Scott Penwell and Kirsten Miller describe the uses of various reinsurance vehicles and attendant regulatory issues.

Renting a reinsurance facility is not a new idea. The first rent-a-captive programmes were developed in the late 1970s and early 1980s. Rent-a-captives, however, have enjoyed a resurgence in the last few years and have received a boost from the offshore insurance domiciles of Guernsey and the Cayman Islands, both of which have enacted, respectively, protected cell (PCC) and segregated portfolio (SPC) legislation permitting one insurance programme to be “fire-walled” off from other programmes.

More recently, onshore protected cell companies have emerged with the introduction of the NAIC protected cell company model law and the passage of protected cell legislation in Vermont, Rhode Island and Illinois. As more and more small and mid-sized companies discover creative ways to use the alternative insurance market, the use of rent-a-captives should increase.

Rent-a-captive organisation and operation

A rent-a-captive is an existing captive insurance company organised by the owner/sponsor to insure or reinsure the risks of several unrelated third parties. The captive effectively rents its capital out to these insureds to use as a captive insurance company, so each insured can receive the profit from its own insurance programme.

Rent-a-captives are designed so that there is a minimum commitment of capital and management effort on the part of the insureds. The owner/sponsor holds control through another vehicle which issues the insurance policies, collects the premium and invests the funds until losses are paid. In essence, a rent-a-captive offers an insured the benefits of a traditional captive insurance company and an insurance package designed to return underwriting profit and investment income.

A rent-a-captive can act as an insurance company by issuing policies directly to an insured, or as a reinsurance company by reinsuring policies issued by a domestic fronting company. Rent-a-captives typically act as the latter, since applicable state law requires many insureds to have insurance policies issued by an admitted carrier for certain coverages or because the rent-a-captive is an offshore company not authorised or admitted as a domestic insurance company.When a rent-a-captive is acting as a reinsurer, it is operated through the use of three major agreements: the shareholder agreement (sometimes called the participation agreement), the insurance policy and the reinsurance agreement.

The shareholder agreement is an agreement between the insured and the rent-a-captive and it is the vehicle by which the insured gains access to, and the use of, the rent-a-captive facility. Under its terms, the insured typically purchases a share of preferred stock in the rent-a-captive. This stock distinguishes the insured and its insurance business from that of all other insureds in the rent-a-captive facility, and it is the vehicle by which underwriting profit and investment income are returned to the insured.

The insurance policy is the contract issued by the admitted domestic
fronting insurance company directly to the insured to cover its losses. Lastly, there is a reinsurance agreement between the domestic fronting insurance company and the rent-a-captive to reinsure the fronting insurance company for the losses incurred by the insured.

Some specific elements distinguish the rent-a-captive insurance company from a captive insurance company and other alternative market mechanisms. These include, firstly, that the owner/sponsor owns the common voting shares and organises, forms and capitalises the rent-a-captive, typically as a stock insurance company. This differs from a captive insurance company which the insured itself must organise and form from inception.

Secondly, the rent-a-captive will establish an account for the insurance business of each insured. This account is then separated via the preferred share of stock from the accounts of all other insureds for the purpose of achieving a separate accounting basis for the business attributable to each insured. Lastly, the owner/sponsor controls the rent-a-captive, so it sets the underwriting policies, prices the risk and sets the investment policies. Income for the owner/sponsor is derived from the fees paid by the insureds.

Participants in rent-a-captive programmes are typically insureds with good loss experience and a desire to control their risk management. In addition, rent-a-captives are very attractive to insureds who are not prepared to contribute the capital required to start-up a captive, but who want to access the alternative insurance market. Lastly, the insured's minimum premium size will vary but, as a rule of thumb, premiums should be at least $750,000 for single-parent programmes and $1.5 million for groupprogrammes.

Separation of accounts in rent-a-captives

1. Contractual
In jurisdictions that do not have specific legislation governing rent-a-captive structures, the rent-a-captive vehicle is formed through the use of contracts and existing corporate laws. In those jurisdictions, each individual account takes the form of a series of preferred stock. While insureds can agree to separate their accounts from one another by contract, the contractual relationships are not binding on creditors. Consequently, if the rent-a-captive or an account suffers a financial setback, creditors of one account may be able to reach the assets of other accounts in the rent-a-captive.

2. Protected cell/segregated portfolio
Guernsey was the first domicile to enact legislation providing for the legal segregation of accounts, with the passage of the Protected Cell Companies Ordinance in 1997. About 18 months later, the Cayman Islands enacted similar legislation, namely its segregated portfolios legislation. More recently, Vermont amended its laws, effective 20 May 1999, to permit “sponsored captive insurance companies”, which may establish and maintain protected cells. On 1 June 1999, Rhode Island approved its Protected Cell Companies Act and Illinois enacted its version of protected cell legislation on 23 July 1999.Whether known as protected cells or segregated portfolios, the attributes of each law are very similar. The primary legal benefit achieved through the formation of a PCC or SPC is the legal separation of accounts or cells, which means that creditors of one cell and creditors of the company itself cannot reach the assets of other accounts or cells.

3. Private act of parliament
Bermuda has enacted a procedure for segregating accounts that fallssomewhere between the contractual rent-a-captive model and the PCC or SPC model. In Bermuda, one may take an existing rent-a-captive facility and achieve legal separation of accounts through the use of a private act of the Bermuda Parliament. However, obtaining this private act involves a certain amount of formality, time and expense, and Bermuda is also exploring the possibility of drafting legislation which would provide for the statutory legal segregation of accounts.

US regulation of rent-a-captives
Offshore captive insurance programmes are regulated by US regulatory authorities, including the Internal Revenue Service (IRS) and federal and state securities commissions. While there is very little statutory and case law guidance with respect to rent-a-captives, one may assume that the tax principles that apply to captive insurance companies in general will apply to rent-a-captive programmes. One major misperception many US insureds have, with respect to the taxation of rent-a-captive programmes, is that underwriting profit and investment income can be accumulated tax free offshore. While this was true prior to 1986, amendments to the Internal Revenue Code have changed that. Captives and their shareholders can be subject to tax if they are deemed to be “engaged in a US trade or business” or are a controlled foreign corporation (CFC).

In addition, most rent-a-captive programmes will be required to pay tax on “related person insurance income”. If 25% of the captive is owned by US persons, regardless of how much stock they own individually, under the Tax Reform Act 1986, both the investment income and the underwriting profit of the captive or rent-a-captive programme attributable to a contract of insurance or reinsurance will be subject to tax, where the primary insured is a US shareholder or related person. In effect, rent-a-captive programmes that primarily insure their preferred shareholders' risks will be subject to tax on the earnings of their programme, whether or not the profits are distributed. The last remaining tax advantage in a captive or rent-a-captive programme is deductibility of premium. Whether or not premium is deductible will be determined primarily by whether or not insurance is present. In order for insurance to be present, there must be the presence of two elements, namely risk shifting and risk distribution.

There is a very prominent line of cases in the US defining when premiums are deductible. Known as the Humana cases, these cases deal with single parent captives, but anyone operating a rent-a-captive would be welladvised to follow the principles of those cases when considering premium deductibility. Rent-a-captive programme owners should also be aware that the writing of considerable third party risk will also make premiums deductible. Generally, the IRS has operated under a rule of thumb that if a programme includes 30% of unrelated risk, premiums are deductible.

In addition, anyone forming a captive or rent-a-captive programme must at least think about securities issues. Whenever stock is issued, be it common or preferred stock to a US shareholder, the issuer must comply with federal and state securities laws, even if the company is domiciled offshore, Generally, this means utilising the private placement exemption in the Securities Act 1933 and its safe harbour regulations.

Conclusion
There is little doubt that the alternative insurance marketplace willcontinue to expand. Rent-a-captive programmes, because of their inherentflexibility and appeal to small and mid-sized companies, will continue to be an important part of that market. Even more exciting is the introduction of protected cell or segregated portfolio companies, both offshore and in the US. The advent of these companies will not only spur the use of rent-a-captives as they are known today, but should also inspire insureds and owners to craft innovative uses for these vehicles.

Scott Penwell is the managing partner of, and Kirsten Miller is an associate in, the Harrisburg, Pennsylvania office of Duane, Morris & Heckscher, which has an international captive insurance company practice.