Here’s How Vermont Regulators Faced Down an Onerous Federal Tax Law

Vermont regulators came up with a creative way to save crucial dollars based on ceded risk.

By: Alex Wright | April 9, 2019

When the U.S. Federal Government brought the Base Erosion Anti Abuse Tax (BEAT) into force in December 2017, the intention was to stop companies hiding their profits overseas to avoid domestic corporate taxes.

The aim of the law was to prevent firms from loading their balance sheets with costs and deductions and shifting earnings to affiliates in low-tax jurisdictions abroad.

But the law unintentionally penalizes insurers that cede their reinsurance premiums to non-U.S. affiliates based offshore in places such as Bermuda and the Cayman Islands for legitimate business purposes.

As a result, those companies with three-year average annual gross receipts over $500 million and base erosion tax benefits of at least three percent have been clobbered with a minimum tax rate of 10 percent, rising to 12.5 percent in 2026.

Help is at hand, though, and it is issuing forth from Vermont, the leading domestic captive domicile. After increased industry demand from those most affected by the BEAT, Vermont introduced new legislation enabling these firms to establish an Affiliated Reinsurance Company (ARC) in the domicile, thus reducing the level at which they are taxed significantly.

Reinsurance Solution

“Beginning in 2018, insurers with large U.S. operations were subject to the BEAT, which significantly increases the expense of using reinsurance vehicles outside the U.S.,” said Sandy Bigglestone, director of captive insurance at Vermont’s department of financial regulation.

The ARC solution enables the retention of underwriting profits within the U.S. as intended under U.S. tax reform, by allowing U.S. insurers to cede to a U.S. affiliate instead of a foreign affiliate.” An ARC is essentially a hybrid between a captive and traditional insurance.

On the one hand, it is limited to reinsuring affiliates and taxed as a captive, while on the other it’s regulated in line with the National Association of Insurance Commissioners’ (NAIC) accreditation standards.

It’s most beneficial for companies with large U.S. operations that use offshore reinsurers, according to David Provost, deputy commissioner of captive insurance at the State of Vermont’s department of financial regulation.

David Provost, deputy commissioner of captive insurance, department of financial regulation, Vermont

The key advantages of the new law are that firms would now pay less tax with a $200,000 cap in state premium taxes, he said.

“The industry approached us with a need for an onshore alternative,” said Provost.

“It’s something we’ve been considering for some time, but the imposition of the BEAT on foreign reinsurance made the timing critical. Instead of paying 10 percent tax on their top line, they have a captive reinsurance premium tax that starts at less than one quarter of a percent and the tax is limited to $200,000. So it’s a significant saving.”

New Structure

Drawing on its own expertise and working closely with the state’s legislature, Vermont’s captive insurance division moved quickly to put together the new law under House Bill 719 late in the 2018 legislative session. After Governor Phil Scott signed it into law in May 2018, Vermont became the first and only state to provide ARCs.

Licensed and regulated by the state’s dedicated 30-person team, ARCs have to meet NAIC accreditation standards, including on solvency, holding company regulation, the use of statutory accounting principles and investment policies, said Bigglestone.

They must also file quarterly and annual statements using NAIC statutory accounting principles.

In addition, the state will carry out an analysis quarterly, focusing on financial performance and making sure that the ARC adheres to its approved operation and investment plan, as well as looking at the financial health of its parent and reinsurance affiliates, said Bigglestone.

Sandy Bigglestone, director of captive insurance, Department of Financial Regulation, Vermont

It will conduct a full statutory examination at least every five years, she said.

A key feature of the ARC law is a simplified investment statute.

“The ARC law requires companies to file an investment plan for regulatory approval,” Bigglestone said. “The plan must address diversity in type and issuer of investment and provide sufficient liquidity for solvent operations consistent with NAIC accreditation requirements.”

An ARC can only reinsure risks ceded by a parent or affiliate subject to a reinsurance contract, according to state guidelines.

It can also cede its assumed risks to another reinsurer, and it must hold a minimum of $5M in capital and surplus, the rules state.

This enables the company to have better operational control and consistency, more effective capital management, and continuity and availability of reinsurance, said Bigglestone. The company is also exposed to less volatility from reinsurance market fluctuations, she added.

The First ARC

Mapfre Re, a Spanish reinsurer, which does business in more than 100 countries, became the first company to form an ARC in Vermont.

The state went to great lengths to accommodate its needs, even bringing in the reinsurer’s representatives to meet with the House committees handling the legislation.

Provost said he is in discussions with several other companies about setting up an ARC. But he doesn’t anticipate a wave of new formations.

Richard Smith, president, Vermont Captive Insurance Association

“ARCs apply more specifically to large corporations using offshore reinsurers, for whom it makes sense to move to a structure like this,” he said.

“Hopefully as a result of the success that Mapfre Re has had, that will attract other similar sized companies to follow suit.”

“It is just another great example of how the State of Vermont is at the leading edge of innovative when it comes to creating a solution that provides an invaluable tool for risk managers and their companies,” said Richard Smith, president of the Vermont Captive Insurance Association.

“The implementation process also shows the importance of having a strong relationship with the state legislature.”

Bermuda: The New Normal

Bermuda will continue to be a key reinsurance hub despite the BEAT, according to the A.M. Best study ‘Global Reinsurance: Optimism Fizzles, It’s Back to the New Normal.’

The study says reinsurers responded to the new law by decreasing the size of their inter-company reinsurance arrangements or eliminating them altogether.

Or they have moved their capital to onshore balance sheets or formed new Bermuda entities that elect to pay U.S. tax.

The report added that while the new law was another driver for mergers and acquisitions, the larger balance sheets of the reinsurers partially offset the pressure on the Bermuda market to conform.

Another report by Fitch Ratings said the BEAT along with the 14 percent cut in the U.S. corporate tax rate will “significantly reduce the long-standing Bermuda tax advantage over the U.S.”

“The U.S. tax reforms will shrink the profitability gap between Bermuda and U.S. companies that has already been narrowing over the last several years as competitive market conditions have reduced Bermuda’s historical return on average equity advantage,” concluded the ‘Bermuda 2018 Market Update’ report. &

Alex Wright is a UK-based business journalist, who previously was deputy business editor at The Royal Gazette in Bermuda. You can reach him at [email protected].

Why Insureds Might See an Uptick in M&PL Claims

George Schalick, Jr., Senior Vice President of the Management and Professional Liability Division, Philadelphia Insurance Companies

The current soft market might come as a bit of a surprise as it does not track with previous underwriting cycles and economic conditions. Afterall, many privately held and non-profit organizations struggled during the early days of the pandemic with shutdowns and rapidly declining revenues. But the Government assistance programs, like the Paycheck Protection Program loans, helped keep many afloat during the tough times.

“During COVID many organizations stopped doing business until they were able to sort out all of the health and safety challenges,” Schalick said. “They were forced to lock down, but then all the government assistance programs allowed them to keep people employed. The increased volume of claims we anticipated we would see coming from the lockdowns and restrictions that were imposed upon businesses in the U.S. didn’t manifest at first.”

“Just because there wasn’t an onslaught of reported claims at the beginning of the pandemic, doesn’t mean the circumstances that would give rise to a claim being reported didn’t occur. Courts and the judicial system were closed or slowed and now that they are back open, we’re starting to see the circumstances that occurred during the COVID lockdowns becoming claims today,” Schalick said. “Litigation is progressing.”

Added to the delayed pandemic litigation is a concern over newer claims that might be filed as the country inches toward an economic downturn. Though a recession was avoided in 2023, experts think a soft dip could occur in 2024, with 76% of economists saying there’s a 50% or less chance of an economic downturn this year — that almost always results in more management liability claims.

“During the Great Recession in 2008, we saw an almost immediate spike in claims because of the economic conditions and the pressure it placed on organizations. They were making personnel changes with significant belt tightening almost immediately.” Schalick said.

What’s in Store for M&PL Policy Rates in 2024?

Despite an uptick in claims and increased economic uncertainty, management liability rates haven’t increased, resulting in market-wide pricing levels that may not meet the increased pressure of rising settlements and jury verdicts.

“Rates are going the other direction and settlement values are not falling,” Schalick said.

The mismatch between rates, claim frequency and severity is, in part, because carriers experiencing the dramatic soft market in the public D&O market are seeking premium gain in the private and non-profit market.

“In the public company market, the rates have been decreasing significantly. The rates were increasing in the private, not-for-profit market, and rightfully so, but there’s a desire to supplement overall mid-size D&O for carriers who also write private not-for-profit, and they see that as an opportunity to aggregate premium,” Schalick said. “So the always competitive landscape in the private, not-for-profit market has dramatically increased in the last 18 to 24 months.”

Still, companies of all sizes and types should be concerned about management liability rates in the future. Legal system abuse is resulting in increases in both the amount of litigation and the size of verdicts plaintiffs are receiving.

Certain areas of the country are particularly vulnerable to this type of legal system abuse. As a result, insureds in these localities are likely to be vulnerable to rate increases.

“The environment is so positive for the plaintiff that forces premium increases so carriers are able to stay in that market long term,” Schalick said.

Why a Tenured Carrier Partner Can Help Insureds Navigate An Uncertain Market

It’s clear that insureds are facing an uncertain M&PL market over the next few years. Fortunately, carriers with a long history in the M&PL space will be there to offer stability.

Philadelphia Insurance Companies has been supporting this market for 35 years. PHLY is committed to offering long-term rate stability, even as economic and claims trends start to push premiums upwards. They have an appetite for all sorts of companies, large and small, for-profit and nonprofit alike.

“We’ve been at this game for a long time and are one of the most tenured underwriters in this space,” Schalick said. “We like to stay very consistent.”

PHLY has worked with both for-profit and non-profit on management liability policies. With dedicated M&PL teams throughout the company’s 13 regions, PHLY provides the support agents and brokers are looking for on behalf of their clients. The teams know their regions well and can respond to local trends. They’re also dedicated to making the renewal process as easy as possible for their partners and policyholders.

“We have real confidence in our results, so we focus a lot on making the renewal experience as painless as possible for all agents and insureds,” Schalick said.

The company is also investing in tools to help insureds avoid losses. Earlier this year, they launched a new online risk management platform, PHLYGateway, which offers resources for insureds on how to create an employee handbook and trainings on issues such as recognizing workplace sexual harassment and discrimination.

If insureds have questions, they can consult a Best Practices Help Line, provided via the platform. That way, they can get on the spot risk management guidance to help them prevent claims.

To learn more, visit: https://www.phly.com/mplDivision/managementLiability/default.aspx.

This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Philadelphia Insurance Companies. The editorial staff of Risk & Insurance had no role in its preparation.