Captives For Rent: Protected Cell Use RisingFast By now we all have heard stories about insurancebuyers whose premiums have risen so dramatically that despite aminimum of losses and a good balance sheet, they can no longerafford to invest in a traditional insurance programeven though theyhave a self insured retention or deductible plan.

As the insurance markets continue to struggle with capacity andaffordability issues for policyholders, many are turning to thealternative market for their solution. For many, the quest resultsin establishing a captive for their risks.

For those who want to “try on” the concept of a captive but lackthe capital or operational expertise, a rent-a-captive is theanswer. But are all rent-a-captives the same? Is a protected cellcaptive the same as a rent-a-captive? In a word, no.

Captives gained in popularity in the 1960s with larger firms andsophisticated insureds that could afford them. However, in the1970s several pioneers in the captive industry sought to make thecaptive concept easier to access and use.

Most of this ground-breaking occurred in Bermuda, which throughmarketing efforts helped to create a market in the UnitedStates.

The result was a “rent-a-captive”a Bermuda-based companyactually owns the registered trademarkthat allowed owners tocapture the benefits of a traditional captive but without thecapital or the duty of administration.

But while rent-a-captives did indeed provide accessibility andbenefits to their owners, especially in the form of producing thepossibility of an underwriting and investment income, some programsexposed them to third-party creditors of others in the samerent-a-captive, despite the contractual segregation of accounts orcells.

In response to this exposure, Guernsey, Europes top captivedomicile, introduced legislation in 1997 to legally separate theliabilities of one cell owner from that of another. These arecalled “Protected Cell Companies” in Guernsey. Similar legislationwas passed in Cayman in 1998, called a “segregated portfoliocompany” and in Bermuda in 2000, called a “separate accountscompany” or “private act company.”

Several U.S. domiciles have also enacted similar legislation,including Vermont, South Carolina, Hawaii and New York.

Protected cell companies, commonly called PCCs, are the actualsponsors of the captive in which one or more segregated cells canbe used by various owners. The PCC is a corporate entity startedwith a minimum of capital, called the “core,” which may or may notbe exposed if one of its cells is liable to third-party claims anddoes not have sufficient means to pay off its debt.

While the intention of the segregated cell is to “wall off” theassets of other cells from creditors, in some domiciles the PCCscore capital may be at risk if one of its cells cannot pay off itscreditors. This is assuming that the sponsors core capital has notbeen used to enter into a risk-sharing agreement with an individualcell.

In Guernsey, the first to pass such specialized legislation, thePCCs core capital is completely at risk following the liquidationof an individual cell. Thus, for very good reason, the sponsors ofthe PCC will be very cautious with whom they do business.

Part of that caution will require the individual cell to haveaccess to a sufficient amount of cash to pay off liabilities, alarger than perhaps needed surplus, a smart business plan and theindividual cell will be subject to auditing.

In reality, this puts the measure of safety on the PCC sponsors.For if the PCC ceases to exist, then the individual cell ownerswill have to find another PCC, perhaps in another domicile.

Under Bermuda legislation, the sponsors core capital isgenerally not at risk following the liquidation of an individualcell. This may or may not lead the owners of the captive to be asconservative in their cell owners surplus conditions.

Caymans legislation calls for the core capital to be exposed tothird-party creditors but only to the extent that the cell beingsettled has surplus assets.

There is an intensifying competition between offshore and U.S.domiciles in the trend to use PCCs and in the fees that are neededto manage them.

In the United States, some legislation passed in individualstates may or may not use any of the above examples as a basis forprotecting the core capital, and thus preserving the sponsor of thePCC from folding.

As part of a feasibility study, in fact, its best to thoroughlyreview the prevailing regulatory and statutory issues in yourdomicile of choice.

Each domicile must be evaluated accordingly in its statutorytreatment of PCCs and while the use of PCCs is increasing, thereare still some traditional captives that do not use specializedlegislation to segregate individual cells. Some of these captivesuse “contractual cells,” which basically insure not only their ownaccounts, but by means of a shareholders agreement, third-partybusiness as well.

Contractual cells can realize a better position in terms of taxdeductibility of their premiums because they can be actual risktransfer programs, which satisfy certain Internal Revenue Serviceguidelines as to deductibility issues.

Though at this point the IRS has not ruled on its position, somePCCs, on the other hand, may only be functioning as supporting therisks of a single entity, and portions of the their premiums maynot qualify under IRS guidelines for deductibility under thedefinition of “risk shifting.”

A possible solution to the single entity PCC is to enter into arisk-sharing agreement with the PCCs sponsor and its corecapital.

The use of protected cells is growing dramatically. In 2002 inGuernsey alone there were seven new PCCs and 43 new cell owners,giving the domicile more than 200 cells.

As of March 31, the Cayman Islands Monetary Authority reportedon its Web site 65 segregated portfolio companies. This represents11 percent of the entire captive market in Cayman, with assets ofmore than $380 million.

It would not be unrealistic to guess that more than 1,000 ofthese cells would be operating worldwide by 2005.

Originally PCCs were used to foster an increase in the use ofrent-a-captives though other uses are constantly explored.

Another use that is rapidly being developed is combining thetechnology of another type of specialized type of captive, theSpecial Purpose Vehicle, through the use of a PCC. These are called“transformers” and could be used to manifest risk transfer programsout of a combination of banking and insurance products.

Despite the sophistication of PCC technology, it appears thatmiddle market clients, agency owners and insurance companieswishing to provide opportunities to their clients are mostly usingsegregated cells.

As the hard market begins its inevitable wane, so, too, may theinterest in relying on the insurance industrys cyclical nature.

Judging by the increasing use and acceptance of alternativerisk, especially with protected cells and their accessibility,policyholders increasingly have more choices for managing theirrisk.

Christopher L. Kramer is vice president, alternative riskmanagement for Neace Lukens in Beachwood, Ohio.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, May 26, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved. Copyright in this article as anindependent work may be held by the author.