EFTA01115304.pdf

THE PRESENT AND FUT1IPE PROTECTED CELL COMPANIES May 2008 INTRODUCTION The use of the Protected Cell Company (PCC) concept is one of the most significant developments in the world of corporate finance for many years. This flexible new technology is already being used to provide a platform for a broad range of financial transactions. including the provision of a stable and cost-effective platform for securitisations and other transformer activities as well as a diverse range of more conventional insurance and other financial applications. The purpose of this paper is to explore the developing usage of PCCs. the introduction of ICCs (Incorporated Cell Companies) and to anticipate opportunities and developments in the next few years. There have been a number of substantial developments in this market in the last few years. notably the incorporation of PCC regulations in Bermuda. Barbados. Gibraltar. Malta. Isle of Man and in many states in the USA and the associated widespread acceptance of FCC structures for applications which were previously merely predicted. Originally the use of cellular rent-a-captive structures began in Bermuda in the 19705 but it was not until 1997 that Guernsey created a new kind of captive that 'ring-fenced' the assets of the participating cells and allowed them to operate as distinct insurance entities. The insurance market was in a state of turmoil following the World Figure I Trade Centre loss of II September 2001. Seeking equilibrium. following years of poor underwriting performance and recent • Creditors of a FCC cell only have access to cellular assets of that downturns in investment returns, the market was hit by the largest particular cell plus the company's non-cellular assets (though. insured loss in history. Some coverages remained tightened, capacity under certain circumstances, access may be able to be limited to reduced. prices increased — a climate which is traditionally positive for cellular assets only). Should the assets be insufficient to discharge captive insurers and PCCs undoubtedly benefited by being able to offer the cell-owner's liabilities, creditors then have recourse to the non- a formalised self-insurance option without the need to commit large cellular assets. which are the responsibility of the PCC sponsor? In amounts of ever-scarcer capital resources. The credit squeeze which is most cases, the cell owners arc expected to collateralise any now impacting the financial markets may well create similar underwriting risk within their cell. circumstances to which cell structures may well be able to respond to. • PCCs can either be newly incorporated or. alternatively, an existing Within the world of insurance. it has been erroneously assumed that the company can be converted to a PCC. The conversion option has main use for FCC technology is to enable the reinvention of the Rent- proved to be relatively straightforward, and is clearly an attractive a-Captive. Indeed, many large insurers and intermediaries have option where there is already an established company in the chosen quickly moved to establish PCCs for this very purpose, with varying location. degrees of success. This is just one of many current PCC uses and it would be quite wrong to equate "PCC" with "Rent-a-Captive", as so • A PCC is a single legal entity. It follows from this that the core of many of the more narrowly focussed specialist insurance press features a PCC and its cells are not separate entities. Therefore a PCC has. have thus far pretended. and can only have, one board of directors, who manage the affairs of the FCC as a whole. Equally it will hold a single annual general meeting of its shareholders. However, a committee can be formed PCC PRINCIPLES AND KEY FEATURES to oversee the operations of a cell under a delegated authority of the board. Specific regulations have been introduced to provide statutory segregation of the assets and liabilities of individual users and co- • From a regulatory perspective, a FCC files a single annual return owners using a corporate structure known generally as a Protected Cell Company. Application is across the world of banking and insurance. but regulatory approval is required in relation to the business plan of each cell. and it is fair to say that the PCC technology is a key catalyst in the fusion of those historically distinct financial markets. • The PCC's tax status in the domicile in which it is located. The key features of a PCC are as follows: • A PCC operates in two parts. with a non-cellular part (also commonly known as the core) and an unlimited number of cells. as shown in figure I. There are many possible structures and the eventual structure adopted is tailored to the needs of the sponsor and users in each case: the following describes a typical arrangement. A new cell owner is met with minimum establishment costs and administration. The core capital can be a large amount. enabling full insurance risk transfer to be incorporated within the company's contracts. or alternatively can be a nominal amount. in cases where individual members provide cellular capital. %Valli Interruption 2008 EFTA01115304  Aside from these unique swaures, the primary classifications of PCCs FORMATION AND FUNCTION OF A CELL are as follows: The PCC's articles will normally empower the directors of the company to create cells at their discretion. Rent-a- The PCC owner offers traditional rent-a-captive Captive services to clients with the added security of statute The provisions as to how cells are created are contained within the to support the segregation of assets and liabilities PCC's memorandum and articles. The process of loaning a cell should between cells. Insurance companies have been be relatively straight forward, with the directors simply resolving to setting up PCCs to'lock-in' policyholders who create a new cell. Any cell that it is to be come active will require increasingly wish to be captive participants. corporate registration and regulatory approval. in relation to: This concept has been used very effectively in Continental Europe. where captive usage is • Cell shares that may be created and issued relatively low. Large insurers have promoted the • Licensing by the regulator for its planned activities concept of - captive account facilities- for some years and have largely been able to avoid their Each prospective cell owner is required to enter into a cell management clients forming their own captive operations. This agreement with the PCC board and will be bound by the memorandum model is now being adopted an other developed and articles of association of the PCC. There will also be an agreement markets. for management service with the manager of the PCC. which may be included within a tri-panne cell management agreement or dealt with Insurance A number of insurance companies are using their by a separate agreement. The agreement(s) will be tailored to the Companies PCCs not simply as a means of providing rent-a- specific requirements of the individual cell owners to reflect the type captive facilities to their own client base but also to and nature of business they intend to transact and will confirm key extend that facility to clients of other insurers who issues such as entry and exit requirements. have no such facility. An important development has seen the use of PCCs by insurers as an Entry to the PCC is at the discretion of the PCC Board who will require alternative to a standalone captive for their own derails of the proposed business plan and will agree the parameters reinsurance retentions. using a separate cell for their within which the cell is to operate. own activities alongside the cells of client companies. This usage will doubtless increase in In the case of an insurance cell, the risk gap (the difference between the the future (see also Global Programme Solutions premium and risk exposure) will need to be established and how it is to below, where this concept is explained more fully). be funded. The risk gap may be [educed by the purchase of reinsurance and is normally covered by capital or capital -equivalents" Associations Association Captives have operated successfully for such as partly paid callable shams, letters of credit or guarantees. very many years. providing insurance coverage to members of trade associations or companies trading In some cases, a cell may operate with a risk gap that is not funded by in a particular industry. Too often however. the idea the cell owner but is covered by the cote assets of the PCC, under of an association captive is too difficult to "sell" to agreement with the PCC board. A premium will be charged for this the potential participants because of a disinclination and security anangements will generally be required to cover the to share risk - or even to share information - exposure of core capital. between individuals or companies who operate in Fees will typically be charged in relation to accessing the PCC. the direct competition with each other. The PCC PCC's administrative overheads and the administration of the cell and concept is ideal as it permits segregation of assets business conducted. This would be in addition to any charge relating and liabilities as well as enabling confidentialities to to the exposure of core capital. be observed. There has been little evidence of this type of PCC so far, but a difficult insurance market could precipitate some activity. USE OF PCCS As already indicated. the PCC concept is not merely the reinvention of Offshore Offshore life insurers have embraced the concept of a rent-a-captive facility. The FCC concept is just as suitable as a Life Insurers PCCs to provide added protection to policyholders. means of commoditising Special Purpose Vehicles (SPVs) and as a Using separate cells for individual policies or basis of structuring investment products. The extension of PCC usage products does not greatly increase running costs but beyond traditional rent-a-captives and investment funds has been a ensures segregation of risk rand supporting asset major development. classes). Should the life insurer decide to also write general business and become a composite. the PCC The ownership of PCCs by banks and by insurers to transform banking structure is one of the few accepted corporate products into insurance products and vice versa has been a big structures to accommodate this without having to development, as it has actively encouraged the fusion of the worlds of establish a separate general insurer (with associated banking and insurance. Vehicles owned by Lehman Brothers. costs of capital and marginal costs). Goldman Sachs and CSFB in Bermuda have demonstrated the potential, as has the creation of a number of vehicles owned by such Niche PCCs can be used to commute captive programmes. financial institutions as Royal Bank of Scotland and Close Brothers in Products provide access to reinsurance markets including Guernsey. PCCs owned by banks and insurers have therefore been Terrorism pools such as Pool Re. write 'niche' formed to be used as Special Purpose Vehicles (SPVs) for products where conventional cover is unavailable or StellfiliZSIPIllallSaCtiOllS. In such transactions. the PCC may issue expensive and act as a reinsurer for customer bonds. notes or other debt securities where the repayment is to be services e.g. extended warranty. This is an funded from the proceeds of the PCC's investments. indication that a PCC can provide a suitable structure for the development of revenue enhancement opportunities. Wilbs Global Captive Practice 2008 EFTA01115305 GLOBAL PROGRAMME SOLUTIONS ROLE OF PCCS POST WORLD TRADE Protected Cell Companies are also used to restructure global insurance CENTRE programmes through a captive-type operation. The same structure can The state of uncertainty in insurance and reinsurance trinkets as well as be used by insurers seeking to manage their underlying retentions the associated hardening in market terms in certain covers led to around their reinsurance programme. also as an alternative to a increased self-insurance for mast corporations. Traditionally. this is a conventional captive. The following benefits are identified: climate where captive business thrives as there was a need for all organisations to be able to demonstrate a clear risk management • Ability to segregate risk by Group subsidiary or operating strategy and the formalisation of their risk financing programme company. through a captive - or FCC - vehicle was a logical step along a well- • Captive capital can be provided by subsidiaries rather than wholly trodden path. At the same time, as insurance terms were hardening, the by Group. global economy was slowing, leading to reduced profitability for many • Segregated risk information can be used to identify risk organisations. This is a climate where increased self-insurance can management needs. provide more control and reduce the cost of risk. • Individual subsidiary underwriting can be carried out for low-level and primary layer losses. PCCs will become ever more active in providing "virtual captive" • Profit recognition on a subsidiary basis can be achieved as services, especially where organisations do not wish to form their own individual cell results are readily identifiable. captive vehicle. or are unwilling to commit capital funds. PCC • In the event of Merger and Acquisition (M&A) activity. a PCC- products include: structured captive is far better suited to the identification. inclusion or removal of individual trading companies or subsidiaries. • Financing of increased self-insured retentions with the development • The interests of minority shareholders in Group subsidiaries and of flexible multi-year programs to smooth the occasional adverse associate companies are safeguarded. experience at Group P&L level. • Insurance cover for Joint-Ventures and strategic alliances can be • Provision of coverage excluded by the conventional market (a form provided through the captive on a fully segregated basis. of "Difference in Conditions- protection). • The provision of high-level catastrophe coverage can be included on a cross-cell basis. Use of a PCC to manage retained risk does not create additional market • In some locations, the PCC may be used to provide other offshore capacity in the short-term but, as the market softens as it has done so financial services. such as trensury, financing activities and inter- recently. with the provision of additional capital from new and existing group invoicing. providers, it is possible to reinsure PCC retentions into this changing market environment. This is far simpler and more successful than trying to insure out of an internal fund as the financial and regulatory disciplines imposed by PCCs are attractive to potential risk bearers. SPECIAL PURPOSE VEHICLES/TRANSFORMERS AND SECURITISATION CURRENT DOMICILE INVOLVEMENT The PCC structure can also be used as a platform for any type of FCC legislation was pioneered by Guernsey in 1997. with the Cayman Special Purpose Vehicle (SPV). including those established as Islands introducing similar provisions soon afterwards. Even before transformer vehicles to support settuitisations. Even before the Bermuda introduced dedicated legislation. over IOU PCCs were introduction of specific PCC legislation in Bermuda. entities such as established under private law. PCC provisions have also been enacted Lehman Bros and Goldman Sachs established PCCs by making use of in Vermont and the NAIC has introduced a model act specifically to Bermuda's private law facility. encourage securitisation business back onshore. Barbados. Gibraltar and Malta have introduced PCC regulations. The Isle of Man followed The use of an offshore SPV is already well understood and in 2004. Of the established captive domiciles. only Luxembourg and documented. It takes advantage of the same regulatory. legislative and Dublin have no confirmed plans to implement PCC regulations in the fiscal environment which has benefited traditional captive business. foreseeable future. This is less than critical to the use of PCCs. given Bermuda has a particular advantage, as the regulatory definition of that Gibraltar and Malta able to offer the facility throughout the "insurance" states that it is a contract that pays in the event of a loss of European Union through EU "passporting" provisions. money or money's worth or that pays for loss occasioned on the happening of an event. The more forward-thinking of Guernsey's This latter feature is likely to become increasingly popular especially PCCs are now following the Bermuda lead in this area. as it will be particularly useful in structuring corporate programmes whilst producing an economical alternative to traditional fronting. It is Structuring an SPV as a PCC also has the advantage of enabling the also possible that combined solutions can be created for companies segregation of different classes or categories of investor. For example. wishing to maintain captives outside the EEA (European Economic particularly risk-averse investors may wish only for the coupon to be Area) whilst benefiting from the direct capability of a vehicle within exposed with their capital commitment remaining intact. whereas the EEA. A captive can reside in an offshore location from where it others may be happy to risk both coupon and capital. in exchange for a reinsures a cell in a PCC in either Malta or Gibraltar. which effectively higher potential return. This therefore increases both the flexibility and provides the offshore captive with direct writing capabilities into the 28 workability of the programme. The proof of true legal segregation of EEA countries at the lowest possible cost of capital. cellular assets is even more important in the area of SPVs than for the more traditional Rent-a-Captive vehicles. There has been immediate success for those institutions that have established PCCs to provide a transformer capability for the provision of segregated SPV facilities. The main benefit is concentrating expertise and experience. whilst minimising the transactional costs involved in the separate licensing. operation and control of each programme. The reduction in marginal coat is likely to give such institutions a competitive edge. Willis Global Captive Practice 200S EFTA01115306 LEGAL ENFORCEABILITY CONCLUDING COMMENT Initially, a number of commentators expressed doubts as to the legal The use of cell structures will grow and prosper. They are acting as a enforceability of the PCC structure but the identity of the PCC catalyst for the fusion of capital and insurance markets, and are sponsors in Guernsey and Bermuda demonstrates that some of the providing a structure and capability to move the world of risk financing largest insurance companies and banks are confident enough of the into the 2 P Century. PCCs and ICCs are an innovative way to help legislation to have invested considerable resources. The addition of organisations to finance risk and they are flexible enough to offer a Vermont to the list of locations that have adopted PCC legislation is wide range of possible products and solutions. A tough insurance further evidence of the robustness of this technology, as is the market will provide a further boost, as will the regulatory and fiscal acceptance by the NAIC that they should follow Bermuda's lead. The attacks on conventional captives. The number of domiciles offering expansion of PCC provisions would not have born so widespread or so PCC services will expand. though the head-star gained by Guernsey. rapid unless full legal. business planning and due diligence review Cayman and Bermuda will see these locations consolidated as the processes had been carried out and satisfied by each of these sponsors major centres for this business. and domiciles. Not withstanding this due diligence, the robustness of the PCC structure has yet to be tested in the courts. In the near future. a further usage of the cell structure might be to enable conglomerates to restructure their entire corporate operation. taking advantage of the 'ring-fencing' and demonstrable corporate RENT-A-CAPTIVE VS. PCC governance compliance opportunities provided by the statutory segregation of assets and liabilities. That concept would not have been It is possible for cellular structures to exist without dedicated credible even a year ago but now seems just one step away. legislation to support them. One example of this is the traditional rent- a-captive cell facility, which operates on exactly the same basis as a The original version of this paper. issued in September 1998. PCC but without the statutory protections. The individual cells are concluded as follows: "Just as Limited Liability Companies and segregated by contract with a shareholders' agreement being used to partnerships were once a new concept. so the introduction of limited avoid cross-contamination. This has proved to be a successful liability cells should be seen as a part of the evolutionary process of structure for many years though it is the view of many sponsors and commerce". The case is proven and the contribution of cell vehicles to users that the greater safeguards available from the PCC facility. the transformation of the risk finance industry cannot be offering statutory protection, are of considerable benefit. underestimated. Nonetheless, there are traditionally-structured Rent-a-Captive With the current state of uncertainty in the insurance market and the providers who have elected not to adopt PCC status and who see little associated patches of volatility in terms of capacity. coverage and obvious benefit in doing so: they argue that they have been operating in price, cell structures are set for a period of continued growth. this way. successfully. for some years. and have no need to change their status. The majority of these are likely to consider changing their status in the near future in order to remain competitive. ENTERING THE ICC AGE In 2004 the District of Columbia amended its captive law to allow individual cells to be incorporated as legal entities in order to provide companies with added security over the true segregation of their assets from other participants within a PCC. This slightly predated Jersey's incorporated cell company (ICC) legislation and was followed suit by Guernsey in 2006. Unlike in PCC legislation. individual incorporated cells will be allowed to transact with each other and exchange assets. The ICC law also clarifies and facilitates the conversion of cells into fully fledged captives and vice-versa and provides participants with greater flexibility in the way they operate their segregated accounts. Compelling arguments in favour of ICC legislation have yet to be presented by regulators though and there does not seem to really be a rationale to convert existing PCCs to the ICC format. Recent changes Willis Global Captive Practice to the Guernsey PCC legislation have reversed the previous position where creditors of a cell had automatic recourse to the core assets in Contact: the absence of a non-recourse agreement between the cell and the Malcolm Cutts-Watson creditor. This has strengthened the robustness of the PCC structure. Leader International Ca rive Practice However. the ability of ICC cells to contract with each other may be a benefit for some structures where cells are owned by the same group or a joint venture is involved. In addition. the perception that the ICC structure is less open to legal challenge and inter-cellular Dominic Wheatley contamination of claims. in the event of insolvency. may make the ICC Chief hlarketin Officer International Captive Practice more attractive for those who still harbour doubts about the PCC Email: SWUM%C. Willis Global Captive Practice 2008 EFTA01115307