U.S. captive domiciles are healthy and growing, but it wasn’talways this way.

Dateline Bermuda, 1950s. Fred Reiss, a creative insurance agentfrom Youngstown, Ohio, develops a superior alternative totraditional insurance for his client by establishing a “captive”insurance company under the insurance laws and regulations ofBermuda. This alternative risk-financing method quickly catcheson.

Within a decade there are hundreds of captives. Bermuda,followed by the Cayman Islands, the Channel Islands and otheroffshore domiciles, learn that captives are good for their localeconomies and compete vigorously with each other to attract captivebusiness. Meanwhile, infrastructures grow. Captive managementbecomes a new business and accounting, actuarial and law firmsdevelop expertise in captives.

But this new industry is almost entirely limited to offshoredomiciles. Colorado and Tennessee make initial efforts to attractcaptive business but in general their laws are too restrictive andgovernmental support is tepid. Only a handful of captives domicilein those two states. Within the risk management business, it isclear that offshore is a “friendlier” place to do captivebusiness.

Fast forward to 1980-81 when another insurance agent, LincolnMiller, is seeking a domestic captive option for his client andapproaches Vermont. George Chaffee, Vermont’s Commissioner ofBanking and Insurance, takes a big risk for a traditional stateinsurance commissioner and, with the support of the governor andlegislature, takes steps to develop Vermont as a captive domicile.

Vermont passes captive insurance legislation based on a modelbill developed by the Risk and Insurance Management Society. It wisely sets up a self-financed and knowledgeable regulatorystaff. Vermont effectively markets itself and begins attractingcaptives. An infrastructure of captive managers, auditors,actuaries and legal specialists quickly emerges. The Green MountainState enjoys additional tax revenue from hotels, restaurants,airlines, etc.

In a process that mirrors the private sector, other statesnotice Vermont’s success and emulate it. Hawaii has reasonablesuccess attracting captives from West Coast organizations.Washington D.C. competes with flexible regulation. Utah develops aniche for “831(b)” microcaptives. Today there are more than 30states with captive laws.

Domestic domiciles now house over 2,000 captive insurancecompanies. The states have shown they can do more than compete withtheir offshore brethren if given an even playing field.

Changes in the federal income tax code in 1984 and 1986 werehelpful in providing domestic domiciles with a more even playingfield. Tom Jones, a captive tax expert at McDermott, Will &Emery, says that taxable captive parents now have a tax advantagein domestic domiciles (family owned businesses seeking “passthrough” tax treatment may be an exception). But for tax-exemptcaptive parents (such as hospitals and healthcare systems) there isoften a tax advantage in locating offshore.

For onshore captives the tax code allows a tax exemptorganization to write only about 10% unrelated business beforetreating all captive income as taxable. In contract an offshorecaptive can write up to 50% unrelated business before all itsincome is taxable.

Many healthcare organizations are integrating clinical,financial and risk management services and want to provide aseamless professional liability insurance solution to unrelatedhealthcare providers. These organizations may find itadvantageous to locate their captives in an offshore domicile.Clearly Congress could find a way to eliminate this unintentionalbut real bias against domestic domiciles. Doing so could allowonshore domiciles to compete on a level plane with their offshorebrethren for this segment of the captive business.

Domestic domiciles do enjoy some advantages. Only domesticcaptives can write terrorism coverage while accessing reinsurancethrough The Terrorism Risk Insurance Program Reauthorization Act of2007. And domestic captives can reinsure employee benefitscovered by ERISA. Also, a group captive operating under the RiskRetention Act must be located in a domestic domicile.

What does the future hold for onshore domiciles? All captivedomiciles, whether offshore or onshore, must continue to respond asnew risks evolve. Over the last decade regulators have allowedcaptives to address terrorism and cyber risks. Perhaps captives canrespond to increased weather related catastrophes by expandingcapacity for natural disasters, including permitting more use ofinnovative risk sharing mechanisms such as catastrophe bonds. Orcaptives might play a larger role in health insurance financing iffederal tax and regulatory impediments are addressed.

Domestic captive domiciles have come a long way from practicallyno presence to often being the best option, but they cannot rest ontheir laurels. There are too many competitors and too many riskfinancing problems to stand pat. States, with targeted federalsupport, have to look for additional ways to help organizationsfinance their risks. In a competitive environment, those statesthat wish to compete must adapt their captive legislation whilesimultaneously asserting effective oversight.

Even with these challenges, growth in new domestic captives willaccelerate as organizations strive to finance emerging risks andmore efficiently finance traditional risks. With some modestfederal tax code and regulatory changes, the robust U.S. captivedomicile market could play an even greater role in addressing riskfinancing challenges.