De-Mystifying Cell (Re)Insurers

            Copyright 2024 Charles F. Barr, Esq.

The major differences between a traditional and a cell re/insurer, especially a cell also operating as a collateralized re/insurer, are: a cell is typically not a legal entity and thus records its assets and liabilities using a “virtual balance sheet”; there is legal segregation of the cell’s assets and liabilities from other cells and the core company even when the cell is not a legal entity and is using a virtual balance sheet; its virtual balance sheet might include only a single contract or be used only for a limited number of years; the cell will likely seek to exactly match its assets to its liabilities and thus starts without any surplus and likely does not seek to retain any it creates (by dividending out profits); and there should be an enforceable legal release from any further insurance or reinsurance liability once the cell’s stated re/insurance obligations end or the limited amount of pledged collateral is exhausted.

            A cell company is a legal entity that can be licensed as an insurer or reinsurer. The legal entity creating the cells is sometimes referred to as the “core company”. A protected cell company creates “protected cells” which are merely accounting entries created by the legal entity’s Board resolution. [An incorporated cell company creates “incorporated cells” which are actual corporations.] The legal entity cell company’s purpose is not to conduct business as a legal entity via its “general account” and actual balance sheet, which often holds only the minimum capital required for licensing. Instead, the legal entity exists only to create cells and to execute legal acts solely for the benefit of its protected cells using assets allocated to them, which cells (whether protected or incorporated) are the actual operating units using only their virtual (or actual) balance sheets.  

Contracting. Each cell conducts business as an individual unit on the strength of its actual or virtual balance sheet. Visually, it’s as if a protected cell’s counterparty was conducting business with a “page of a general ledger”, rather than with a legal entity. A cell enters into an insurance policy or reinsurance contract of its own, which for protected cells must be executed by the legal entity on behalf of the specific cell, because it cannot legally contract for itself. [An incorporated cell can contract on its own as a legal entity.] The statutes describe the assets of the legal entity as being “linked to” the cell; as are the cell’s liabilities.

Ownership of the Cell Company Legal Entity. The cell company legal entity is owned by the holders of its common voting shares – and not by investors in the operations of a particular cell. Investors in the operations of a particular cell typically receive non-voting preference shares from the legal entity which do not vote regarding the affairs of the legal entity but can vote on the operations of the cell. Cash raised by the investment is allocated to the virtual (or actual) balance sheet of the cell responsible for the capital raise for it to use in its business operations as a cell re/insurer.

The profits of a successful protected cell’s business can be distributed to the preference shareholder investors whose cash was allocated to that particular cell. This is not a dividend on common shares paid to the owner of a legal entity. It is a distribution of segregated profits from the segregated business conducted by a cell. Holding company law (e.g. in the U.S.) limits an insurer’s payment of “extraordinary dividends” without regulatory approval. Distributions by U.S. cells to their capital providers should not be so regulated or restricted since they are not dividends on a common stock which controls the re/insurer legal entity. That distributed income is like interest earned on your savings account at the bank (which is different than participating in the earnings of the bank itself).

Ownership and Use of Cell Capital. Each protected cell raises its own capital via preference shares issued by the legal entity to the cell’s investors, who are “beneficial owners” of the cell’s assets, i.e. they have rights to the use, income and value of the assets without having legal title to the assets. Investors thus have property rights in the cell’s assets. The legal entity cell company issues common or ordinary voting shares to its shareholders, who hold legal title to the cell company and direct the operations of it as a legal entity. Preference shares issued to investors in a protected cell can vote on the operations of the cell into which their cash is allocated, but not the operations of the legal entity cell company itself.

Each protected cell operates its business with the capital it brings into the legal entity. By statute and contract the assets and liabilities of a cell are not those of, and cannot be claimed by, another cell or the legal entity which created the cell, or by creditors of either. This absence of “liability contagion” – among cells of the legal entity and between a cell and the legal entity which created it – exists by statute, contract and accounting principles.

An incorporated cell company takes that segregation one step further because each of its cells is a corporation, which may require each incorporated cell to get its own license. [A protected cell operates off the insurance license of its legal entity re/insurer.] The same principles of segregated assets and liabilities exist with incorporated cells but are reinforced by the fact each cell is a corporation – but is nonetheless a part of the incorporated cell company legal entity.

A protected cell’s investors “own the business results” of the cell account and can be beneficial owners of the assets allocated to the cell. But the investors do not own the legal entity re/insurer which created the cell. There is no “title” to a protected cell since it is an accounting entry (or “page of an accounting ledger”). It’s like owning the assets in your savings account at a bank – without owning the bank itself.  

By statute and contract the assets of each cell are its own and are not available as assets of other cells or of the legal entity (and vice-versa). Similarly, a cell is not responsible for the liabilities of other cells or of the legal entity (and vice-versa). Thus, it is not appropriate for there to be any claim of “ownership” of a particular cell – or its assets – by any other cell. Or by the legal entity which formed the cell. Or by any creditors of the legal entity or by creditors of another cell.  

Think of each protected cell as if it was a separate corporation – and each incorporated cell is in fact a separate corporation. However, since a protected cell is not a legal entity, the legal entity must contract for the benefit of the cell, which contractual documentation states such (e.g. “ABC Re/Insurer, on behalf of its Cell No. 1”, …).

Re/insurance contracts with a cell re/insurer typically contain a covenant against the counterparty filing any petition for winding up or for insolvency of the cell or of the legal entity cell company – which the contractual counterparty might attempt if it asserts it was not fully paid by the protected cell. Not being a legal entity, a protected cell cannot be wound up. Any attempt to wind up the core company legal entity as a possible avenue to get at assets of a protected cell – so as to satisfy the unpaid obligations of one of the protected cells – should fail as a matter of contract law and statute. Unless a court in the cell’s domicile were to intend to use its discretion to pierce the contractual and statutory bar against a different cell or the core company being obligated for the liabilities of the insolvent cell. Any such judicial disrespect for the concept of cell companies might doom that country as a domicile for cell companies.

A collateralized insurer can be a traditional corporation or a cell company which chooses to place only a limited amount of assets at risk to match its limited obligations. The contracting entity first states an absolute limit on the legal entity’s or the cell’s obligations via the coverage grant, exclusions, limits of liability or other provisions of its re/insurance contracts, then fully collateralizes those limited liabilities. This contracting with third parties can be done on a cell-by-cell basis if the collateralized re/insurer is a cell company (i.e. each cell can issue a policy or treaty and have a dedicated bank account and trust account). This matching of a cell’s assets and liabilities and the lack of recourse beyond the stipulated collateral of the particular cell is supported by statute and the re/insurer’s prominent contractual provisions and disclosures.

If the collateralized re/insurer is a cell company: the liability from the transaction is limited by the terms of the transaction contract; the liability of the cell conducting the transaction is limited by corporate law and the contract (to either the assets of the cell or to a lesser amount such as the balance in a trust account); and the liability of the cell’s investor is limited (as always) to the amount of its investment. Ring-fencing cubed. With no legacy liabilities.

The re/insurer’s contractual counterparty (i.e. the policyholder or cedent): (1) should be aware there are contractual limitations on the liability of the risk-bearer and the assets available to pay such limited liability – if the deal is for collateralized re/insurance; (2) should understand the inability of one cell to invade the assets of other cells or the legal entity re/insurer’s “general account”; (3) should be aware the risk-bearer likely has no surplus (either existing, or intended to be made available as a cushion for any increase in its obligations – which are meant to be finite); and (4) is usually required by the transaction contract to covenant not to force bankruptcy on the re/insurer for nonpayment by its cell (because the re/insurer’s limited liabilities act to release it from any further obligation, which is “the deal”, that should not be circumvented by an insolvency petition).

No Surplus; Party’s Expectations. A collateralized re/insurer operates on a “cash box” basis with a contractual limitation on its obligations that can only be satisfied from the matching amount of assets on its limited balance sheet (which is a “virtual balance sheet” in the case of a protected cell company). There is no need or plan for “surplus as regards policyholders” to be available for unexpected liabilities or adverse development which could cause the protected cell’s Losses and LAE and its reserves for Loss and LAE to exceed premiums collected and the limited amount of assets matched and devoted to its limited amount of liabilities.

When the cash box is empty, its matched liabilities also end by operation of law and contract. This differs markedly from traditional re/insurers which assume liabilities onto the same balance sheet over many years and from many contracts and must retain surplus in addition to its reserves for its liabilities. Each contract of traditional re/insurance will have limits and exclusions, but there can be additional expenses, findings of coverage and piercing of intended limits of liability arising from interpretations by courts or arbitrations. Traditional re/insurers, unlike cell re/insurers, have not taken the step of creating an absolute limit on their liability as an entity – for what are likely a more limited number of contracts or obligations – and thus, traditional re/insurers need surplus to operate commercially and soundly. Cells do not.

Thus, investors in a cell company operating as a collateralized re/insurer can uniquely limit their liability: (1) to the amount of their investment (as usual); (2) to the amount of assets allocated to the cell as counterparty; and (3) to the specific amount of a cell’s collateral that was pledged as the sole recourse for the transaction. This limitation on assets and recourse can be unfamiliar to a counterparty. However, industry participants using collateralized cell re/insurance (as a sophisticated form of self-insurance) should face such limited recourse with greater understanding and acceptance of the concept.

            Segregation and Consolidation. U.S., Guernsey, Malta and ROW provide for both a protected cell company and an incorporated cell company. Bermuda calls cells “segregated accounts”; Cayman calls them “segregated portfolios”. Depending on the country, it may take an ICC legal entity to be able to create incorporated cells.

An incorporated cell company might be chosen when the separateness or standalone legal status of the cell is considered most critical – possibly motivated: to further reinforce the avoidance of “liability contagion”; if the sponsor wishes the cell (perhaps in addition to the core company) to be a “corporate orphan” (i.e. owned by a trust) as an architectural feature of its tax or non-consolidation planning; or to possibly eliminate any motive for an unsatisfied creditor of a protected cell company to attempt to petition the legal entity PCC into winding up as a possible aid to breaking the defenses against liability contagion.

Regarding corporate orphanism, a cell company might have its voting common shares owned by a trust and not by the group sponsoring the cell company. Such separation of the ownership of the cell company from the sponsoring group might be to enhance a conclusion on non-consolidation of the cell company’s operations onto the balance sheet of the sponsoring and owning group.

It naturally is the sponsoring group’s tax and accounting advisors who will determine any consolidation of the cell company. Which determination might be based in part on “orphanism” (i.e. having a trust be the owner of the cell company’s common stock). However, non-consolidation is more likely decided based upon whether the sponsoring group participates in the economic benefits of the operations of the cells of the cell company. If the sponsoring group only owns common shares of the legal entity cell company (which does not operate and exists solely to create cells), and thus does not share in the economics of the cells (which do operate and “own their results”), consolidation of the cell’s assets and liabilities onto the sponsor’s balance sheet might be avoided.

The economic benefits of a cell’s operations are traditionally shared only with investors holding preference shares obtained in return for their investment of cash, which is allocated by the cell company legal entity to that operating cell (to which it is “linked”) and its virtual balance sheet. Thus, the cell’s results are likely not consolidated with those of the sponsor – which is the likely owner of the common voting stock, but which does not share in the cell’s results.  

Cell Uses. A cell operating as a collateralized re/insurer is a common structure for industry participants forming such a Special Purpose Vehicle for various corporate initiatives and ILS transactions, such as:

-        A captive re/insurer owned by a single parent or industry group (e.g. owned by hospitals to cover members’ liability or their welfare benefits) or similar form of a sophisticated self-insurance program – which SPV is created to benefit the owner-policyholders;

 -        A ceding insurer wishing to retain more risk than is normally ceded into the traditional reinsurance market by having its traditional reinsurers retrocede to an SPV-reinsurer the cedent formed with its own capital – which SPV-reinsurer is created to benefit the cedent insurer (alternatively, the SPV-reinsurer might instead directly reinsure the cedent as “front” and retrocede to traditional reinsurers acting as retros behind the thinly-capitalized SPV-reinsurer);

-        The same transaction as above, except the SPV-reinsurer issues catastrophe bonds so that investors fund this sophisticated self-insurance structure sponsored by the ceding insurer – which SPV-reinsurer is thereby created to also benefit its cat bond investors;

 -        Use as a “transformer” in which a derivative contract is used by the cell to assume inbound risk (which derivative transaction is a substitute for “insurance”) which cell-SPV-transformer hedges that assumed liability via the cell-SPV-transformer’s purchase of re/insurance. Or vice-versa (i.e. using a cell to assume inbound insurance then hedge it via a derivative). Thus, the initial risk transfer might be via a derivative that is hedged via reinsurance. Or the risk transfer might be via re/insurance that is hedged via a derivative. Of course, there are accounting and tax issues to resolve.

Conclusion. Cell companies (both protected and incorporated) can be used for a variety of transactions as re/insurers, investment funds, derivative counterparties and transformers. When operated on a collateralized basis, they uniquely limit the amount of risk assumed, then fully collateralize it as the sole recourse. Such limitations on the risk transfer and the limited recourse built into the structure can be advantageous to investors and risk-bearers, but need to be clearly understood by counterparties and creditors.

End.