look beyond the plain meaning.&nbs;Although a protected cell has many attributes of independence from the PCC, it remains a part of the PCC, which has the capacity to act on behalf of the protected cell as in this instance Pacific Re acted on behalf of Cell 5 in agreements at issue.”&nbs;

In summary, “Pacific Re, as the PCC, entered into contracts at issue, both on its own and on behalf of the protected cell.&nbs;It is properly before the arbitration tribunal and will appropriately be bound by the results of the arbitration.”

As Fitch points out, the Pac Re 5-AT opinion raises significant concerns regarding how well "ring-fenced" each cell in a PCC is, and what would happen to a cell if another unrelated cell caused the core of a PCC to become insolvent. 

North Carolina recently revised its captive insurance statute with a number of technical corrections.  Under N.C.G.S. § 58-10-510, “a protected cell captive insurance company licensed under this Part may establish and maintain one or more incorporated or unincorporated cells, to insure risks of one or more participants. . . [ subject to certain conditions].”

Section 58-10-512 goes on to outline in more detail the formation, operation, and obligations under an incorporated cell captive program.  This passage deals squarely with the issue raised by Pac Re 5-AT .  The statute specifically states that:

"In the case of a contract or obligation to which the protected cell captive insurance company is not a party, either in its own name and for its own account or on behalf of a protected cell, the counterparty to the contract or obligation shall have no right or recourse against the protected cell captive insurance company and its assets other than against assets properly attributable to the incorporated protected cell that is a party to the contract or obligation."

As Pac Re 5-AT shows, understanding the applicable corporate law and captive insurance law of any domicile is important not just to those operating PCCs, but to anyone dealing with them as well.

XXX/AXXX captive life insurance class actions dismissed for lack of standing

Two putative class actions arising from captive life insurance transactions have both been dismissed.  In both cases, the Court found that the plaintiff had failed to adequately allege any injury personal to himself, and thus lacked standing to bring a lawsuit. 

 It is well-known in the captive insurance industry that New York state’s regulators have, for several years, been critical of captive insurance.  This includes the New York State Department of Financial Services publication in June 2013 of a 24 page report regarding captive reinsurance transactions in the life insurance industry which was ominously titled Shining a Light on Shadow Insurance.  In that report, the New York regulators assert that captive reinsurance arrangements undertaken by large life insurance companies masks financial weakness (and hints that the entire economy is at risk of a financial collapse if a large, interconnected life insurer were to collapse as AIG Financial Products did in 2008).

These transactions are motivated by an effort to manage the gap between economic reserves and statutory reserves (often called XXX/AXXX reserves) approved by the National Association of Insurance Commissions and adopted by a number of states during the 1990s. Academics have divided views on the propriety of these life insurer captive reinsurance transactions.  Some (notably Ralph Koijen of the London Business School and Motohiro Yogo of Princeton) essentially agree with the New York State Department of Financial Services, concluding that the potential cost of life insurer insolvencies is underpriced or under-recognized by current models and ratings.  Others have concluded that use of the captive reinsurance transaction permits the life insurer to become more economically efficient (thus lowering prices for consumers in a market which is cost-shopped and heavily-driven by premium price) without additional risk of insolvency. 

 

In the first case to be dismissed, the plaintiffs alleged that AXA Equitable Life Insurance Company violated New York statutory insurance law and regulations which prohibited misrepresentation of a life insurer’s financial condition when it used captive reinsurance transactions. Jonathan Ross v. AXA Equitable Life Insurance Co., 2015 WL 4461654 (S.D.N.Y. July 21, 2015).  The Plaintiffs further argued that, by misrepresenting its financial condition, AXA was able to obtain higher ratings from the ratings agencies with less capital.  The opinion also gives a good summary of the background of current life insurance reserve scenarios, XXX and AXXX statutory reserves, and the captive reinsurance transaction. 

However, the Plaintiffs could not articulate any concrete and discrete harm personally suffered.  They did not allege that their monthly premiums were higher.  They did not alleged that AXA had defaulted in any way.  Plaintiffs also did not have any misrepresentation-based allegations; they did not alleged that they relied on the financial statements of AXA in selecting an insurance product or that, had a disclosure of captive reinsurance transactions been made, that they would not have purchased the AXA policies.  Because they had suffered no identifiable, immediate, articulable and concrete harm, the Court dismissed the putative class action for lack of standing.

More recently, another judge in the Southern District of New York came to the same conclusion in Robainas v. Metropolitan Life Insurance Co., 2015 WL 5918200 (S.D.N.Y. Oct. 30, 2015).  In Robainas, plaintiffs alleged that they had purchased MetLife policies, unaware that MetLife had engaged in captive reinsurance transactions totaling over $1.1 billion.  Citing to Ross, the Court rejected similar arguments on the same grounds: the plaintiffs lacked standing under Article III of the United States Constitution to bring this claim because they failed to have any cognizable injury.  Indeed, the plaintiffs in Robainas had included an article by Koijen and Yogo as an exhibit to the Complaint which showed that captive reinsurance transactions actually lowered premiums for consumers.  Even taking the allegations in a light most favorable to the plaintiffs, the Court was unpersuaded that the plaintiffs had suffered any injury when these transactions made the consumers premiums less expensive.  Any risk of future insolvency was deemed too remote or tenuous (note that the Court did not go as far as to say such claims were not “ripe” for adjudication). 

Further, although the Robainas plaintiffs specifically alleged violations of state insurance statutes, the Court held that mere violation of a state statute did not create a federal cause of action absent an injury under Article III.  Although beyond the scope of this blog post, this is the right result.  Similar arguments were presented to the United States Supreme Court in Spokeo v. Robins regarding whether Congress could create standing under Article III when the plaintiff suffered no concrete harm.  All too often in insurance litigation, plaintiffs complain of theoretical "injuries" which have not yet occurred.  Under Article III of the Constitution, these plaintiffs do not have standing to bring a claim until after they have a concrete, demonstrable, and cognizable injury in fact. 

Will North Carolina follow Tennessee's memo on captive reinsurance transactions?

On October 22, the Tennessee Department of Commerce and Insurance adopted a memo which provides guidance to captive insurance companies domiciled in Tennessee regarding the credit obtained for reinsurance from unauthorized reinsurers. This is significant, not only because Tennessee and North Carolina are adjacent states (which to some degree compete against each other for captive insurance domestications and formations), but also because the statutory language of the North Carolina General Statutes and the Tennessee Insurance Code are identical.

Both Tennessee Insurance Code § 56-13-112 and North Carolina General Statute § 58-10-445 explain that: 

Any captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to reinsurers complying with this Chapter. If the reinsurer is licensed as a risk retention group, then the ceding risk retention group or its members must qualify for membership with the reinsurer. The Commissioner shall have the discretion to allow a captive insurance company to take credit for the reinsurance of risks or portions of risks ceded to an unauthorized reinsurer, after review, on a case-by-case basis. The Commissioner may require any documents, financial information, or other evidence that will allow an unauthorized reinsurer to demonstrate adequate security for its financial obligations.

In addition to reinsurers authorized by this Chapter, a captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to a pool, exchange, or association to the extent authorized by the Commissioner. The Commissioner may require any documents, financial information, or other evidence that such a pool, exchange, or association will be able to provide adequate security for its financial obligations. The Commissioner may deny authorization or impose any limitations on the activities of a reinsurance pool, exchange, or association that in the Commissioner's judgment are necessary and proper to provide adequate security for the ceding captive insurance company and for the protection and benefit of the public at large.

 

 The memo from the Tennessee Department of Commerce and Insurance provides a regulatory gloss on the statute. It goes on to state that “Tennessee captives seeking to enter into a reinsurance contract with the same unauthorized reinsurer should likewise include the details of the proposed reinsurance agreement and its proposed business plan or submit a change of business plan.” This obviously has large implications for the risk pools operated by many captive managers.

The Tennessee memo then lays out five factors which it claims will be used in deciding whether to grant credit for reinsurance purchased from unauthorized reinsurers. These factors are:

• “The policy issued to the original named insured is issued by a traditional admitted domestic insurance carrier acting as a front.
• The reinsurance agreement is made upon secured collateral. This includes reinsurance agreements made on a funds withheld basis, via a domestic U.S. trust, or via a letter of credit issued by a reputable U.S. based financial institution.
• The reinsurance agreements are obtained from an accredited reinsurer as defined by Tenn. Code Ann. §56-2-208.
• Reinsurance is obtained from a reinsurer that is highly rated by a reputable rating agency.  
• The reinsurer has a paid in unencumbered capital and surplus of at least $20,000,000 and agrees to submit to Tennessee copies of its audited annual financial statements as well as copies of any examination report conducted by its home domicile.”

Two additional factors are also explained: Tennessee will provide additional weight to a reinsurer if it is “domiciled in a jurisdiction with a solid reputation for providing accountability and oversight to its insurers” and the Department will give weight to the “experience and reputation of the captive manager and other service providers selected by the captive owner.”  These factors, of course, beg the question as to what qualifies as a domicile with a "solid reputation."  Does this exclude all off-shore domiciles?  Will Tennessee consider any on-shore domiciles other than itself to be qualified?

This memo continues that “some captives choose to participate in reinsurance exchange pooling arrangements structured in any number of ways. When such pooling arrangements include scenarios where a Tennessee captive insurance company cedes risk to an unauthorized reinsurer, the Department will give the greatest weight to arrangements where the ceded premium is held in a domestic U.S. trust, or where all pool participants are managed by the same captive manager. Any type of proposed pooling arrangement should include information sufficient to satisfy the Department that adequate controls are present and that the pooling arrangement, and its participants, possesses sufficient liquidity and accountability.” 

The memo concludes by stating that the Department of Commerce and Insurance retains its discretion to grant credit for reinsurance on a case by case basis.

This memo is important because it applies a regulatory interpretation to statutory language that is identical to North Carolina’s captive insurance law.  It will be interesting to see whether North Carolina's Department of Insurance reacts in any way to this memo.  Even if North Carolina's regulators do not adopt the Tennessee memo outright, would they consider compliance with it as a "plus factor"?  Conversely, depending on whether Tennessee construes its policy memo narrowly or broadly could have implications for North Carolina's captive insurance industry.