Cell Captive Overview

A protected cell company (PCC) is a legal entity that can be considered as a condo of insurance. A PCC facilitates a turnkey solution for companies by offering clients an individually protected cell that is insulated from the risk of other cells within the PCC; each condo operates as its own captive (with certain restrictions) and does not share risk or rewards with the other condos in the building (PCC). PCCs can vary in type and operational structures. The underlying principle of a PCC is that they are established by a sponsor that funds the capital required by the core. The sponsor is also responsible for ensuring other captives operate within the business plan parameters of the PCC. Clients benefit from a PCC as they spend less time and resources on the operational and establishment activities for the program.

When cell captives were first introduced to the market, they were largely in the form of unincorporated cells, where participation and service provider agreements worked to protect the sponsor’s investment rather than through structural protections.

The model for cell captives has evolved to allow more control for cells with the establishment of incorporated cells. Incorporated cells allow cells to even have their own Board of Directors at the cell level.

Regardless of the type, any cell captive structure allows constituents to benefit from pooled administration, but not from pooled risk, as each cell is independent. Sometimes a company will own multiple cells within the PCC, which are all treated individually.

Cell captives are attractive risk funding vehicles because they offer:

• Easy entry. Cell captives are turnkey and can be established quicker and in a more efficient manner compared to standalone captives.
• Economies of scale. Administrative savings are generated as the costs are pooled across cells.
• Professional captive management. Typically, cell owners can be fairly hands-off with built-in program management.

In addition to being a great solution for small and mid-sized companies, cell captives align with a range of other use cases and can be flexible in structure and purpose, for example:

• A captive owner may want to reform a pure captive into a cell captive to allow different Joint Ventures of the parent company to be insured through cells jointly.
• An organization can use a cell captive to separate higher risk areas of the business, without impacting the rest of the captive. For example, each business unit could head up an individual cell. For instance, an organization may view it advantageous for senior management of each of its subsidiaries to own cells that insure the subsidiaries they manage. In this case, each entity, whose risk profiles may vary greatly, would have its own cell that is run independently but still in favor of the parent organization.

Cell captives were once most commonly leveraged by mid-sized companies entering captive funding for the first time and seeking lower barriers to entry and extra assistance. While still a great fit for mid-sized companies, market conditions are driving more and different types of organizations toward cell captives.

The Surge in Cell Captive Demand

In more recent years, we have increasingly seen large multinational organizations entering the cell captive space, in establishing and owning the entire structure as part of their enterprise risk management strategy. In addition to the basic cell captive advantages listed above, other driving factors that may be of interest include:

• A lower required upfront capital investment, as compared to a standalone captive
• Greater ability to meet different business objectives at once, as well as to adapt
  • It is simpler to add a cell to an existing program than it is to set up a new single parent captive for a different line of coverage. On the other hand, it is also relatively easy to “phase out” a cell that was insuring a critical risk two years ago, but that risk or the level of need is no longer there today.
• While all captives offer flexibility over commercial market solutions, cell captives are unique in that each individual cell can be in the form of a reciprocal, a risk retention group (RRG), a limited liability company (LLC), a non-profit, and other types without the need to match each other
• The ability to write third-party risk while leveraging capital and surplus from an additional captive program

Hard insurance market conditions as well as the landscape for emerging risks are making cell captives even more attractive. While often a good fit for more traditional lines, more and more cell captives today are being used for risks like voluntary benefits, cyber insurance, and excess liability. Further, more domiciles have passed cell captive legislation in recent years, opening doors to many.

As with any assessment regarding alternative risk financing, always start with a feasibility study. While cell captives are growing in popularity and advantageous for many, a thorough analysis of the pros, cons, and other contributing factors specific to your organization, its risk and its objectives, is necessary before any decision is made.

A critical starting point in setting up a captive is the captive feasibility study. Captive feasibility studies come in many forms, and there are no industry standard report formats. As a result, many captive owners do not know what to expect as a final deliverable, and we see many feasibility reports that are severely lacking.

The feasibility study forms the cornerstone for the establishment of a captive and is usually one of the first documents that would be requested for in the event of an audit by the IRS.

Every captive actuarial study should include both qualitative and quantitative aspects. Not only should it clearly map out expected financial results, but it should also highlight important insurance considerations that ensure an appropriate and compliant captive structure.

To help provide a framework, here are five key questions that captive owners should be able to answer based on their captive feasibility study.

1. Do you have appropriate data?

As part of the captive feasibility study process, captive owners should work closely with their current insurance carriers to gather as much high-quality data as possible. The study should reflect at least the following for all proposed lines of coverage:

• All Plan Documents or Summary Plan Descriptions
• Current rates, volumes, exposures, and premiums
• At least 6 years’ worth of prior experience reports, which will show paid premiums, constant premiums, paid claims, and reserves by incurred year
• Large claim, premium rate, and plan change histories

This data will be used to develop future loss estimates once the coverage is placed in the captive. All of it should be readily available, and organizations should be reviewing this data regularly, regardless of whether it is undertaking a captive feasibility study. 

2. Has an actuary reviewed your loss experience?

Once you’ve gathered the necessary experience data, it is important that an experienced actuary review it. All experience reports are different in layout and content, and an actuary will know best how to interpret the data, develop the best estimate of future losses, and ask the right questions of the carrier.  A captive feasibility study should always include a robust actuarial analysis.

A good actuary will ensure that plan changes, rate changes, and overall population changes have been properly reflected in the experience report.  If they aren’t, the actuary can make the necessary adjustments.

The actuary should also review the claim reserves that the carrier is reporting.  In our experience, carriers typically overstate reserves due to conservative assumptions, inflating the loss ratio. A good actuary will independently calculate reserves to compute a more accurate estimate of historical loss ratios and future losses.

3. Do you have a clear sense for the expected administrative expenses – at the start of the program and ongoing?

Administrative expenses related to operating an employee benefits captive include actuarial, captive management, legal, audit, letter of credit (if used for collateral), carrier fronting fees, premium taxes, captive domicile fees, taxes, and state procurement taxes (if domiciled outside of home state).

These fees play a large role in determining whether the captive will be profitable at fully-insured market rates.  If your captive charges rates higher than market rates to turn a profit, then the fees are too high. Carrier fronting fees are typically the largest expense and the most important to get right. Captive owners need to understand how these fees were determined in the captive feasibility study and if they are market competitive and realistic.

We always recommend that a company placing employee benefits in their captive conduct an RFP process to select vendors, and that includes competitive fee arrangements.

4. Is the party that conducted your feasibility study independent, or could there be a conflict of interest?

We have seen many captive feasibility studies completed by non-qualified entities or by organizations that have a vested interest. For instance, many insurance brokers will conduct a high-level analysis to conclude a captive program is not feasible. It is essential to understand the interests of all stakeholders and to work with organizations that have the appropriate credentials to help you make an informed decision.

Find an independent party who can provide an objective, transparent, and unbiased recommendation.

5. Will the coverage qualify as insurance?

Every captive feasibility study must comment in detail on the qualitative aspects of captive insurance including what it means to qualify as insurance. This is an important consideration from a captive owner’s perspective and must be fully understood. There are many case laws that have commented on the lack of understanding of insurance company operations.

For instance, an important aspect of any insurance transaction is that it must achieve risk transfer and risk distribution. There are a few industry-accepted risk transfer tests that will demonstrate that the coverage adequately transfers risk from the insured to the captive.  The “10-10 Test” is the most common, determining whether there is a 10% chance of a 10% loss.  Alternatively, there is the Expected Reinsurance Deficit (ERD) Test where the threshold is an ERD ratio of at least 1%.

Risk distribution requires that the captive distribute its risk among several insureds.  Typical risk distribution tests are meant to ensure that no more than 30%-50% of the risk is from the same insured, and if the captive is a brother-sister insurance company, there must be at least 12 participating entities, each having no more than 15% of the risk.

We also recommend the Coefficient of Variation test to better understand the impact of the law of large numbers.  As the number of independent exposures increases the less volatile actual loss experience will become and therefore more predictable.

Employee benefits or not, all captive feasibility studies should address whether there will be adequate risk transfer and risk distribution.

To summarize, a captive feasibility study is one of the most salient parts of placing employee benefits in a captive.  Captive owners should aim for feasibility or refeasibility studies that are transparent, objective, highly robust, and consider all aspects of the captive transactions.

Our Managing Partner, Karin Landry was in a Q&A with Financer Worldwide, in which she discussed some of the leading healthcare risks and what changes we can expect to see in the insurance market. Check out the full discussion here.

Our Senior Vice President, Teri Weber spoke in a panel discussion hosted by the Boston Business Journal. She discussed the importance of mental health resources during the pandemic. Check out the article here.

Our Senior Vice President, Teri Weber published an article in the Boston Business Journal explaining how organizations can better support employees who also act as caregivers. Check out the full article here.

In Risk & Insurance’s March 2021 magazine, they spotlight research conducted by Spring and quote our Managing Partner, Karin Landry. Check out the magazine here.

Our Managing Partner, Karin Landry published an article in the Boston Business Journal focusing on the gap in employee benefits for gig workers, which has risen greatly during the pandemic. Check out the full article here.

Our Managing Partner and Senior Vice President, Karin Landry and Karen English laid out some of their predictions of what businesses can expect to see in 2021. Check out the HR Teach Outlook piece here.

Our Chief P&C Actuary, Peter Johnson was spotlighted in Captive International’s Captives Rising: Hard market brings new opportunities report. In which Peter how the pandemic has changed the risk management practices and what businesses should look out for. Check out the digital report here.