Regulation by Litigation
Rob Walling

Regulation by Litigation

Rob Walling May 01, 2015 Posted in: Blog Posts, Captives
The captive insurance industry is built on a regulatory model based on a partnership between state captive insurance regulators and service providers, especially captive managers. It is not dissimilar to Ronald Reagan's favorite adage of "trust, but verify." However, this collegial relationship can be severely tested when a rogue captive owner circumvents the safeguards in place to protect the captive insurance system and finger pointing begins. This is particularly concerning when significant unfunded losses and/or criminal activity threaten the reputation of captive managers, service providers and regulators alike. Legislation recently proposed in Delaware, and subsequently withdrawn, appeared to indicate an abrupt shift away from "trust, but verify" regulation to “regulate, then litigate” in these contentious situations.

The captive insurance industry has a number of safeguards, checks and balances intended to protect the industry from financial failures and prevent unethical or criminal activity. These measures include the licensing of captive managers, captive managers’ internal vetting of prospects as part of their own risk management protocols, interviews between captive owners and regulators, detailed captive applications, actuarial funding studies and pro forma financial statements, and reviews by independent consultants retained by the regulators. This oversight by captive managers, actuaries, auditors and insurance regulators continues after a captive is formed through annual financial statements, renewal funding analyses, audit opinions and actuarial analyses and loss reserve opinions. But what if something goes terribly wrong?

Just such a worst case scenario occurred in Delaware. Without belaboring the details, the opinion of Vice Chancellor Parsons in Stewart v. Wilmington Trust SP Services, Inc. et al.1 that was distributed on March 26, 2015, suggests that several safeguards failed in this instance. On March 26, the Court of Chancery of Delaware dismissed several of the motions against the captives’ managers and auditors. On March 31, the Delaware Department of Insurance introduced Senate Bill 48. The most worrisome element of the legislation §5935 Actions By and Against the Receiver attempts to revoke several of the legal protections of captive service providers that had been upheld by the Court of Chancery less than a week earlier. This is a significant cause for concern to all captive service providers.

Fortunately, under pressure from the Delaware Captive Insurance Association (DCIA), the legislation was withdrawn almost as quickly as it was proposed. However, the initial reaction by Delaware captive regulators to a court verdict begs several questions:
  • Is there an opportunity for the captive law or the regulatory approach to be improved to identify a captive owner attempting to mislead a captive manager, auditor and ultimately the captive regulator?
  • Has this overt initial effort to make it easier to sue captive service providers permanently altered the relationship between captive managers and regulators in Delaware or can it be repaired?
  • How could tightening the domicile’s captive regulations to prevent another similar act impact the momentum of a booming captive domicile?
  • Even with the proposed legislation withdrawn for the time being, are we headed towards captive regulation by lawsuit in Delaware?
The history of U.S. captive insurance regulation has seen numerous domiciles grow very quickly due to favorable legislation, youthful exuberance and the aroma of tax revenue only to experience a significant “retrenching” once they got what they asked for. The idea of legislating the ability of regulators to sue service providers when protections from liability have been part of common law for decades seems an over-reaction. To the Department’s credit, they have withdrawn SB 48 for further comment and consideration in response to captive industry concerns.

Is SB 48 a sign of Delaware “retrenching” or simply a misstep that will ultimately make the relationship between regulators and captive service providers stronger?” Will captive managers continue to recommend a domicile that has shown some intent to sue captive service providers or will some of the myriad of other domiciles benefit from a shift in formations and redomestications in response? Stay tuned.

1Elements of this litigation are ongoing and its merits and outcomes are well outside the scope of this blog post. This blog post is also not intended to provide a rigorous legal analysis of the facts and legal interpretations of the case described.

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