Insurance Post

At the core

Cell captives have proved popular since their creation. Paul Sykes looks at the development of these honeycomb-like entities where assets and liabilities are segregated

Cell captives came into being following Guernsey's enactment of the Protected Cell Companies Ordinance in 1997. This legislation is arguably one of the most innovative developments in corporate legal technology since the Limited Liability Act of 1855. The legislation conceived a corporate entity in which separately identifiable cells are created for cell users, under which the assets and liabilities of each cell are legally segregated from those of every other cell. Each is, therefore, to be considered 'bankruptcy remote' from other cells so that if one becomes insolvent the creditors of the insolvent cell cannot recourse the assets of any other.

PCCs comprise a single 'core' that contains the non-cellular assets.

A PCC can have an unlimited number of cells surrounding the core that contain cellular assets although the core capital of the PCC can be used to support the individual cells. This allows for a flexible allocation of capital.

PCC legislation has subsequently received global acceptance through its rapid adoption in European and US state jurisdictions. Nearly 20 domiciles now boast cell captive capabilities, including Gibraltar, Bermuda, the Cayman Islands and New York. There are more than 1000 non-life cell captives belonging to approximately 300 core companies.

It is perhaps unfortunate - if unsurprising - that many of the jurisdictions set out to define their own brand of cell captive company and chose different names for what is essentially the same type of entity. Consequently, PCCs are known as segregated portfolio companies in the Cayman Islands; segregated account companies in Bermuda; and sponsored captives in Vermont.

In addition, the rent-a-captive model exists in most international financial centres to provide a risk-financing facility to its clients in much the same way as a PCC. The fundamental difference is that the segregation of assets and liabilities in RACs is not pursuant to a statutory framework.

Because assets are pooled in RACs, stakeholders are insecure about their exposure to unlimited liability in the event of a claim by one or more of the other stakeholders.

The solution was found in the PCC concept, which turned the problem on its head. Whereas traditional insurance, through the common fund mechanism of pooling, demands that the premiums of the many fund the losses of the few, PCCs ensure that the premiums of the few are protected against the losses of the many. RACs are, therefore, the original antecedents of cell captives.

Celling captive benefits

The growth of cell captives has been prolific, despite the confusion surrounding their nomenclature. And yet the reference to a captive is fitting because the principal benefits of self-insuring through a captive or a cell captive are identical: cost savings against insurers' expense ratios; access to the reinsurance market; arm's length insurance policy; capturing underwriting profits and investment income; and consolidating group risk exposures.

The benefits above are the same for both conventional captives and PCCs, but in order to understand why cell captive growth has outstripped that of traditional captives the differences between them must be examined.

One big attraction of cell captives is that they are available at lower cost than captives. The PCC has only one core; therefore, the PCC is one legal entity. Consequently, it can be operated with minimum capital and without incurring formation costs such as stamp duty, legal and incorporation costs. Lower ongoing operational costs are enjoyed because there are lower audit and regulation charges, no need for the cell to employ directors and, therefore, reduced management expenses.

A second significant feature contributing to the popularity of cell captives is the speed with which they can be created and exited from. There is no formal incorporation or liquidation requirement and this, together with lower costs, has opened up new markets to smaller companies that were previously unable or unwilling to incorporate their own captive insurance company subsidiary.

What's their use?

A third reason for cell captive popularity is the flexibility of the vehicles. The PCC lends itself not just to traditional captive purposes but much more. For example, a PCC mutual structure can be used to bring advantages to firms of a legal or accounting practice. PCCs are used for life insurance structures, particularly for high net worth individuals who desire control, transparency and security. Cells have been used successfully as special purpose vehicles to facilitate securitisations and to transform capital market products like derivatives and catastrophe bonds into insurance products.

A slowing down in cell captive formations has already begun as the hard insurance market softens and more conventional insurance capacity reduces the need for buyers to look for alternatives; however, cell captives will continue to be formed by the more sophisticated insurance buyers.

The increasing number of new cell captive jurisdictions will also intensify competition and potentially dilute the revenue streams of the established domiciles. Practitioners in the competing domiciles will persist in attempting to differentiate their cell captive product in the hope of creating a competitive advantage or publicity, though any differences are, at best, debatable.

The most significant of these is that SACs in Bermuda do not have to be authorised individually, which makes them slightly cheaper but less well-regulated than, for example, Guernsey PCCs, where each individual cell is approved by the regulator. It is also argued that the core capital is more at risk in a Guernsey PCC than it is in a Cayman Islands SPC or SAC. In practice, there is limited, if any, recourse to the core capital of the major cell captive companies in any jurisdiction.

Legal uncertainty

There continues to be some legal uncertainty expressed about the integrity of cell captive structures and the legislation has not been tested to destruction. However, the legal opinions taken by governments prior to enacting PCC legislation, the growth of cell captives and their use by many of the world's leading companies, should allay any fears about their robustness. The European Union Insolvency Directive deems that local judgement will prevail and it is difficult to envisage courts overriding statutes enacted in their own jurisdictions. Despite this, some lawyers remain sceptical.

It is interesting to reflect, as does Gower's Company Law, that nearly 150 years ago - prior to the Limited Liability Act - "one could detect more than a slight whiff of humbug" from the legal profession as MPs tried to persuade them that limited liability was desirable. Similarly, PCCs can be expected to stand the test of time.

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