The latest development for Cayman Islands segregated portfolio insurers
On 25 March 2013 the Insurance (Amendment) Law was enacted in the Cayman Islands to allow Cayman Islands segregated portfolio insurers to incorporate their cells. The Amendment Law, whilst now on the statute book, is not yet in force at the time of writing but will be brought into force once necessary amendments have been made to the underlying Insurance Regulations.
This legislation is, arguably, the most significant legal development for Cayman’s captive insurance sector since the introduction of segregated portfolio companies in 1998.
To learn more, Cayman Financial Review met with two lawyers who were closely involved in the development of this legislation, renowned tax and captive insurance specialist, Tom Jones of the Chicago office of McDermott Will & Emery LLP, and Paul Scrivener, head of the insurance group at Cayman Islands law firm, Solomon Harris.
CFR: What were Cayman’s principal objectives for the introduction of incorporated cell company legislation in its captive insurance sector?
TJ: As a leading offshore domicile, Cayman’s goal is to offer a broad array of captive structural alternatives. The incorporated cell creates an important addition due to several key beneficial attributes, which could be characterised largely as greater certainty of outcome, that are inherent in IC structures.
CFR: We understand that the legislation enacted is somewhat different from similar legislation in competitor domiciles such as Jersey and Washington DC. Can you explain why Cayman adopted a slightly different model?
PS: The Amendment Law provides a model for incorporated cells which differs from that in other domiciles in that it is specific to the insurance sector. The legislation amends the Insurance Law rather than the Companies Law and was deliberately crafted as a modification to the existing regulatory regime for SPC insurers rather than a major change to substantive law. The most important difference with the Cayman model is that cell incorporation is achieved by a separate company being established by the SPC underlying the relevant cell rather than the cell itself taking on incorporated status.
Cayman favoured a more conservative solution than competitor jurisdictions and preferred to rely on clear and well-established principles of corporate law. The concept of an incorporated entity underlying an SPC is readily understood and is essentially a parent/subsidiary relationship. An SPC insurer which wishes to incorporate one of its cells will set up a regular Cayman exempted company – in this context called a portfolio insurance company or PIC for short – which will be owned by the SPC insurer on behalf of the cell in question. Effectively, the cell will own the PIC and generally the PIC will, for all practical purposes, replace the cell. So if the cell has an existing insurance programme, going forward, that programme will be operated by the cell’s PIC and no longer by the cell. A PIC is simply a subsidiary of the SPC but tied to a particular cell of that SPC.
CFR: What are the main advantages that a PIC can offer compared to an unincorporated cell of a segregated portfolio company?
TJ: First, the efficacy of segregation in the cell world is not yet well defined due to a lack of court decisions. Whilst legal experts believe cell walls will be upheld in properly structured programmes, an incorporated cell benefits from strong case law around the world supporting corporate limitation of liability. Second, contracts between PICs, as well as between a PIC and the general account (core) or between a PIC and another cell, are legally binding.
This is not the case where a cell attempts to contract with one of its own sister cells. Third, PICs clarify the US federal tax status of offshore cell structures. Fourth, PICs as separate corporations have their own boards of directors in contrast to advisory committees for traditional cells. Finally, although both PICs and traditional cells legally can “hive off” from the core and become a stand-alone captive, because a PIC, unlike a cell, is a pre-existing corporation having its own memorandum and articles, board of directors, etc the process is less disruptive.
CFR: Will a PIC need its own insurance licence and how will it be regulated by the Cayman Islands Monetary Authority (CIMA)?
PS: A PIC will be regulated by CIMA but, as long as it remains a PIC, it will not need its own insurance licence. Instead it will operate under the umbrella of the licence held by the SPC insurer which controls it. The legislation provides for a straightforward registration process for each PIC with CIMA. The level of regulatory oversight that CIMA will have over a PIC will largely be the same as for an unincorporated cell. So, for example, audited statements reflecting the financial condition of each PIC will need to be filed with CIMA.
However, the ability for a PIC to simply register with CIMA applies only as long as the PIC is wholly-owned by the cell of a licensed SPC insurer. For example, if a PIC’s shares were to be sold to a third party the PIC would have to obtain its own insurance licence. Only a cell – or strictly the SPC acting on behalf of a cell – will be able to hold the voting shares in the PIC. In this way, the PIC will at all time by controlled by the SPC through a cell and hence why it is appropriate for the SPC insurer’s licence to extend to each PIC established by the SPC insurer.
CFR: The vast majority of Cayman’s captive business emanates from the US. We gather that there has always been a level of uncertainty about the US tax treatment of an individual cell of an offshore captive. Do you think that the use of a PIC will address this uncertainty?
TJ: Under proposed IRS regulations, for domestic cell companies (and series LLCs), each cell (or series) will be treated as a separate taxpayer and thus will file its own returns and make its own tax elections. In contrast, for foreign cells the regulations are very narrow. Only if the cell, considering just the activity occurring in that cell, constitutes an insurance company under applicable tax principles will it be treated as a separate taxpayer.
The regulations refuse to characterise foreign cells not qualifying as insurance companies on a stand-alone basis due to, for example, lack of risk shifting or insufficient risk distribution. Worse, in many cases it’s not completely clear whether a cell will pass all the insurance company tax tests. So the tax status of that offshore cell is in limbo. In contrast that same cell would have been a separate taxpayer had it been formed onshore in the US as part of a domestic cell company. Again, PICs come to the rescue. Because PICs are indistinguishable in legal format to foreign corporations, it would seem axiomatic that they will be respected by tax authorities as separate taxpayers notwithstanding their being part of an incorporated cell company structure. This is a major benefit for federal tax clarity.
CFR: If an existing segregated portfolio company insurer has a number of cells already operating their own insurance programmes, how easy will it be for some or all of those cells to transition to PICs without any operational dislocation?
PS: You raise a very good practical point. The benefits that a PIC can offer would be lost if the transition of an existing programme from cell to PIC were cumbersome and time-consuming. In developing the Amendment Law we were very mindful of the need for a streamlined process for novating assets and liabilities. This is addressed by the Amendment Law providing for an automatic novation by operation of law by simply filing with CIMA a straightforward declaration sworn by two directors of the SPC containing certain prescribed particulars and obtaining creditor consents. Thus, a formal novation transaction is avoided.
CFR: We had heard that there is considerable appetite onshore in the US to use PICs with some projects even on hold awaiting the legislation coming into force. Could you outline some the examples that you are seeing of how PICs might be used and indicate the business and, perhaps, tax drivers?
TJ: I think two specific illustrations might help:
A global construction company engages in numerous mega-projects with large joint venture partners. It proposes an OCIP or CCIP program to roll up each project’s risks into a separate risk pool. But the JV partner requires direct governance input as a condition of agreeing to participation in the insurance programme. Only a PIC-type structure will address this factual scenario. As is typical, each project will be placed in a separate cell. But a traditional cell doesn’t work because the construction company won’t allow the JV partner to have a representative on the cell captive core board. That board oversees many projects in which the JV partner is not involved. Using a PIC solves the problem. The JV representative is placed on the relevant PIC board and the insurance programme proceeds.
A healthcare system maintains two offshore captives formed in the Cayman Islands, originally not combining them due to the distinct differences in their parent hospital affiliates. One is a specialized children’s hospital and the other a general all-specialty community hospital. Each captive has a separate board of directors expert in the medical professional liability exposures inherent in operating that particular type of hospital. Now that PICs have become available, the two captives plan to convert to two ICs and continue the same separate board structure as previously, but attached in a single ICC structure.
CFR: The legislation is insurance specific. Do you see the opportunity to extend the PIC model to other areas of Cayman’s financial services industry?
PS: The legislation was developed to address a pressing need in Cayman’s insurance sector and so does not extend to other sectors of Cayman’s financial services industry. It is uncertain at this stage how much wider appetite there may be. However, I do see potential interest for hedge funds in that it is not uncommon for the sponsor of a hedge fund set up as an SPC to want to have the ability for one cell (sub-fund) to be able to invest in another cell (sub-fund) of the same SPC. This is not currently possible under Cayman law because contracts between two cells within the same SPC are not legally enforceable. It will be interesting to see whether this sort of innovation will be taken up in other sectors of the industry.