PCCs Are An Increasingly Popular Option For Companies Needing Cost-Effective Solutions To Risk Transfer. Justin Wallen Of Hexagon PCC Group Outlines The Different Solutions Cells Can Provide.

As the managing director of the Hexagon PCC Group in Guernsey, I have witnessed first-hand how protected cell vehicles have become the most popular option for the types of business that we facilitate for our clients. As an organisation we are focused on our control environment and are actually quite risk-averse when it comes to placing business into protected cells. We are not in favour of protected cells conducting direct insurance, particularly to consumers. We believe that cells are more suited to sophisticated counterparties and to reinsurance arrangements.

ILS transformer cells

A lot has been written about the growth of the insurance-linked securities (ILS) funds over the past 18 months, and certainly the ILS funds with which we have relationships have all seen a substantial increase in assets under management during this time as pension funds and other large investors continue to seek the non-correlated returns that an asset class such as ILS can bring. I saw this growth in funds heading into the ILS sector as an opportunity for the Hexagon PCC Group to specialise in assisting with providing transformer cell vehicles in Guernsey.

The basic premise is that ILS funds invest in protected cells within an insurance company, which can in turn enter into fully collateralised reinsurance trades. Our board of directors have been involved with well over 100 such transactions over the years and our specialism in these types of trades certainly gives comfort to our business partners. The process for such ILS transformer arrangements has been well documented and it is a tried and tested methodology that has been utilised in Guernsey for many years.

Our Hexagon PCC Group experience in this field over the past six months has seen a large number of protected cells being created for ILS transformer business across different protected cell companies (PCCs), for assets at risk well in excess of $200m. This year we have seen a move away from more traditional property catastrophe risks towards alternative risks such as marine and energy, crop and even prize indemnity reinsurance.

This is evidence not just of ILS funds becoming increasingly diversified in their investment strategy, but also that they are seeking higher returns via new and more unusual reinsurance risks as the sector sees more in-flows, putting pressure on the pricing of certain types of more traditional risk. Some 1 April deals coming to market appeared to be priced below the expected loss, which is clear evidence of the increasing amount of capital available to participate in these types of risks. None of the ILS funds we deal with were interested in taking on deals with those types of parameters, but it would appear that certain investors chasing yield were prepared to take such a risk.

We are confident that the growth in fully collateralized catastrophe reinsurance in Guernsey will continue based upon our platform of offering ILS funds a chance to manage their transformer cell service provider risk by using an alternative to their traditional facility, such that they therefore don't have all of their eggs in one servicing basket, both in terms of manager and domicile. At Hexagon we work responsively to each transaction in order to speed up the deal completion process as much as possible, which is well received by brokers under pressure to get the reinsurance bound as quickly as possible.

Guernsey has also had some well publicized private catastrophe bond (cat bond) placements listed on recognised stock exchanges, demonstrating Guernsey's willingness to facilitate more of this type of ILS business, backed up by the excellent support of our regulator for transactions of this nature.

MGA risk retention

While it's true to say that the majority of new business we have facilitated recently is with ILS funds, it is by no means the only type of enquiry received as to how a cell can be utilised to take insurance risk. Protected cells have already successfully been used as a vehicle to provide managing general agents (MGAs) or Lloyd's brokers with the ability to start participating in the risks with which they are associated by having a risk-accepting facility. Such risks tend to be passed into the protected cell on a quota share basis by a fronting insurer as a means of participating in the underwriting profits of a particular book, or books, of business being managed by the MGA. A protected cell is a more cost-efficient vehicle by which MGAs can participate in these risks rather than having to set up their own stand-alone vehicle or direct EEA insurer.

By having some direct participation in these risks, MGAs are finding that they can increase the amount of business underwritten by the fronting insurer, as confidence in that book of business is buoyed via the MGA's participation. The fronting insurer will of course charge a ceding commission and, over time, perhaps request collateral for the risks being ceded to the unrated protected cell. However, with a stable book of business demonstrating sufficiently low loss ratios and, ideally, a short tail, this does not prevent the protected cell from generating underwriting profits. On more risky books of business, a stop-loss reinsurance policy is a way of reducing the MGA's downside risk when participating in the portfolio in this manner. A protected cell allows for faster and lower-cost entry and exit than the traditional captive alternative.

EU captive alternative

There is no doubt that having a captive licensed in the European Union (EU) is a costly and capital intensive exercise and a major barrier of entry to companies operating in Europe. The use of an EU-licensed and regulated insurance company to "front" risks into a Guernsey protected cell operating as a reinsurance vehicle would allow insurance business to be written into all EU/EEA territories. By utilising a fronting company, the cell captive is still able to retain the risks that the parent company wishes to self-insure but without the capital commitment, time and administrative cost of owning an EU direct writing captive. By forming a protected cell in Guernsey, companies can participate in a value for money captive vehicle. In my opinion, this structure offers a genuine alternative to owning an EU direct writing captive, both for those already incurring the time and expense of owning such a vehicle who are expecting those costs to only increase under Solvency II, and also for those considering establishing such a vehicle in the near future.

Captive run-off alternative

A protected cell is also a more efficient and cost-effective insurance vehicle to run-off captive risks when compared to keeping your incorporated captive vehicle open over several years. A captive subsidiary company in run-off incurs higher levels of annual costs than a protected cell achieving the same results. Once a protected cell is up and running, it benefits from participating in the shared costs of the PCC as a whole, such that significant savings are available on expenses including management and audit fees, regulatory costs and non-executive director fees when compared to a stand-alone captive vehicle. It's a simple way of reducing run-off costs and I'm surprised that more corporations are not taking advantage of this facility.

Traditional captives in decline?

I have certainly noticed that the appetite for traditional captive vehicles continues to wane from the peak activity levels we noted over a decade ago. Perhaps this decline is due to continuing soft market conditions, or regulatory, capital and other cost burdens reducing the efficiency of captives. A protected cell captive continues to offer reductions in many of the costs associated with the traditional captive set-up and in my view is still an attractive option for those looking to self-retain an element of their risks.

At Hexagon PCC we are very positive about the continued growth of our company as we position ourselves to provide services in what we see as industry growth areas. I would like to take this opportunity to thank the clients who have supported us since we embarked on this venture, without their support our success to date would not have been possible.

Justin Wallen is the managing director of the Hexagon PCC Group, which is part of the Robus Group of companies. He has unrivalled experience in managing PCCs and ICCs accumulated over more than 10 years in the insurance management industry. Justin is a Chartered Accountant based in Guernsey.

Originally published in Captive Review's Cell Company Guide 2013, July 2013.

For more information about Guernsey's finance industry please visit www.guernseyfinance.com

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