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Insuring On Shore Risk Through Segregated Cells –
The international business community has accepted the concept of segregated cells for insurance risk management and for non-insurance purposes. Captive insurance statutes around the world provide for the establishment of segregated cell vehicles in which the assets of one cell are not subject to the claims of the creditors of other cells. Captive insurance professionals and their clients will claim that even the core assets of the cell vehicle are not subject to the claims of creditors of the individual cells. In addition, the segregated cell policyholder/ owner may also anticipate that other assets it owns will not be subject to the claims of creditors of the segregated cell. However, no court anywhere in the world has accepted these claims of limited liability or for that matter even considered such claims. Courts in the United States have usually considered favorably the idea of statutory protection of stockholders’ personal assets against the claims of creditors of corporations and limited liability companies. Those who seek to establish a segregated cell company that will insure on shore risk in the United States should study the decisions and underlying rationale of United States courts that have ignored limited liability and pierce the corporate veil. In addition, they should review the legislation of jurisdictions being considered as locations for the cell entity, the insurance insolvency statutes in those jurisdictions, the tax implications of the use of a segregated cell structure, and ongoing industrial uses of segregated cell structures in those jurisdictions. They should carefully draft the documents that create the protected cell entity especially to ensure that they reflect the limited liability protection that is available by statute and provide for fair administration in the event of insolvency. This exercise in due diligence will enable the designers of a cell structure to reasonably predict whether United States courts will decide whether the segregated cell structure has a strong and legitimate business reason or if it was established only as a means of avoiding corporate responsibility. Historically, the first captive was formed in Bermuda in the 1950s. Separation of accounts has been around in Bermuda since the early 1990s established through 140 private legislative acts. Bermuda passed the Segregated Accounts Companies (SAC) Act in 2000 but before that, many companies operated in Bermuda as rent a captives without the benefit of statutory separation of accounts. Guernsey is a world leader in segregated accounts captives with premiums of approximately 300 million. The Segregated Portfolio Companies Act was passed in the Cayman Islands in 1998. The health care industry in the United States has been attracted to the Cayman Islands and it is estimated that such programs account for about 70 million in premiums there. Under the Insurance Amendment Act of 2002, segregated portfolio companies (SPC) can be registered in the British Virgin Islands. Both Vermont and South Carolina have provisions for the formation and operation of segregated cell companies. A record number of captive insurance companies were formed in the year 2002. A record number of captives were liquidated in 2002. The use of segregated cells increased twenty percent in 2002. It is not the purpose of this presentation to draw any conclusion from these statistics. It is suggested however that United States Courts may consider the extent and nature of liquidations in the captive industry as those judges decide whether they should pierce a corporate veil or tear down a fire wall. Segregated cell designers should have a historic perspective on captives and particularly on the distinctions between off shore and on shore segregated cell legislation. Experts predict that the legitimacy of the segregated cell arrangements and the fire walls provided there will probably be decided by a sophisticated New York federal court that will either be familiar with the captive industry or be able to quickly grasp the logic of the fire wall structure of a segregated cell. It is more likely that with the proliferation of segregated cells used in the health care field primarily though off shore arrangements that many of the fifty states through their local county judges will have the first opportunity to test these structures. Consideration first by a circuit court judge in a state such as Tennessee is a more likely situation than consideration by a New York federal judge. The segregated cell captive is as a rule a rent a captive. The rent a captive rents its surplus, core capital, insurance license and legal status to the policyholder. Under a segregated account structure the policyholder insures its risk though its participation as a segregated cell. The assets of the segregated account are held exclusively for the benefit of the beneficial owner and statutory “fire walls” insulate those assets from the claims of other creditors. The segregated cell is often marketed as a less expensive way to enter the captive arena. The advocates of segregated cells claim that less personal supervision over an insurance program and less financial investment is required of a policyholder. These same attributes have led others to speculate that a segregated cell may be more likely to become insolvent than would a free standing fully funded captive. They argue that one can reasonably make the assumption that a policyholder who approaches the alternative market with insufficient capital to fund its own captive and lacking insurance personnel to adequately manage and supervise its risk portfolio is a likely candidate for eventual insolvency. United States Courts that have pierced corporate veils to find personal liability on the part of shareholders usually find that the corporation was no more than the alter ego of the incorporators and shareholders. The test applied by these courts to determine alter ego is a “totality of the circumstances” test. A corporate veil may be pierced whenever necessary to avoid injustice. Factors considered include, but are not limited to, the failure to observe corporate formalities; nonpayment of dividends; the insolvency of the debtor corporation; siphoning funds from the corporation by dominant shareholders; non-functioning of officers and directors; absence of corporate records; operating the corporation as a mere façade for the operations of a common shareholder or shareholders; gross undercapitalization; intermingling of shareholders and corporate finances and a general confusion with respect to business titles and responsibilities. It is suggested that when considering a request to ignore the “fire walls” of a segregated cell arrangement, United States courts will adhere to this totality of the circumstance test. The insurance designers of the cell structure should test these segregated walls during the formative stages by a hypothetical application of these tried and true court tests. Operation of the cell structure after formation should be conducted in such a manner as to avoid those traps that would lead a court to ignore limited liability. Tax issues are beyond the scope of this presentation. However, it is likely that a United States court will review the tax treatment and tax intentions of the policyholder in its review of the legitimacy of the cell arrangement. Segregated cells are caught on the horns of a dilemma when it comes to meeting the tests of both segregation and tax deductibility. On the one hand, the designer of the program is attempting to create a firewall to insure protection of the assets of other cells and on the other hand, the designer is aware of the taxing authority's tendency to not allow deductibility in the absence of unrelated risk being insured in the captive. Tax authorities suggest that if the cell owner and the insured are the same that there will be no tax relief on premiums paid. This conclusion is based upon the tradition concept that a single parent insuring only its own risk in a captive cannot deduct premiums since there is no transfer of risk. Both in the UK and in the US, if the cell is deemed a controlled foreign company the tax consequences could be negative. Furthermore, it is suggested that if the controlling company is not an insurance company it is likely that no tax relief will be granted on accumulated reserves. This may not be a problem in an on shore domicile like South Carolina because the controlling company must be an insurance company although it could be a captive insurance company. How can one place uncontrolled or third party business within a cell and still isolate individual accounts within the entire cell structure? Perhaps one can thread this needle by placing third party business within the cell or one can establish a holding company approach with cell participation in profits only. One would then argue that the cell owner is participating in insuring unrelated risk to the tax authorities on one hand but argue to the court that is considering the legitimacy of the fire wall on the other hand that the cell is not subject to exposure to the losses of other cell participants so its liability is limited. W hen standing before a judge that is focused on piercing a corporate veil, demonstrating how tax law was seriously considered in the formative stages of the cell and providing good records of the segregated cell’s accounting that is consistent with accepted tax treatment will be helpful to demonstrate to the court the legitimacy of the segregated cell approach. No concept of the tax treatment and lack of accounting treatment that reflects a certain tax treatment, even if it is non- deductibility, could hamper the quest for limited liability at the judicial level. Uses of the segregated cell as well as uses of the protected cell approach in the jurisdiction where it is established will also be a relevant consideration by a U.S. judge who may be struggling to understand the segregated cell concept and whether to respect the limited liability concept. The bottom line in this judge’s mind will be whether these cells are being employed to insulate bad business in situations where losses and ensuing insolvency were predictable. United States judges and the United States business community are well schooled in a fundamental concept that under company law, a corporation has one set of assets, one set of liabilities, one set of accounts and one set of creditors. Lets consider an example of a fictional attempt at segregating loss exposures that would not be looked on favorably by United States courts. Years back life insurance companies in the United States wrote disability policies based on “own occupation.”as opposed to “any occupation”. High income professionals snatched up these policies and they proved to be a financial disaster for those companies who wrote them because it did not take much for example to disable a surgeon from performing surgeries although he still could be employed in hospital administration and the like. Companies that accumulated these disability policies in an attempt at loss control treated these own occupation portfolios in many ways. Some companies sought sale or merger of the company itself. Some failed at this and considered insolvency. Some companies attempted to sell off the bad business. Some sadly in an effort to curtail losses may have applied a harsh claims treatment or at least some plaintiff lawyers argued that in bad faith civil actions filed across the United States. What if a creative actuary within one of these companies at an early stage of claims development read the handwriting on the wall and consulted with house counsel and together they devised a scheme to move this business into a segregated account cell in a huge Bermuda cell structure moving with it all applicable premium, reserves and investment income. The actuary performs a very thorough study reflecting that the cell will be adequately capitalized. It is submitted that such an approach will be found in United States courtrooms to be lacking a sound foundation. It will be concluded that the purpose of the cell creators was only to protect the assets of the cell owner from the claims of the cell itself i.e. the disabled policyholders. This is a fairly obvious example but the point is that segregating high risks and transferring poor performing portfolios by the cell in order protect its own assets will be subject to close examination by United States courts. The timing of the asset transfer, capitalization and legitimate business reasons will be keys to the success of any cell structure venture to have the limited liability recognized by United States courts. Many jurisdictions, particularly off shore jurisdictions, tout the protected cell as a means to solve situations where insurance has become unavailable such as with nursing homes, trucking, terrorism and securitization of risk in coastal properties. Bermuda makes the SAC available to a full range of non-insurance uses such as mutual funds, real estate development, segregating maturing liabilities, e-commerce, trust and banking risks, replacing divisions or subsidiaries of a company, securitization transactions, and ship and aircraft fleet companies. Clearly from a sophisticated business point of view and risk management point of view, Bermuda will be applauded and has been applauded as once again demonstrating with the SAC why the country is referred to as the insurance laboratory of the world. However, the point may well be missed by our Tennessee judge who after reviewing the SAC may find that it violates his training and experience in corporate law that a corporation has one set of assets, one set of liabilities and one set of creditors and attempts to segregate the good from the bad through the use of off shore cells should not be looked on favorably. Treatment of insolvency by the jurisdiction where the cell structure is located would be an important consideration by United States courts. Insurance and insurance insolvencies are governed by individual state laws in the United States. Insolvencies in the captive area have become an important topic of consideration by states and with the National Association of Insurance Commissioners particular since the recent insolvency of a large auto warranty captive that had an off shore situs. Generally, when an onshore captive or insurance company becomes insolvent, the insolvency proceedings are run by the insurance commissioner of the state where the captive or insurance company is located. In fact, the insurance commissioner usually declares the insolvency and runs the liquidation on a national basis under the oversight of a local circuit court whose decisions are usually given full faith and credit by other courts throughout the country. Insurance insolvency statutes in the United States are uniform from state to state. Historically, insolvencies have been limited to regional companies but that has recently changed with large commercial companies that serve both the traditional market (Reliance Insurance) and the alternative market (Legions Insurance) becoming insolvent. Insurance insolvencies are not simple anymore. It once took only a couple of years to close the estate of an insolvent insurer. Some of the existing insolvencies could be around for a decade or more. We have worked on the collection of reinsurance for a small insolvent risk retention group and the negotiations and collections took two years. We are working on recovery of subrogation for a major, large commercial carrier that became insolvent over four years ago and are still filing subrogation lawsuits that may take years to resolve. The amount of litigation in connection with insurance insolvencies particularly in the alternative market will rise dramatically in future years. States may sue states. Litigation against directors and officers will rise. Recovery of insurance proceeds will become controversial and litigious. We should not wring our hands and exclaim that the sky is falling but rather we should, with our insurance program in hand, approach this environment only after a study of the fairness of the treatment that can be anticipated in the event of insolvency. Different treatment of certain creditors by the rules governing insolvency of segregated cells particularly in off shore arrangements as compared to the treatment afforded creditors in United States insurance insolvency laws will not go unnoticed by United States judges who are being asked by creditors to ignore the fire walls ostensibly created within the off shore segregated cell structure. One of the primary reasons insurance companies are subject to liquidation provisions in the state insurance codes rather than under the federal bankruptcy codes is that losses from policyholders and third party claimants have priority over other creditors. Under the federal bankruptcy code the costs of administration and claims of federal, state, and local government from past due taxes and fines are usually the first claims that are paid in full before any creditors of the insolvent debtors are paid. Most off shore segregated cell legislation provides for the distribution of assets in the event of insolvency. If that legislation and treatment does not favor policyholders and third party insured claimants, there could be a tendency of a United States judge to add this as another reason to permit these policyholders and insured third party claimants to ignore the walls that block these individuals from recovering their losses. With this background, I have prepared a checklist that may be considered when establishing a segregated cell entity that will insure United States risks where one wishes to ensure limited liability treatment:
John J. O’Brien JD, CLU, CPCU is an attorney
and captive insurance company manager. He is senior partner of the national
law firm of O’Brien and Hennessy and chief executive officer of
Charleston Captive Management Company, which is located in Charleston,
South Carolina. John J. O’Brien JD,CLU,CPCU Web site: CharlestonCaptive.com |
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