North Carolina's modern Incorporated Cell Captive statute should allay Fitch's fears

Recently, Fitch announced its new views regarding credit risks it believes may be inherent in protected cell captive insurance companies ("PCCs").  This questioning of the structure of PCCs is in light of Pac Re 5-AT v. AmTrust North America, 2015 WL 2383406 (D. Montana, May 13, 2015 ).

A protected cell company is a captive insurance company composed of (1) a “core” and (2) a number of “cells” which are established around the core.&nbs;Unless limited by statute or regulatory rule, there can be an unlimited number of cells.&nbs;The assets and liabilities of each cell are segregated from the assets and liabilities of every other cell, as well as from the core.&nbs;The PCC structure was designed so that the assets of each cell are only available to creditors of that cell.&nbs;  Once a PCC is established by a sponsor, the sponsor can then operate each cell as an independent insurance company.&nbs;Or, more commonly, the sponsor can operate the core and other, non-related companies can operate each cell as independent insurance companies.&nbs;The cell structure – and its shared overhead – permits smaller companies who do have the capability or desire to operate a single parent captive insurance company to obtain some of the benefits of captive insurance.&nbs;

In Pac Re 5-AT v. AmTrust, a contract dispute regarding a captive reinsurance agreement between a cell and its reinsurer (which was subject to arbitration) broadened into an issue of first impression regarding protected cell companies.   Originally, the dispute was between the reinsurer and the one single protected cell (Pac Re 5-AT a/k/a Cell 5) under the terms of the captive reinsurance agreement.  However, the reinsurer named both the cell and the core (Pacific Re, Inc., a Montana captive insurance company) as a party as well.  Pacific Re then sought a declaratory and injunction in federal court that it was not a party to the arbitration. 

On cross motions for summary judgment, the court applied Montana’s corporate law to its captive insurance enabling statutes (which established protective cell captive insurance companies).&nbs;

Stating that this was an issue of first impression under Montana law (and indeed, an issue of first impression under all domestic United States law), the court stated in pertinent part:

The statutory construction issue arises here because a cell is not a separate de jure legal entity, but has many de facto aspects of a legal identity.&nbs;It is clear that the liabilities and assets of a protected cell are segregated from the other cells and from the PCC, but it is also clear that a protected cell does not have a separate legal identity.  Each cell, in essence, operates as its own separate entity, but remains part of the larger PCC.&nbs;Though the statute does not contemplate that the assets of a protected cell will be used to satisfy the liabilities of any other cell, the cells are not entirely independent from the PCC.

The court went on to rule that:

 “A protected cell is not a separate legal person.&nbs;Without a separate legal identity, and absent a statutory grant to the contrary, a protected cell does not have the capacity to sue and be sued independent of the larger PCC.&nbs;The statutory language is clear, and the court may not look beyond the plain meaning.&nbs;Although a protected cell has many attributes of independence from the PCC, it remains a part of the PCC, which has the capacity to act on behalf of the protected cell as in this instance Pacific Re acted on behalf of Cell 5 in agreements at issue.”&nbs;

In summary, “Pacific Re, as the PCC, entered into contracts at issue, both on its own and on behalf of the protected cell.&nbs;It is properly before the arbitration tribunal and will appropriately be bound by the results of the arbitration.”

As Fitch points out, the Pac Re 5-AT opinion raises significant concerns regarding how well "ring-fenced" each cell in a PCC is, and what would happen to a cell if another unrelated cell caused the core of a PCC to become insolvent. 

North Carolina recently revised its captive insurance statute with a number of technical corrections.  Under N.C.G.S. § 58-10-510, “a protected cell captive insurance company licensed under this Part may establish and maintain one or more incorporated or unincorporated cells, to insure risks of one or more participants. . . [ subject to certain conditions].”

Section 58-10-512 goes on to outline in more detail the formation, operation, and obligations under an incorporated cell captive program.  This passage deals squarely with the issue raised by Pac Re 5-AT .  The statute specifically states that:

"In the case of a contract or obligation to which the protected cell captive insurance company is not a party, either in its own name and for its own account or on behalf of a protected cell, the counterparty to the contract or obligation shall have no right or recourse against the protected cell captive insurance company and its assets other than against assets properly attributable to the incorporated protected cell that is a party to the contract or obligation."

As Pac Re 5-AT shows, understanding the applicable corporate law and captive insurance law of any domicile is important not just to those operating PCCs, but to anyone dealing with them as well.

Will North Carolina follow Tennessee's memo on captive reinsurance transactions?

On October 22, the Tennessee Department of Commerce and Insurance adopted a memo which provides guidance to captive insurance companies domiciled in Tennessee regarding the credit obtained for reinsurance from unauthorized reinsurers. This is significant, not only because Tennessee and North Carolina are adjacent states (which to some degree compete against each other for captive insurance domestications and formations), but also because the statutory language of the North Carolina General Statutes and the Tennessee Insurance Code are identical.

Both Tennessee Insurance Code § 56-13-112 and North Carolina General Statute § 58-10-445 explain that: 

Any captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to reinsurers complying with this Chapter. If the reinsurer is licensed as a risk retention group, then the ceding risk retention group or its members must qualify for membership with the reinsurer. The Commissioner shall have the discretion to allow a captive insurance company to take credit for the reinsurance of risks or portions of risks ceded to an unauthorized reinsurer, after review, on a case-by-case basis. The Commissioner may require any documents, financial information, or other evidence that will allow an unauthorized reinsurer to demonstrate adequate security for its financial obligations.

In addition to reinsurers authorized by this Chapter, a captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to a pool, exchange, or association to the extent authorized by the Commissioner. The Commissioner may require any documents, financial information, or other evidence that such a pool, exchange, or association will be able to provide adequate security for its financial obligations. The Commissioner may deny authorization or impose any limitations on the activities of a reinsurance pool, exchange, or association that in the Commissioner's judgment are necessary and proper to provide adequate security for the ceding captive insurance company and for the protection and benefit of the public at large.

 

 The memo from the Tennessee Department of Commerce and Insurance provides a regulatory gloss on the statute. It goes on to state that “Tennessee captives seeking to enter into a reinsurance contract with the same unauthorized reinsurer should likewise include the details of the proposed reinsurance agreement and its proposed business plan or submit a change of business plan.” This obviously has large implications for the risk pools operated by many captive managers.

The Tennessee memo then lays out five factors which it claims will be used in deciding whether to grant credit for reinsurance purchased from unauthorized reinsurers. These factors are:

• “The policy issued to the original named insured is issued by a traditional admitted domestic insurance carrier acting as a front.
• The reinsurance agreement is made upon secured collateral. This includes reinsurance agreements made on a funds withheld basis, via a domestic U.S. trust, or via a letter of credit issued by a reputable U.S. based financial institution.
• The reinsurance agreements are obtained from an accredited reinsurer as defined by Tenn. Code Ann. §56-2-208.
• Reinsurance is obtained from a reinsurer that is highly rated by a reputable rating agency.  
• The reinsurer has a paid in unencumbered capital and surplus of at least $20,000,000 and agrees to submit to Tennessee copies of its audited annual financial statements as well as copies of any examination report conducted by its home domicile.”

Two additional factors are also explained: Tennessee will provide additional weight to a reinsurer if it is “domiciled in a jurisdiction with a solid reputation for providing accountability and oversight to its insurers” and the Department will give weight to the “experience and reputation of the captive manager and other service providers selected by the captive owner.”  These factors, of course, beg the question as to what qualifies as a domicile with a "solid reputation."  Does this exclude all off-shore domiciles?  Will Tennessee consider any on-shore domiciles other than itself to be qualified?

This memo continues that “some captives choose to participate in reinsurance exchange pooling arrangements structured in any number of ways. When such pooling arrangements include scenarios where a Tennessee captive insurance company cedes risk to an unauthorized reinsurer, the Department will give the greatest weight to arrangements where the ceded premium is held in a domestic U.S. trust, or where all pool participants are managed by the same captive manager. Any type of proposed pooling arrangement should include information sufficient to satisfy the Department that adequate controls are present and that the pooling arrangement, and its participants, possesses sufficient liquidity and accountability.” 

The memo concludes by stating that the Department of Commerce and Insurance retains its discretion to grant credit for reinsurance on a case by case basis.

This memo is important because it applies a regulatory interpretation to statutory language that is identical to North Carolina’s captive insurance law.  It will be interesting to see whether North Carolina's Department of Insurance reacts in any way to this memo.  Even if North Carolina's regulators do not adopt the Tennessee memo outright, would they consider compliance with it as a "plus factor"?  Conversely, depending on whether Tennessee construes its policy memo narrowly or broadly could have implications for North Carolina's captive insurance industry.