SHOULD YOU CONVERT YOUR CAPTIVE TO AN SPC?

By Kay Carter

Cayman’s progressive protected cell legislation permits conversion of an existing captive into a segregated portfolio company.

Protected cell companies, called segregated portfolio companies or SPCs in the Cayman Islands, continue to be used for a variety of purposes in the captive insurance industry. It can be cost efficient to use SPCs as captives because the cells of a captive SPC are covered by the single insurance licence issued to the SPC, thereby reducing the operating costs that would have applied if the program(s) in each cell had been operated through separate captives.

The feature that makes SPCs desirable and particularly useful as captives is that they are able to create any number of cells with assets and liabilities that are statutorily ring-fenced from each other and generally from the core of the SPC (the core being the assets and liabilities of the SPC that do not relate to any particular cell). As a result, a creditor dealing with one particular cell of an SPC would only have recourse to the assets of that cell and would be denied recourse to the assets of other cells of the SPC. Such a creditor would also be denied recourse to the core assets of the company if the constitutional documents of the SPC provide that the core is not liable for the excess liability of any cell. Ring fencing allows insurance programs carried on by different cells to be “firewalled” from each other as if the programs were carried on through separate captives.

For any Cayman captive considering a conversion to an SPC, the first thing to assess is whether there is a good business case for it. This is fundamental and whilst obvious sometimes the issue is not fully explored. There is often a misunderstanding about what an SPC is and what it can offer. Legally, an SPC is one company; the cells are not separate legal entities. Simplistically, an SPC with cells is similar to a North American company with divisions of its businesses with the important distinction being that each cell of an SPC has statutory protection from creditors of the other cells (the ring fencing).

However, It is not possible to carry out risk pooling within one SPC that has cells without resorting to the recent amendments to the Insurance Law that will, once enacted, allow a cell to create a company, called a portfolio insurance company or PIC. PICs will be discussed briefly below.

So, when would an owner consider converting a captive to an SPC? The recent mergers and consolidations of healthcare systems in the United States have resulted in situations where the merged system has more than one captive, sometimes in different jurisdictions. An owner of a merged system may want to reduce the cost of having more than one captive while maintaining separation of the insurance programs for performance tracking or other reasons. In this situation, the captives might be merged with the surviving captive usefully converted to an SPC. Each of the insurance programs formerly carried on by the captives could be transferred to cells or, in the alternative, the core could operate the “old” insurance programs and the cells could be used to create new programs.

Another situation where an owner might consider converting a captive to an SPC is when there is a desire to expand the insurance programs offered to other areas of the owner’s business. For example, a healthcare system might want to offer groups of physicians medical malpractice insurance through a cell of an SPC. Even if the physicians already have a captive, the physicians’ captive could be placed into run off and new insurance placed through a cell for the physicians. In the alternative, there could be a loss portfolio transfer from the physicians’ captive to a cell.

Gazing into the crystal ball, it seems likely there will be an ever increasing number of captives using or converting to the SPC structure.

Some owners convert captives to SPCs because they find themselves wishing to expand their captive insurance structure to outside parties, so they effectively become rent-a-captives. Most of the early rent-a-captives were created to provide similar insurance coverage for the cell owners (e.g. workers compensation benefits). Whilst it is still highly desirable for the cells of one SPC to provide similar types of insurance, some SPCs have been created in situations where the similarity is in the businesses carried on by the owners of the cells, not in the types of insurance provided.

Examples of a possible expansion of insurance programs by using SPCs might be to offer the use of a cell to other healthcare systems in the same region or to affiliated educational institutions that carry on clinical trials. It seems that the potential use of SPCs is only limited to the imagination of those who advise on creating them.

An amendment to the Insurance Law in 2013, which has been passed but is awaiting passage of regulations before it is enacted, created incorporated cell legislation which the Cayman insurance industry believes will further bolster the use of SPCs. The incorporated cells are called portfolio insurance companies or PICs. Under the new legislation, a cell may create one PIC. There is a process to automatically transfer the cell’s assets and liabilities to the PIC (with a provision to opt out should the cell wish to retain prior year business). As in the case of cells, PICs are covered by the SPC’s insurance licence.

The perceived advantages of PICs include the fact that they are separate legal entities, thereby allowing risk pooling within an SPC and creating more certainty regarding treatment by the IRS. In addition, a PIC has its own board of directors who need not be members of the SPC’s board, which enables a cell owner who is a director to have direct input into the management of the PIC’s business. Last, but not least, there is an easy transition if the owners of a PIC decide that they want a stand alone captive. All of these features enhance the attraction of SPCs and potentially aid in making a solid business case for conversion.

Once the business case to convert a captive to an SPC is made, how difficult is the process to convert to an SPC? The regulatory process is relatively straight-forward and would typically not take more than 4 to 6 weeks. As you would expect, the written consent of the Cayman Islands Monetary Authority (“CIMA”) is required and this will be applied for by the captive manager. CIMA will want to have a clear understanding of how the new structure will operate and will require an updated business plan in relation to the core and each of the new cells to be set up.

Having obtained CIMA approval, it will be necessary for the voting shareholders of the captive to pass a special resolution authorizing the transfer of the captive’s assets and liabilities into cells.
In addition to regulatory approval, the legislation requires that each creditor of the captive must consent in writing to the transfer of assets and liabilities into cells.

In the alternative, if adequate notice, defined as notice in writing to all creditors which are owed CI$1,000 (US$1,220) or more, is given and ninety-five per cent of those creditors based on the value of the amount owed consent, the conversion may proceed.
In most cases, the creditors of a captive will comprise policyholders with outstanding claims and professional services providers with outstanding fees. The more problematic issue is whether contingent or prospective creditors have to be taken into account and this has not yet been considered by the Cayman courts in the context of the SPC legislation.

The Cayman case, Brac Construction Ltd v. Broome & Broome, considered the standing of a creditor to issue winding up proceedings. That case leaves open an argument for saying that a contingent or prospective creditor claiming an unspecified sum would not be a creditor of a captive and therefore need be involved in the creditor consent process. However, this is only an argument, not settled law, and therefore a cautious approach should be adopted.

Timing constraints or administrative issues may make obtaining creditor consents problematic. If that is the case and the SPC is being established to separate an existing program from new programs which are being set up from scratch, one possibility is to retain the existing program in the core of the SPC, rather than transfer that program into its own cell, and then establish cells only for the new programs being created. In this way, no assets and liabilities of the captive are being transferred into cells and therefore the consent of creditors is not required. The reason why creditor consent is not required where the existing business is put in the core is because creditors of the existing program are not prejudiced by the conversion; the assets available to them prior to conversion remain available to them in the same way after conversion.

To effect the conversion, the Cayman Islands Registrar of Companies requires the filing of a declaration signed by at least two of the captive’s directors. The declaration must deal with a number of matters. There must be: (a) a statement of the current assets and liabilities of the captive (current means not more than 3 months old), (b) details of any material changes in those assets and liabilities since the relevant balance sheet date, (c) confirmation that the SPC into which the captive wishes to convert intends to operate, (d) details of the assets and liabilities which the captive proposes to transfer into cells, (e) confirmation as to solvency of the captive as of the date of conversion and (f) confirmation that the creditor approval process has been completed.

There must also be attached to the declaration a copy of the special resolution of the shareholders of the captive authorizing the transfer of assets and liabilities into cells together with the letter from CIMA approving the conversion. As part of the conversion process, the captive will also adopt new articles of association suitable for an SPC and restructure its share capital, so revised and restated memorandum and articles of association need to be filed with the Registrar.

The provisions of the legislation permitting the conversion of an existing captive to an SPC strike a careful balance between the need to facilitate conversion wherever it is commercially appropriate and the need to protect both the shareholders and creditors of the captive being converted. In view of the increasing importance of SPCs to the Cayman Islands insurance industry (as at 30 September 2014 there were 138 Cayman SPCs with total premiums in excess of US$751 million) and with the imminent availability of PICs, gazing into the crystal ball, it seems likely there will be an ever increasing number of captives using or converting to the SPC structure.