The use of SPCs

Cell companies have been around since 1997 when Guernsey introduced legislation permitting the formation of cell companies through the Protected Cell Companies (PCC) Ordinance. Since this time various jurisdictions including Delaware, Bermuda, the British Virgin Islands, and Cayman have introduce similar legislation.

In Cayman, Segregated Portfolio Company (SPC) legislation was first introduced in May 1998 by an amendment to the Companies Act.

The main underlying tenets of an SPC are that it is a single legal entity and that assets and liabilities can be allocated to different cells, or SPs. The assets of the core/general company and SPs are only available to, and may only be used to meet liabilities of, the creditors and shareholders of the SPC who are, respectively, creditors in respect of each cell/SP or holders of shares attributable to that cell/SP and are entitled to recourse to those assets.

It should also be noted that an SPC’s articles will normally specifically prohibit the SPC’s general assets from being used to meet any cell liabilities to the extent that any cells assets are insufficient to meet its obligations. In addition any cell is not entitled to have recourse to any other cell’s assets. As a result each cell’s assets and liabilities are effectively ring-fenced from creditors of other cells.

The cell company attraction

Why form a cell instead of a regular single parent captive? The main reasons are as follows:

Cost: In Cayman the annual government fees for a cell are significantly less than those for a standalone captive. By participating in a cell company structure there are often economies of scale that mean service providers’ costs for management, audit, tax and actuarial can be discounted, assuming the same service providers are utilised across all cells. The cell company owner will however normally charge a cell rental fee for the use of the facility and to help fund its expenses.

Capital: In Cayman there is no minimum capital requirement for each cell, as the requirement of the law stipulates only that each cell must be solvent. In practice each SPC owner will be keen to make sure each cell is adequately capitalised.

Premium: Given the lower operational cost base a cell may be more appealing to a client whose insurance programme may not support the formation of a single parent captive, so for mid-market clients a cell programme may work well.

Speed: Cell formation is usually quicker than the formation of a single parent captive, for example in Cayman new cells can be added to a cell facility through the approval in-house of the Insurance Division of the Cayman Islands Monetary Authority (CIMA), rather than the submission having to be presented to CIMA’s Management Committee.

CIMA’s requirements for a new cell are still however on par with that of a single parent company. Some jurisdictions such as Bermuda do not currently require regulatory approval to form a cell, while Guernsey introduced a pre-authorisation scheme that permits so called “just-in-time” creation of new cells in existing cell company structures as long as a full application is submitted with 14 days to the regulator.

Flexibility: There are many types of SPC structures. Some are owned by insurance managers as an additional service for clients, some are owned by third parties who use the cell facility as a means to attract business. Others are owned by single clients who may want to segregate business units or programmes into separate cells. For example a hospital may decide to house its non-employed physicians in a separate cell or a managing general underwriter may use separate cells for specific clients.

A more recent development has been the use of SPCs as special purpose vehicles (SPVs) either to facilitate the translation of capital market transactions into insurance transactions or as risk transfer conduits to enable securitisation of future income streams.

Management time: The owner of the SPC facility will provide the directors. This means any cell participants management time requirement is likely to be less than that required if owning a single parent captive.

Cell company considerations

Having highlighted the reason why clients may be interested in utilising a cell company structure there are certain considerations that go along with this, these include the following:

Participation or shareholding: Different cell company structures will have different requirements. Some operate on a contractual basis and will use a participation agreement only to document the relationship and the requirements of the cell, while others will use shareholder and subscription agreements. Those joining a cell structure need to determine what works for them; overall participation via a shareholding structure is felt to provide an additional layer of protection and evidence of segregation.

Collateral/security: Many cell company owners will require some form of security up to the aggregate limit of the programme being written to avoid any underwriting risk. For a fronted programme the reinsurer will likely use a trust, funds withheld, or a letter of credit to ensure funds are available to cover the projected loss fund. Often there will be an additional GAAP collateral requirement.

Limited recourse: Cell company operating agreements often include some form of limited recourse language. This language will make it clear the participant acknowledges that any obligation or liability of the SP is limited to the assets of the SP and any collateral provided by the participant and if such assets and collateral are insufficient to satisfy any such obligation or liability, the cell company will have no obligation to make up the insufficiency.

Underwriting risk: Some cell company owners will not permit cell formations if the cell plans to write business on a direct basis. The main reason for this is the perceived additional risk to the cell facility. If a cell operates on a reinsurance basis then the fronting company has ultimate responsibility to ensure claims are paid. Any cell deficit will affect only the reinsured and not the insured.

Solvency: The last thing a cell company owner will want is an insolvent cell as this has the potential to cause regulatory issue that can affect the whole of the SPC structure. For this reason the cell company operating documents will normally include a clause that requires any cell participant to make up any shortfall or deficit immediately.

Control: As the SPC as a whole is a legal entity directors will sit at the SPC level and will not be appointed by each cell. Therefore any cell wishing to make any changes to the existing cell, to write a new line of business or pay a dividend to the cell participant will need the SPC director’s approval. Of course such approvals will not be unreasonably withheld, but there is the potential for conflict.

Transactions with other cells: Under the SPC structure because the SPC as whole is the legal entity individual cells are unable to legally transact with each other. This means if a cell participant owned two cells in a structure one cell could not reinsure the other.

Incorporated cells

Because of some of the limitations of the cell company structure the regime was enhanced by the introduction of additional legislation which again started in Guernsey as so-called Incorporated Cell Companies (ICCs) were able to be formed, sitting under the existing cell ownership umbrella. In Cayman similar legislation was adopted where the incorporated cells are known as Portfolio Insurance Companies (PICs).

The main differences between a cell or SP and a PIC are as follows:

Legal entity: Being separate legal entities PICs are able to transact with each other.

Protection: A PIC structure provides an extra layer of protection for investors who may be concerned about the legal standing regarding the ring-fencing of liabilities within SPCs, particularly in foreign courts where the concept does not exist.

Directors: As it is a legal entity directors can be appointed to the board of the PIC. This means there is a greater control over the entity by its owners or participants. In practice in Cayman most cell company owners still require that at least one director of the cell company also serves on any PIC board just to make sure the individual PICs don’t do anything contrary to the cell company’s requirements.

Capital: Incorporated cells do require to be separately capitalised. In Cayman the existing solvency regime applies which means for a single parent PIC the minimum and prescribed capital is US$100,000.

Formation: The formation process closely follows the usual captive formation process and therefore in Cayman this means CIMA’s management committee will approve each PIC instead of the insurance division internal approval process for a cell.

Flexibility: Given each PIC is a separate legal entity it makes it easier should a PIC decide to convert to a standalone captive or if were sold to be merged into another entity.

The future for cell companies

Having reviewed the benefits and considerations for SPs and PICs it should be noted that since their introduction they have proved to be very successful. Looking at the Cayman statistics at 3Q 2021 there are a total of 144 SPCs that house over 600 SPs and 42 PICs.

The pace of SPC formations in Cayman shows no signs of slowing down. Driven by the formation of SPCs, individual SPs and/or PICs the industry continues to find innovative uses for such structures. These include new lines of business, customer-specific programmes or use in ILS transactions.

Here at Artex we have a number of owned cell facilities in different domiciles available for use by clients. These include a facility here in Cayman available to clients that help reduce clients’ dependencies on the commercial market going forward, while also we provide advice, infrastructure and ongoing management support.

Kevin Poole is director–business development, Artex Risk Solutions (Cayman) Limited. He can be contacted at: kevin_poole@artexrisk.com