The Big Bang Theory vs cell captives

If you spend a few hours watching the sitcom series, The Big Bang Theory, then you will no doubt encounter the ‘Fun with Flags’ vlog, co-hosted by characters Dr Sheldon Cooper and Dr Amy Fowler. The vlog within a sitcom dives into the incredibly nerdy world of flags, with sometimes hilarious outcomes. In the world of insurance, this vlog would likely be unseated by ‘Fun with Cell Captives’ perhaps hosted by Danny Joffe, Head of Legal at Hollard Insure.

The parachute analogy

The ‘fun’ part of these vlogs derives from the unbridled passion that the presenters, and by association their audiences, have for the subject matter. Joffe demonstrated the requisite level of enthusiasm for cell captive insurers during his recent presentation to the popular InsureTalk initiative. “This is a great opportunity for us to discuss one of the big, topical areas within our insurance law,” he gushed, before launching into his presentation. He opened with a wonderful analogy of cell captives as a form of insurance ‘parachute’ and hence the need to get the structure 100% right the first time… It is, after all, quite unpleasant to only learn that your parachute is not working the moment you pull the release to deploy it. 

“The financial, regulatory and reputational impact of a cell captive deal or relationship make it important to get things right up-front,” Joffe said. He added that local insurers had walked a long path with the cell captive structure, but that there was still a long journey to complete before regulatory certainty was reached. One of the reasons there is so much ‘mystique’ around the structure is that not all insurers offer cell captives, and those that do are often viewed as being boutique insurers. The best way to understand this complex sector is to consider the basic definitions of what a cell captive insurer and / or structure is.

Ring-fenced insurance schemes

Cell captives were originally regulated under the old Short-term Insurance Act, since overtaken insofar as prudential regulation by the Insurance Act, 2017. “A cell captive is a ring-fenced insurance scheme which tracks the profit and loss of that scheme in addition to accounting for its capital requirements, premium, reinsurance needs, and claims,” Joffe said. He added that it helps to think of the full balance sheet of an insurer being run within an insulated cell. The cell “issues a special class of shares to the owner of that cell, who enters into a shareholders’ agreement with the cell captive insurer, also called the cell underwriter”. Shareholders earn dividends depending on the success of the scheme, and in accordance with the shareholders’ agreement. 

The cell captive insurer can issue different classes of shares, thereby allowing it to operate numerous, independent cell captives. “Each cell has separate capital requirements and is separately underwritten so, in theory, even if one cell has problems it in no way impacts the other cells that are operating,” Joffe explained. As currently set out, the regulation holds the cell captive insurer responsible for all conduct related matters across its cell captives. “The regulator looks to the insurer for any issue that may arise from within a cell captive relationship,” he said. In other words, the insurer is on the line for treating customers fairly (TCF) failures; claims hiccups; financial challenges within the cell, etc. According to Joffe, there are a lot of benefits to running a cell, which explains the structure’s growing popularity among certain market segments. However, before considering this arrangement, cell owners must be aware of the capital required and the demands that go with managing and operating an insurance business. 

Conflict in broker and NMI participation

The ‘dry’ part of the InsureTalk presentation focused on cell captives as presented in the Insurance Act. To begin, a cell is described as “an arrangement under which a person, the cell owner, holds an equity participation in a specific class or type of share, with equity participation that is administered and accounted for separately”. According to the Act, any cell owner is entitled to a share of the profits by way of a dividend. Joffe commented on the unique challenge presented by brokers or non-mandated intermediaries (NMIs) who were cell owners, due to “binder holders and NMIs not being allowed to earn profit from such schemes”. He also observed that it was possible to achieve cell-like results without entering into a shareholder’s agreement with a cell captive insurer, through something called a ‘similar arrangement’… 

The regulator has many concerns over the conduct, due diligence and risk management roles that a cell captive insurer plays in overseeing cell captives. “An obvious conduct issue arose from brokers and NMIs owning cells through the conflict of interest in receiving a share of the profits,” Joffe said. This challenge has been somewhat addressed through a ‘carve out’ for cell captive structures within the binder regulations. At present, “we have a situation where a cell captive structure is still allowed to operate in the same way as it always has”. And for the time being it seems the regulator is unlikely to pull the plug on cell captives that are structured in this way. 

New licensing regime appears inevitable

They regulator is, however, considering requiring cell captive insurers to be separately licensed, and having to apply for separate licences for first- and third-party cells. In a recent newsletter covering Yard Insurance’s ‘take’ on cell captives, we offered a basic explainer of first- and third-party cell captives. Joffe gave his description of these constructs too. He referred to a first party cell as a type of self-insurance mechanism where the cell owner is the only policyholder; there are no other consumers or third parties in the cell. A third-party cell is a structure through which policies are sold to many consumers. 

From a prudential point of view, the main regulatory concern is that insurers maintain proper risk mitigation procedures across their cell captives. “There must be adequate governance and management arrangements [and insurers must ensure] appropriate information and data management within the cell structure,” Joffe said. In addition, insurers must conduct regular assessments of the creditworthiness of the cell owner and ensure that the investment strategy and investment mandate in the cell is aligned with the overall investment strategy of the insurer. 

Much of the second half of this presentation focused on the potential conflicts that arose from NMIs being cell owners. Conflict creeps in due to the broker or NMI earning a share of the profit generated from the cell, which profit is influenced by the broker’s choice of insurer and / or the administration of claims within that cell. “A broker that sells a policy gives the perception to the client that they are independent, acting on the client’s behalf, and prepared to fight for the client in terms of getting the best deal from an insurer,” Joffe said. The profit motive could prompt a range of poor behaviours from an NMI, such as pushing the best risks into the cell without considering alternative solutions for such clients. 

Insurers likely to be more hands-on

At this stage, the regulator seems keen that an NMI be a tied agent to the insurer for all products that they perform financial services for in that cell structure. “The cell captive owner, the NMI or the financial services provider (FSP) would have to be a tied agent of the insurer and only support one insurer for all their business,” concluded Joffe. “And the insurer would have to make sure that there is proper conduct oversight, including that there are no poor outcomes for customers and that any potential conflict of interest does not prejudice customers in any way”. The consequence: cell captive insurers will have no choice but to interfere within cell captive structures to make sure they are TCF, and that customers are getting a good deal. 

Writer’s thoughts:

The regulation of cell captive insurers has been in a type of limbo since the regulator first set eyes on the construct, back in 2012. Aside from a few minor TCF tweaks, it seems more-or-less business-as-usual for major ‘players’ in this space. Are you surprised by the slow pace of regulation in the cell captive space? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].

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