Clyde & Co
Ernie van der Vyver, partner at Clyde & Co, explains what new legislation will mean for cell captive insurance companies in South Africa
What is current cell captive insurance company legislation in South Africa?
Unlike other jurisdictions, South Africa does not have protected cell company (PCC) legislation.
Until as recent as 1 July 2018 there was no specific definition of a cell captive insurer and thus no dedicated cell captive insurance licence. A cell captive insurer was an insurer registered in terms of the Long-term Insurance Act, 53 of 1998 and/or Short-term Insurance Act, 52 of 1998, respectively with specific conditions of registration (for example, policy benefits may not be limited to the funds available in the cell).
Unlike traditional insurers in South Africa, who were prohibited from issuing different classes of shares without prior approval from the relevant authority at the time, over time cell captive insurers were permitted to issue different classes of shares.
The creation of different classes of shares allows cell captive insurers to distribute profits in the forms of dividends to the various cell owners, based on the profitability of the insurance business generated through the particular cell owner.
However, on 1 July 2018, the Insurance Act, 2018 took effect, which seeks (among others) to provide a consolidated legal framework for the prudential supervision of insurers and repeals substantial portions of the Long-term and Short-term Insurance Acts dealing with prudential supervision.
The Insurance Act also introduces the definition of a cell captive insurer and now provides that only cell captive insurers licensed under the Insurance Act may conduct insurance business through cell structures. We note that the full detail regarding cell captive insurance business will be dealt with in terms of subordinate legislation issued pursuant to the provisions of the Insurance Act.
It is important to note that the Insurance Act is one of several changes in the insurance industry of South Africa.
The Financial Sector Regulation Act was recently enacted in South Africa and certain sections of the Act commenced with effect from 1 April 2018. The said legislation establishes the so-called Twin Peaks model of regulation in South Africa, which entails establishing two regulators being the Prudential Authority within the South African Reserve Bank, and the Financial Services Board transformed into the new Financial Sector Conduct Authority.
Similar to regulation in the UK, the Prudential Authority will supervise the safety and soundness of financial institutions while the Financial Sector Conduct Authority will supervise how financial services firms conduct their business and treat customers.
On 3 July 2018, the Financial Sector Conduct Authority and the Prudential Authority published a joint communication which inter alia, confirms that the Prudential Authority intends to consult on proposed subordinate legislation to deal with adequate governance and risk management, including provisions to be provided for in cell agreements and the Financial Sector Conduct Authority intends to consult on subordinate legislation which constitutes primarily conduct of business matters which includes, amongst others, who may be a cell owners. On 20 July 2018, the draft conduct of business subordinate legislation was published for consultation.
Of import, the Insurance Act has not changed the position that there is no PCC legislation in South Africa. Given that there is no PCC legislation in South Africa cells are not regarded as distinct legal entities and there is no legal ring-fencing of funds in the case of liquidation of a cell. Therefore, all the assets and liabilities of each cell forms part of the assets and liabilities of the cell captive insurer.
However, cell captive arrangements between cell captive insurers and cell owners in South Africa are primarily governed by contractual arrangements, most notably by way of shareholder agreements and the cell captive insurer’s memorandum of incorporation. The cell captive insurer utilises the shareholder agreements with each cell-owner to notionally ring-fence cells.
Have these legislative/regulatory changes been in the pipeline for a while?
As early as June 2013, the Financial Services Board (as it was then known) published a discussion paper titled ‘Review of Third Party Cell Captive Insurance and Similar Arrangements’. The said paper provided the initial regulatory policy proposals of the Financial Services Board with respect to third-party cell captive insurance and this concept of “similar arrangements”.
Notably, the discussion paper, as the name suggests, was merely a discussion paper in which the authorities set out its views on how it intended to deal with third party cell captives in future.
It was postulated that a final position paper on cell captives would be released as early as the end of 2015, which would contain the final regulatory proposals. However it took until 3 July 2018 for the joint communication by the Financial Sector Conduct Authority and the Prudential Authority to be published which provided an update on the regulatory policy proposals mooted in the discussion paper.
While we are still waiting the publication of the proposed subordinate legislation, which will deal with adequate governance and risk management in cell agreements, the draft conduct of business subordinate legislation was published on 20 July 2018 for consultation.
What are the key points of the update provided by the joint communication
The joint communication provides inter alia, an update on the extent to which the regulatory policy proposals mooted in the discussion paper have been accommodated in the Insurance Act and provides clarity regarding the supervisory oversight of the two authorities in regulating cell captive insurers.
In this regard, the Prudential Authority will regulate matters pertaining to adequate governance and risk management, including provisions to be provided for in cell agreements, whereas the Financial Sector Conduct Authority will regulate who may be a cell owner.
The regulatory concerns, which the Insurance Act, together with the aforesaid subordinate legislation seeks to address were summarised in the discussion paper. By no means exhaustive, the primary concerns related to the lack of uniformity of license conditions for active cell captive insurers; and the ownership structures inherent in cell captive arrangements could give rise to significant conflicts of interest, depending on who the cell owner is.
Regarding the latter issue, conflicts and the impact thereof on policyholders has been a primary consideration of the respective authorities. Of particular concern was the situation where a cell owner was an intermediary or an associate of an intermediary. The intermediary’s ability to earn profits (through the shareholder arrangement with the cell captive) creates the potential for conflicts of interest (for example, intermediaries market and sell policies and earn prescribed commission, but also have a vested interest in the profitability of the insurers, which is directly influenced by policy volumes and loss ratios).
To mitigate such risks, the Financial Sector Conduct Authority has in its draft subordinate legislation provided certain limitations on the ownership of cell structures by intermediaries (or an associate of intermediaries).
Firstly, it is proposed that the cell owner must only render intermediary services in respect of policies underwritten by that cell owner. The intermediary must thus act as a tied agent. Secondly, the intermediary must not own cells in more than one cell captive insurer (for example, acting clearly on behalf of one insurer only). Thirdly, an ‘affinity relationship’ must exist between the main business of the cell owner and the insurance business conducted through the cell structure. Lastly, the primary business of the cell owner is not the rendering of services as an intermediary.
A relationship will, based on current proposals, constitute an ‘affinity relationship’, if the primary business of the cell owner is not insurance business and the broader business relationship between the cell owner and the policyholder results in the offering of suitable insurance products and consistently offers fair value to the policyholder.
Is the new legislation bringing regulation to a space in which it was previously lacking?
Specific cell captive legislation did not exist prior to the enactment of the Insurance Act and cell captive insurers were regulated in terms of the general insurance regulatory framework. Only specific regulation was achieved by including cell captive specific conditions in the cell captive insurer’s licensing conditions.
Several material risks (to both financial soundness and fair conduct of business) for insurers, policyholders and effective supervision that may arise from such structures and business models were identified in the discussion document and measures to mitigate these risks are now in the process of being introduced through the Insurance Act and its subordinate legislation.
What is the timeline moving forward?
In terms of the transitional arrangements contained in Schedule 3 to the Insurance Act, the Prudential Authority must by 30 June 2020, convert the registration of all previously registered insurers to a licence in accordance with the Insurance Act.
Until such time, insurers registered in accordance with the Long-term and Short-term Insurance Acts continue to exist as an insurer and may continue to do insurance business until a licence is granted in accordance with the Insurance Act.
The Prudential Authority has published a communication which details the envisaged conversion process and notes therein that a progressive implementation of conversion will take place such that from 1 January 2019 to 1 October 2019 existing cell captive insurers will be converted.
Notably, said conversion is largely dependent on the finalisation of the subordinate legislation applicable to cell captive insurers, which is yet to be completed. In the joint communication it is noted that the envisaged effective date of the proposed subordinate legislation dealing with prudential matters is 1 January 2019.
What effect do you predict this will have on the South African market?
Given the current proposals regarding the limitations pertaining to cell owners, it is possible that exiting cell owners will no longer be permitted to own cells. This concern is becoming a critical concern from the relevant industry, as we have been asked to advise several clients of this risk and whether their current business conducted through a cell will survive this regulatory change, as currently proposed.
It is difficult to advise on the true impact the regulatory changes will have on the cell captive market in South Africa given that the advice is limited to regulatory proposals. However, we anticipate that based on the current proposals there will be a reduction in existing cell owners, partly as a result of non-compliance with the limitations of cell ownership and partly due to increased regulatory supervisory requirements.
The impact is not only limited to cell owners. Cell captive insurers will also be impacted by the advent of the Insurance Act and related subordinate legislation. Cell captive insurers are accountable for the financial soundness and regulatory compliance of each cell structure that it puts in place. The financial soundness obligations are similar to those stated under Solvency II and will undoubtedly place new pressures on existing cell captive insurers. Cell captive insurers will also not be allowed to underwrite any traditional insurance business (for example, non-cell insurance business).
