Cayman Islands: Segregated Portfolio Companies – Firmly in the Mainstream?

Seven years on from its introduction as a new statutory vehicle in the Cayman Islands, the segregated portfolio company, or SPC for short, is now firmly established and here to stay, particularly in Cayman’s thriving insurance sector. Indeed it was the insurance sector that gave birth to the SPC - in the early days it was a product only available to licensed insurers. It is now generally available throughout the Cayman financial services industry but its roots firmly remain in insurance and it is within this arena that its flexibility and multi-purpose application have come to the fore.

The Cayman captive insurance industry continues to experience explosive growth and one wonders the extent to which Bermuda nervously eyes in its rear view mirror the rapid acceleration of the world’s number two captive domicile. As at 30 September 2005 there were 725 captives in the Cayman Islands of which 102 were SPC's with total assets of more than US$1600 million held within those SPC's. So why has the SPC become an important part of the industry?

The SPC is the ideal vehicle in any situation where there is a risk of cross-class liability and therefore a commercial need to ensure that assets and liabilities are legally, and not just administratively, segregated. Most will now be broadly familiar with the type of vehicle the SPC is because equivalents, albeit with different names, have been developed in a number of other jurisdictions, including Delaware, Guernsey and Bermuda, and therefore today what was once "cutting edge" is now firmly within the offshore mainstream thereby giving a high level of comfort to those considering utilising the SPC for their own insurance programs.

The SPC is a particular type of company which is able to create one or more segregated portfolios or cells. A cell might be thought of as a sealed compartment within the company but is not a separate legal entity in its own right. There is no restriction on the number of cells that an SPC can create but each cell must be separately identified and include the word "Segregated Portfolio" in its name. The key feature of the SPC is that the assets and liabilities of each cell are statutorily "ring-fenced" from the assets and liabilities of all other cells of the SPC. It is this ring-fencing which makes the SPC ideally suited for captive insurers with multiple programs and in particular where programs are offered to more than one insured. Of course, where any of the SPC’s assets are held outside the Cayman Islands, legal advice should always be obtained in the relevant jurisdiction to ensure that the structure would be recognised and it is always desirable that all contracts and transactions entered into by the SPC are governed by Cayman Islands law and made subject to the jurisdiction of the Cayman courts.

Those who pushed for the introduction of segregated portfolio legislation in the Cayman Islands in the 1990’s had the rent-a-captive very much at the forefront of their mind. It is therefore no surprise that it has proved to be an important tool in this area enabling onshore companies to test the water with offshore alternative insurance programs without having to commit the cost, time and effort involved in setting up a "full-blown" captive of their own. More importantly, they have enjoyed a high level of comfort that the insolvency of any program operated by a fellow "renter" would not impact the assets of their own program, an issue that it was not possible to adequately address, from a legal point of view, prior to the emergence of the SPC. The success of the SPC in the rent-a-captive arena has led to the emergence of a number of entrepreneurial insurers setting up what might be called "captive incubators" for clients where not only cells are available but the entire infrastructure for a captive program including accounting, administration, legal and policy documentation.

Association captives too have shown interest in the SPC concept. The traditional association captive where different members hold different classes of shares in the captive can be of concern to more cautious associations where there is an unwillingness to share risk among the individual members and possibly nervousness about members in competing businesses being privy to each others’ insurance information. With an SPC each member owns their own cell and therefore enjoys a far greater level of protection and confidentiality.

How does the capital structure of an SPC work? The regulatory capital is typically provided by the insurer and forms part of what is known as the core or the general assets ie assets which are not held within any particular cell. The extent to which the owner of a cell will capitalise the cell at the outset will depend on a number of factors including, the nature of the program, the requirements of the regulator and the extent of the program’s reinsurance arrangements. Under the statutory ring-fencing concept, the assets of a cell are only available to the creditors of that cell and not to creditors of other cells or to general creditors of the SPC. A general creditor would typically be a person or entity that has provided services to the SPC as a whole rather than to a particular cell and professional service providers would typically fall into this category. A creditor of a cell first has recourse to the assets of that cell and if there is a shortfall, may have recourse to the general assets of the SPC unless either the articles of association of the SPC prohibit recourse to the general assets in these circumstances or the SPC does not have capital in excess of any minimum regulatory requirement. An insurer would not always protect the general assets from cell creditors by an appropriate exclusion in the articles because it is sometimes desirable to permit recourse to the general assets in order to demonstrate some element of risk sharing. Without statutory ring-fencing, the legal segregation of portfolios of assets and their associated liabilities can only be achieved by the use of contractually-binding non-recourse covenants from creditors or special purpose vehicles. Both of these alternatives add to the cost and administrative burden when compared to using an SPC structure.

In the case of most SPC’s the economic ownership of each cell will be evidenced by the issue of segregated portfolio shares in respect of each cell to the owner and these will typically be redeemable preference shares in contrast to the ordinary shares held by the insurer in respect of the general assets. The use of segregated portfolio shares provides a useful mechanism to facilitate the payment of income to the owner in the form of dividends and the repayment of capital by the redemption of shares subject, of course, to regulatory constraints. There will invariably be a shareholders agreement in respect of each cell between the insurer and the cell owner or owners. However, the legislation is flexible and the issue of segregated portfolio shares in respect of any cell, whilst usual, is not a requirement. For example, SPC’s setting up in the arena of life products and annuities, where a separate cell is established for each policy or annuity to offer added protection for policy holders, will often not go to the trouble of issuing segregated portfolio shares and the ownership is instead established on a contractual basis.

Whilst an SPC offers considerable flexibility, there are some important obligations which fall to the directors if the integrity of the structure is not to be compromised. The directors must ensure that the assets of each cell are properly segregated from the assets of all other cells and from the general assets (therefore, each cell must have its own bank account, custody account etc) and ensure that assets and liabilities must not be transferred between cells otherwise than at full value. Another important feature is that where transactions or agreements are entered into on behalf of a particular cell, it must be made clear on the face of the relevant agreement or document that the execution is on behalf of that cell. Failure to do so potentially exposes the directors to personal liability for the liabilities incurred under that transaction or agreement.

As the use of segregated portfolios has become more established and much more part of the mainstream, there has been something of a trend of some existing captives converting to an SPC. It would be wrong to say that there has been a stampede to go this route but there has certainly been some activity. This has been particularly prevalent in the healthcare area where some healthcare systems with a limited number of existing programs have seen the opportunity to develop additional "non in-house" programs, say, for self-employed physicians or other regional healthcare systems. Conversion is a relatively straight-forward process involving, amongst other things, the filing of a statutory declaration sworn by two of the directors, a balance sheet which is not more than three months old, creditor consents where the conversion involves the transfer of assets and liabilities into cells and the written consent of the Cayman Islands Monetary Authority.

The SPC has in the past seven years developed from a vehicle which was once seen by some as perhaps too much at the cutting edge and as offending basic principles of corporate law to the stage now where it is well recognised, within the mainstream of the offshore world and in a position to help further enhance the Cayman captive insurance industry.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.