Key Accounting Issues for Cell Captives

The IRMI Glossary of Insurance and Risk Management Terms defines "cell captive" as "a sponsored captive or rent-a-captive, which maintains underwriting accounts separately for each participant. May be called protected cell captive (PCC) or segregated cell insurer. If the cells are legally segregated, it may be used to securitize risk."

Cell captive use in the alternative insurance space continues to expand, and—not surprisingly—as these entities have proliferated, the accounting for them has become more complex. Recently, Josh Partlow from Johnson Lambert and Karin Landry from Spring Consulting Group have teamed up to produce a white paper, titled Crafting Cell Captives, which discusses key accounting issues associated with cell captives.

While cell captive taxation has been well documented, the accounting for these entities has not received as much attention; the cell captives white paper expands understanding surrounding some of the generally accepted accounting principles (GAAP) questions. This said, the white paper does not supplant the need for cell captive users to speak directly with both their accountants and attorneys to gain a full understanding of the implications associated with these structures.

The white paper's opening summary provides evidence of the complexity surrounding accounting for these structures.

Entities are increasingly looking to utilize cell captive structures to achieve various business, financial and risk management goals. The evolution of cell structures using incorporated and unincorporated cells has resulted in various financial reporting and regulatory models, which are important for business leaders to understand while crafting such programs. Obtaining an understanding of the various requirements can be slow and cumbersome, given the complexity of accounting guidance on consolidation found in the Generally Accepted Accounting Principles (GAAP) in the United States. Complexity from the GAAP ultimately leaves many cell programs with financial reporting that do not align with the business purpose of the entities.

The authors suggest the best way to gain a better understanding of the accounting complexities is to look at the evolution of cell captives and how GAAP guidance has been applied to these structures. In this manner, the writers suggest users of this model can craft a cell structure that hopefully provides alignment between the business purposes the cell was created for and the financial reporting as required by GAAP.

The basic accounting question comes down to whether the financial results of the cell must be consolidated with the financial results of the core or whether the core just operates in a fiduciary oversight capacity. While this may seem to be a technical question best left to the accountants, the answer plays a large role in determining whether there is true segregation of the cells from the core and from each other—and, conversely, transfer of risk to the core, or parent, where no such liability is intended. The authors note that it is important for potential users of the cell structure to properly define what they hope to accomplish through the cell's creation.

The paper provides four such examples for consideration, as follows. ¹

1. Structure —An insurance producer creates a cell structure to allow customers to participate in their own risk. The producer may want to control the entity and consolidate or, alternatively, may want to allow cell participants more control—allowing the cell participants or parent to consolidate.
2. Joint Venture Model —A captive owner may want to reform a pure captive as a cell captive to allow several joint ventures entered into by the parent to be insured through cells jointly owned by the joint venture owners.
3. Business Operation Model —A parent company may want to legally separate risks associated with certain business operations deemed as having more risk, without putting the other operations of the captive insurer in danger. The goal could be to consolidate the insurance operations of each cell into the core or parent or alternatively to carry the insurance operations at the operating unit level (i.e., each operating unit consolidates and is responsible for its cell).
4. Skin in the Game —A large family-owned business may want to give the senior management of its operating subsidiaries risk management "skin in the game," by allowing the senior management team to own incorporated cells insuring the subsidiaries they run either directly or via the operating entity they manage.

Not surprisingly, this is just a small subset of what these structures can be used for. That is why it is important before any contracts are signed or money changes hands that potential users develop a sound business plan outlining exactly what they want to accomplish. For small and/or midsize firms looking at cells as a way to enter the captive market, it is important to have the business plan vetted by an outside third party.

In many instances, this may well be the broker or agent that works with the firm. However, the analysis should never be conducted by the party who controls the parent or core of the proposed cell, be it a broker, captive manager, reinsurer, or other vendor. This eliminates the potential conflict of interest involved and ensures the users of the cell understand exactly how their interest will be accounted for and how the risk will be handled. As in most transactions. doing the proper due diligence in advance can save a lot of headaches down the road.

In short, when it comes to cell captive structures, beyond the tax questions, prospective users should also look at the accounting issues. Read a basic introduction to cell captives. In an upcoming article, we will explore an actual example of a cell captive in action.

1. The four examples are taken directly from the white paper with minor edits. Crafting Cell Captives, by Josh Partlow and Karin Landry, published by Johnson Lambert and Spring Consulting Group, April 2019.