The use of a first party cell captive as risk retention mechanism
WE ARE OFTEN ASKED TO EXPLAIN CELL CAPTIVE STRUCTURES AND WHY OR HOW THEY ARE UTILISED BY BUSINESSES. A cell captive is simply a preference share (or B-class ordinary share) issued by a suitably licenced insurer to the preference share holder. The preference share is coupled by a preference share agreement, which confers certain rights and obligations on the shareholder and the insurer.
The main features include:
the right of the shareholder (cell owner) to share in the profits of a specified book of insurance policies; and
the cell owner’s obligation to recapitalise the cell should there be significant losses which erode the cell’s capital base. Capitalisation and recapitalisation of the cell is by way of a cash injection into the insurer, who allocates the capital (determined in accordance with the Prudential Standards issued by the Prudential Authority) to the cell. As such, a cell captive is a ‘mini’ insurance company, owned by the shareholder and administered by the insurer. GROUPS UTILISE FIRST PARTY CELL CAPTIVES A distinction is made between ‘first party’ and ‘third party’ cell captives in the Insurance Act 18 of 2017. In terms of the Act, ‘first party risks’ are, in respect of a cell captive insurer, the operational risks of the cell owner and the group of companies of which the cell owner is part. An example of a first party cell captive is a group holding company that:
holds a preference share in an insurer; and
utilises the insurer’s licence to issue insurance policies to its subsidiaries. Why would a company do this? It all comes down to its strategy around (a.) risk retention and (b.) risk appetite. A FORMAL RISK RETENTION STRUCTURE Risk retention is a company’s act of taking responsibility for a particular risk it faces as opposed to transferring the risk to an insurer. Informal mechanisms of risk retention include:
excesses/deductibles on insurance policies; and
deliberate non-insurance. A cell captive on the other hand is a formal risk retention structure. A company’s choice of risk retention mechanism depends on its financial sophistication and the particular risk management challenges it faces. GROUP RISK APPETITE MAY BE HIGHER THAN THE SUM OF THE PARTS Risk appetite is the level of risk that a company is prepared to accept in pursuit of its objectives before action is deemed necessary to reduce the risk. ‘Action’, in this case, could be the requirement to purchase insurance from the market. The group in the example above may consist of a number of subsidiaries, each with its own management who require insurance protection. It is important to note that the group’s risk appetite may be significantly higher than that of the individual subsidiaries. In fact, the group risk appetite may even be higher than the sum of the subsidiary parts’ risk appetites. The question, therefore, is how to provide the individual subsidiaries with protection whilst retaining a higher level of risk at the group level… This is where the first party cell captive comes in. A NEAT SOLUTION The cell captive provides the group with a neat solution to have insurance policies for full cover issued to the individual subsidiaries, whilst allocating the book of policies to the cell owned by the group. The individual subsidiaries pay premium (preferably market related) to the insurer for full cover, and the insurer allocates these premiums to the cell. At a group level, management decides on its risk appetite. Above the group’s risk appetite, conventional reinsurance is purchased from the market, by the insurer, who allocates the costs to the cell. The result is that a level of premium is retained in the cell which is utilised to fund the group’s risk appetite and build financial capacity to retain higher levels of risk in future.
By Alfons van der Vyver, Executive Head: Risk Finance Solutions, Centriq Insurance