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The Actuary The magazine of the Institute & Faculty of Actuaries

Risk: Divide and multiply

Rating agencies are often asked to offer comments on emerging issues. This makes sense, as companies need to make critical decisions on developing their business or structuring a specific transaction, so it is vital that management understands how decisions will be viewed by third parties.

When answering any general questions, however, ratings agencies may face problems if their advice is taken out of context; as with any business decision, the facts and circumstances must be understood before a view can be developed. This becomes all the more important when providing advice on the use of protected cell companies (PCCs).

PCCs are being formed in increasing numbers and used in more targeted ways to handle risk exposures. From a rating agency perspective, will this benefit the risk management community?
There is an interesting dynamic in this situation whereby risk exposures are continuing to evolve, grow or diminish relative to others as economic, political and social circumstances develop. At the same time, commercial insurers may not be able, or willing, to respond to the needs of the risk management community due to time or accessibility constraints. An increased demand for solutions has led to captive formations, group captives and risk retention groups, and now PCCs.

The other side to this search for risk-financing options is that the entities created to provide the protection may not be capable of responding when required. This is especially true if a protected cell is so narrowly focused or insufficiently capitalised that its own risk profile may be more volatile than the entity seeking protection from it.

What key factors should a risk manager be aware of when looking for a PCC to handle the exposures of its organisation?
In order for a cell captive to gain acceptance from senior management and pass corporate governance mandates, a risk manager should perform the same process of due diligence as with any other risk-financing solution — and maybe more.

For example, an insured organisation establishes its own PCC, which will be a licensed insurance organisation, and subdivides its risks into a number of protected cells within the PCC. For all practical purposes, this is similar to establishing a pure captive insurer but with the added feature of being able to monitor lines of business, or the results of subsidiary operations, on a stand-alone basis. In this way, the costs of risk can be better allocated within the parent organisation. So long as each cell has the flexibility to access additional funding should it run into claim payment difficulties, then this option should be roughly equivalent to that of a pure captive operation.

On the other hand, if the risks of an organisation are placed into protected cells that either have no access to additional funding or fall under the umbrella of another company’s PCC or core, then a careful review is needed to ensure that the anticipated protection will exist if required. In this case, the protected cell will have limited ability to pay claims. What will justify its use is if the risk manager is aware of the quantity of risk transferred, both on an expected and worst-case basis, compared with the capabilities of the cell to respond to those potential claims.

In most cases, due to its smaller size and limited scope, an individual protected cell will not have sufficient resources should adverse circumstances occur. Its own results, therefore, have the potential to be volatile, unless the scope of coverage is carefully defined and limited. Nonetheless, due to the flexibility allowed in the contractual arrangements for establishing a cell, mechanisms can be incorporated to either adequately fund the cell upfront for all circumstances, or to have access to additional funding from the PCC or from the cell’s owner.

So long as the arrangement meets the needs of the risk manager and is part of the overall enterprise risk management solution, this option should be viable and beneficial.

Given its potential volatility, how would a rating agency evaluate a protected cell or the sponsoring PCC?
There are some significant differences between evaluating or rating either a protected cell or a PCC for reasons that are related to their role in assuming risks. For the former, the mechanism can be compared to the process of assigning a financial strength rating to any other type of insurance entity, including captive insurers.

The analytical team will examine the cell’s financial condition and risk profile, as well as its actuarially determined loss and IBNR reserves and credit exposures. In addition, a thorough review of any contractual relationships with other protected cells and with the core PCC will be carried out. As mentioned, financial flexibility and the adequacy of the protected cell’s capital relative to the risks assumed are the critical factors in this situation.

An analysis will focus on the likelihood of the PCC’s own capital base being eroded from any contractual relationships it has with the member cells, utilising the position that all the risks placed with a PCC organisation are at the level of the individual protected cells, and that the PCC core does not take any underwriting risks from outside parties. This could take the form of capital maintenance guarantees, stop-loss agreements or similar arrangements with the cells.

In addition, the contracts will need to be examined carefully to determine the extent of these liabilities, as well as the potential for attachment of funds by a regulator or a court of law in the case of any protected cell becoming insolvent. In these cases, a financial evaluation of all cells, which could have a potential material impact on the PCC, needs to be conducted regardless of whether or not those cells are rated. The aggregate exposure to the PCC must be compared with the resources available to respond to those needs.

It should also be made clear that a financial strength rating on a PCC does not automatically extend to the individual cells within its structure.

What are the value considerations for a risk manager in determining whether to use a protected cell or PCC option?
It is all about risk — the PCC or protected cell option can provide a very focused and viable tool to manage risks within an organisation. It offers a means to assume reinsurance from a fronting carrier, and to isolate certain exposures from a more broad-based risk-financing programme. This may allow a fronting or a commercial insurer to be more responsive to the rest of the needs of a pure captive programme. The protected cell taking on the risk, however, will still need to prove its risk-handling capabilities to a fronting carrier or little credit will be given to it from a statutory capital relief perspective.

A protected cell also offers a smaller insurer entry into alternative risk transfer options that may be more cost-effective than establishing a fully licensed captive insurer. This has the further benefit of giving the insurer better control of its risks and financing, and provides the experience needed should it wish to move to a pure captive in the future.

Control and monitoring of any protected cell captive programme is crucial to ensure that the expectations for response to claim incidents will be met, given the capabilities and limitations of the cell captive. There are certain overlying themes and issues that will have an impact on the utility of such a programme for the insured.

Fronting carriers and reinsurers will also examine them carefully to determine whether such a programme could still result in them shouldering the risks that supposedly have been laid off to the cell. Important considerations include:
>> The type of protected cell that is employed
>> Whether the cell is open, closed or somewhere in between
>> The nature of contractual relationships among cells in the programme and those of the core
>> The cell’s ability to absorb shock losses or adverse development
>> The regulatory framework under which the PCC and the cells are established and monitored.

Protected cell companies
A protected cell company (PCC) is formed in an offshore jurisdiction where particular assets and liabilities are segregated into ‘cells’, such that the assets of one cell cannot be used to satisfy the liabilities of another. PCCs originated in Guernsey, after which a number of other jurisdictions followed, including Bermuda and the Cayman Islands. They have many uses, including reinsurance where finite reinsurance contracts and securitisation issues can be placed within separate cells.

Henry K Witmer is assistant vice-president of AM Best in Oldwick, New Jersey.