How Does a Protected Cell Company Work?

How Does a Protected Cell Company Work?

Captive insurance companies are powerful risk management tools that add tremendous value to their parent companies. As more middle market companies incorporate these alternative risk management vehicles and realize the value inherent to them, these companies develop an advantage over their peers without captives. Consequently, the demand for captive insurance is on the rise. Traditionally, captives were only available for large companies with insurance premiums of well over $5 million. Today, a growing portion of the middle market companies are using innovative ways to create captives.

Ever since the IRS blessed protected cell companies (“PCC”) with Revenue Ruling 2008-8, the market has incorporated these captive insurance structures into alternative risk strategies. PCCs offer tremendous flexibility for middle market companies to be able to construct unique products unavailable with traditional carriers or single parent captives. Given that PCCs are relative newcomers to the captive insurance field, these entities are worthy of special consideration.

 

What is a Protected Cell Company?

 

A PCC is a unique business model involving no less than two separate entities. First, there is a core company that stands as the sturdy trunk of the tree. Second, you have the cell companies which are analogous to the branches of the tree trunk. Just as no two branches are alike, neither are any two cells.

The core company is generally set up by a captive manager, promoter, or similar party with the intent of developing business within cells of the core company. This party is known as the “Sponsor” in Rev. Rul. 2008-8. The core company has its own capitalization, its own financial records, is subject to its own audit, and is an autonomous company separate and apart from any cells within it.

Each cell within the core company is a separate captive insurance company. These cells must meet statutory capitalization requirements, have sufficient risk shifting and distribution in accordance with IRS standards (if an American company), maintain their own financial records, and will be responsible for managing its own claims and losses. Cells within a core company operate just like a traditional captive.

The value of the PCC structure is that the core company and the cell company will have some sort of a legal and/or financial arrangement between them. This arrangement will vary based on the needs of every situation and the myriad different ways of structuring the PCC is only limited by our imaginations. However, let’s look at a few examples to see how the PCC may be of more value than a traditional single parent captive.

 

Capitalization in a Protected Cell Company

 

As we all know, the IRS is generally concerned with risk shifting and risk distribution when evaluating a captive. When dealing with a PCC, risk shifting is an important concept to address. Risk shifting has two components:

  • there must be a valid insurance contract
  • the captive must be adequately capitalized

A captive insurance company needs enough money to pay its claims. Adequate capitalization for any captive is basically a ‘smell’ game because there are no hard and fast rules around it. This is generally a good thing as there are plenty of situations where an undercapitalized entity may grow into a stronger position if well managed. Adequate capitalization will never be questioned if premiums do not exceed capital (surplus) by more than 3:1, although a 5:1 ratio is fine in virtually every U.S. jurisdiction. Plenty of offshore domiciles permit looser ratios, but actuaries generally prefer 7:1 at a minimum.

A common technique for captive management is to start with a looser premium to surplus ratio, such as 10:1, and then grow into a stronger position over time. While this may displease the IRS, this is an economic reality for most businesses as they often do not have the adequate capital to fully fund their captive program on day one. It is permissible to bet on the future since not all losses are likely to fully materialize in a captive’s first year. Most actuaries spread expected loss payouts over five years as losses take time to materialize and result in a resolution. Smart underwriting solves the short term undercapitalization issue since underwriting profits from year one can be used to fund additional reserves in year two, which may obviate the necessity for an infusion of additional capital.

 

Examples of a Protected Cell Company

 

So, let’s dive into an example. Let’s say you want to set up a captive insurance company with a conservative 5:1 ratio. If we expect to write premiums of $1 million annually, then we need to make sure that we have no less than $200,000 in the captive at start. This is fine in every U.S. jurisdiction and even the IRS would be pressed to find fault. However, let’s say a smaller company lacks $200,000 up front but has about $1 million in annual premiums. What can a PCC do for them?

The core company has capital as well. The new cell can utilize capital from the core company to make up a capital shortfall. For example, a new PCC wants to write $1 million in premium but only has $100,000 in up front capital. The PCC can access the core company for the additional $100,000 of missing premium. This utilization may take the form of a loan or a risk sharing agreement. Fortunately, the IRS also believes this arrangement is legitmate.

What if we extend example #1? Imagine the core company was only capitalized with $100,000 and uses that capital to help PCC #1 set up a cell in the company. Now, business #2 wants to join the club. Can the core company allow business #2 into the cell structure?

A good lawyer will always tell you, “Yes, but…”

The answer here is “Yes,” but let’s remember the rules from above. A captive insurance company can start business with a loose capital to surplus ratio, but is generally expected to grow into a stronger position over time. In this example, we would need to know how much premium company #2 wants to place with the core. If it’s $1 million or less, then we are likely fine as the aggregate premium to surplus ratio between the two companies will not exceed 10:1.

 

Contact Venture Captive Management today to set up your own protected cell captive.