A recent shift in policy by the Department of Labor ("DOL") has cleared away a decades-old roadblock under the Employee Retirement Income Security Act of 1974 ("ERISA") which discouraged companies from using their own captive insurance subsidiaries to reinsure employee benefits such as short-term disability, long-term disability and employee group term life insurance. This change in policy may be of particular interest to companies with existing captive affiliates because adding employee benefits to a captive's risk profile can smooth loss volatility while facilitating tax deductibility of related party property and casualty premiums paid to their captives. Companies that have not yet established a captive now may find more incentive to do so.
The DOL previously required employers wanting to reinsure ERISA regulated employee benefits through captive subsidiaries to show that at least 50% of the captive's annual premiums were attributable to third-party risk, i.e., risk that was unrelated to the employer and the employee benefit plans. The DOL, charged with protecting the benefits of employees, felt that requiring at least 50% outside business bolstered the captive's financial soundness. Reinsurance of employee benefit plan risk by a captive that failed to meet the 50% test would have been characterized by the DOL as a "prohibited transaction" under ERISA, with potential monetary and criminal sanctions. Over the past year, however, the DOL indicated that it was considering allowing employers to demonstrate that captive reinsurance was in the best interests of their employees through some other method. A recent DOL notice now provides employers with a realistic alternative to the 50% test.
The Columbia Energy Exemption
On August 17, 2000, the DOL issued a notice of proposed exemption from the prohibited transaction rules relating to the reinsurance of employee long-term disability risks by a State of Vermont branch of Columbia Insurance Corporation, Ltd., a wholly owned Bermuda subsidiary of Columbia Energy Group, Inc. (65 Fed. Reg. 50223, 50237). The DOL did not require the Columbia Energy captive to demonstrate at least 50% third-party risk, as long as each of the following conditions was satisfied:
Independent Fiduciary: The employer retains an independent, third- party fiduciary to review the transaction, determine that it is in the best interests of plan participants, and oversee the arrangement on an ongoing basis. Also, the fiduciary must confirm that employees are charged premiums at reasonable market rates.
U.S. Regulation: The captive subsidiary must be a licensed insurer in at least one state, such as Vermont, whose laws require a financial examination by an independent accountant and annual review of reserves by an independent actuary. Vermont's captive insurance laws were recently amended to accommodate offshore captives forming a branch for the sole purpose of insuring or reinsuring ERISA regulated employee benefits. The DOL ruled many years ago that an insurance company licensed in and regulated by the United States Virgin Islands also would qualify (DOL Opinion 83-59A).
Increased Employee Benefits: To help demonstrate that the transaction was in the employees' best interests, Columbia Energy agreed to improve long-term disability insurance benefits for employees in the first year of the transaction by liberalizing the plan's definition of disability and removing certain Social Security offsets from the plan's benefit formula, resulting in increased benefits for lower-paid employees.
Highly Rated Primary Insurer: The DOL required the primary ("fronting") insurer (in this case, an affiliate of Liberty Mutual Insurance Group) to have a rating of "A" or better from A.M. Best Company. Further, the reinsurance arrangement could not relieve the primary insurer of liability in the event of the captive's inability to pay benefits.
As in the case of any prohibited transaction exemption, the captive also was prohibited from realizing a profit from the reinsurance arrangement, and no commissions could be paid with respect to the sale or reinsurance of the insurance contracts.
Advantages of Establishing a Captive
Companies that already insure or reinsure property and casualty risks through a captive subsidiary now should consider reinsuring employee benefit risks as well. Economies of scale can be achieved and loss control may be improved because employee benefit risks tend to be less volatile than property/casualty risks. Moreover, even though the Internal Revenue Service disagrees (Revenue Ruling 88-72), under applicable case law (see Harper Group), property and casualty premiums paid to a captive subsidiary may be tax deductible if at least 30% of the captive's business (measured by net premiums) is generated from unrelated risks. Unlike the DOL, the IRS has taken the position that employee benefits, such as employee group term life insurance, constitute unrelated risk (Revenue Ruling 92-93) because the economic risk of loss being insured is not the company's risk. Consequently, reinsuring employee benefits through a captive may help the captive reach the 30% unrelated risk threshold and help sustain a tax deduction for the parent company's property and casualty premiums, while having no effect on the tax deduction the company may take for the cost of providing the employee benefits.
Individual Prohibited Transaction Exemption Process
Individual prohibited transaction exemptions apply only to the parties requesting the exemption. Accordingly, companies wishing to reinsure employee benefit plan risk through a captive subsidiary must submit their own exemption application to the DOL. The DOL is likely to get a number of exemption requests similar to Columbia Energy's in the future. If enough exemptions are approved, applicants may be able to take advantage of the DOL's expedited application procedure ("EXPRO"), where processing is completed within 45 days. However, EXPRO requires companies to notify employees of the proposed transaction, and to show that two previous exemptions were approved by the DOL whose facts are "substantially similar" to the applicant's. The latter requirement has historically been applied narrowly by the DOL. For example, the DOL could require EXPRO applicants to point to two previous exemptions covering identical types of benefits (life insurance, disability, etc.) and identical benefit improvements in order to take advantage of the DOL's expedited procedure. On the other hand, applications that fail to satisfy EXPRO criteria still can be considered under the DOL's standard individual exemption procedure, since the information and representations required under the standard procedure are also required under EXPRO.
For now, the standard individual exemption procedure may offer more flexibility to employers. Although the DOL is unlikely to relax its requirements for a highly rated "fronting" insurer, an independent fiduciary, an independent accountant, and actuarial reviews, it remains to be seen what level of benefit improvement the DOL will require in future exemption requests as a minimum for different types of employee benefits.