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Direct Procurement Taxes: A Primer for Captives

Tax Laws-SF
February 22, 2017

By P. Bruce Wright, Saren Goldner, M. Kristan Rizzolo, and Andrew Appleby
Eversheds Sutherland (US) LLP

Direct procurement taxes, also known as self-procurement taxes, are imposed by many states when an insured purchases insurance from an insurer not licensed in the state. These taxes, of course, drive up the cost associated with buying such insurance and may apply to insurance obtained from a captive as well as a surplus lines insurer. This article is a primer on direct procurement taxes and how they operate.

The insurance laws of all states generally have a provision formulated in one way or another that proscribes the conduct of an insurance business unless conducted by an entity licensed by that state. In all states, there are various exceptions to this rule, the most common of which is for excess lines or surplus lines insurers that are "approved" but not licensed.

In addition, most states have either a "direct placement" or an "industrial insured" provision that allows a resident to deal with an insurer not licensed in the state. These provisions vary from state to state, and, thus, an insurer dealing with a resident in a particular state must review the particular law of the state in which the insurer is a resident to avoid being characterized as doing an insurance business in the state in violation of state law.

In general, "direct placement" statutes in one form or another require the insured to leave the state of its residence to deal with the nonadmitted insurer. "Industrial insured" statutes generally provide a definition of an "industrial insured" (often in terms of premium volume, number of employees, and existence of someone experienced in insurance and/or risk management) and allow nonadmitted insurers to come into the state of residence of the industrial insured to solicit, negotiate, etc., with the industrial insured.

Most states with one or the other of these types of statutes impose a tax, generally on the resident insured, which is usually between 3 percent and 5 percent of the premium (depending on the state). In general, the tax applies with respect to premium paid to a nonadmitted/licensed insurer. Therefore, it would apply, for example, to premium paid to a nonadmitted commercial insurer as well as to premium paid to a captive insurer affiliated with the insured located in another state. This is usually called a "direct procurement" tax but is also sometimes referred to as a "self-procurement" tax.

Prior to the Dodd-Frank Act, it was thought that if the risk insured by the policy issued by the nonadmitted insurer covered risk in multiple states, the insured would be obligated to allocate the risk among the states in which risk covered by the policy was located. The insured would then file a separate form in each state and pay a tax based on each state's rate applied to the allocated amount of premium.

The Nonadmitted and Reinsurance Reform Act, which was a part of Dodd-Frank, became effective in January 2011. Under this legislation, the entire tax due would be paid to the "home state" as defined in the legislation and the home state would have no obligation to share the tax revenue with other states in which risk covered under the policy was located. In general, "home state" is defined to be the principal place of business of the insured, unless there was no risk covered under the policy in that state; and, in that event, the state with the greatest allocation of premium would be the "home state." If, however, the business was operated through various corporate entities that are covered by a single policy, the principal place of business state of the corporation with the greatest premium allocation would be the "home state."

Given that there are now more than 30 jurisdictions with captive insurance laws, there is an opportunity to reduce this tax burden through domicile selection. For example, if the captive can be domiciled in what would be the "home state" under Dodd-Frank, the premium would not be subject to tax in any state. This is because the only state that could tax the premium would be the "home state" but, since the premium is being paid to a captive domiciled in that state, it is not being paid to a nonadmitted insurer and the direct procurement taxes do not apply.

P. Bruce Wright, Saren Goldner, and M. Kristan Rizzolo are partners, and Andrew Appleby is counsel, in the tax department of the law firm of Eversheds Sutherland (US) LLP. Ms. Goldner and Messrs. Wright and Appleby are located in New York, and Ms. Rizzolo is located in Washington.

Copyright © 2017, International Risk Management Institute, Inc.

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