A decision by the Financial Services Tribunal (FST) has clarified the delineation between first-party and third-party risks when it comes to reinsurance business conducted through cell captives.
Centriq, the non-life insurance cell captive owned by Santam, took its case to the Tribunal after the Prudential Authority (PA) turned down its request to reinsure the risks of foreign insurers using the first-party cell captives established for some of its clients.
The core question before the Tribunal was whether the proposed reinsurance business constituted the underwriting of first-party risks or third-party risks. This is crucial because the Insurance Act prohibits cell captive insurers from insuring both first-party risks and third-party risks in the same cell structure.
Centriq argued that if a South African cell owner has a subsidiary in another country, the operational risks of that subsidiary fall within the ambit of the definition of first-party risks in the Insurance Act. It contended that the reinsurance agreement between a foreign primary insurer and Centriq, structured on a first-party indemnity insurance basis, would constitute first-party risk.
Furthermore, Centriq contended that the exclusion in the definition of operational risk, which excludes risks associated with the insurance obligations of an insurer, does not prevent reinsurance from being categorised as a first-party risk. It argued that the term “insurer” in the Insurance Act refers only to a local insurer obliged to obtain a licence under the Act before conducting insurance business in South Africa.
Prudential Authority’s argument
But the PA disagreed. It submitted that reinsurance business concerns the insurance of the insurance obligations of the primary foreign insurer, which are excluded from the definition of first-party risks. Therefore, reinsurance business can only be construed as third-party risks.
The Authority maintained that section 25(6)(b)(i) of the Insurance Act prohibits cell captive insurers from insuring both first-party and third-party risks under the same cell structure. Centriq may reinsure the risks of foreign primary insurers, but it must do so in a separate cell structure from those housing the first-party risks of the cell owners.
Additionally, the PA relied on section 25(6)(b)(ii), which prohibits cell captive insurers from insuring the risks associated with the insurance obligations of another insurer without the Authority’s approval.
The PA argued that the correct interpretation of the Act requires a clear distinction between first-party risks and third-party risks, and these two categories of risks must be housed under different cell structures. Reinsurance business involves insuring the risks associated with the insurance obligations of a primary insurer (domestic or foreign), which constitute third-party risk.
The dispute essentially revolved around whether the risks involved in the insurance relationships between the cell owner and its primary insurer and between Centriq and the foreign primary insurer are the same.
Centriq argued that both relationships cover the operational risks of the cell owner. The PA contended that the reinsurance arrangement manages a third-party risk, distinct from the operational risks managed in the insurance arrangement between the foreign primary insurer and the foreign subsidiary of the cell owner.
The PA maintained that a foreign primary insurer’s risk, which would be reinsured, does not become a first-party risk simply because it pertains to a contingency insured against with reference to the operational risks of the cell owner.
Tribunal’s decision
The Tribunal agreed with the PA’s interpretation of the Act.
It said Centriq urged the FST to the focus on the nature of the risk insured against, rather than the identity of the parties involved in the insurance arrangement. The argument was that both the insurance relationship with the cell owner and the reinsurance relationship with the foreign primary insurer should be considered as the operational risks of the cell owner.
But the Tribunal said this argument did not hold water.
The risks involved in the insurance relationships between the cell owner and its primary insurer and between Centriq and the foreign primary insurer were not the same. The reinsurance arrangement managed a third-party risk, distinct from the operational risks managed in the insurance arrangement between the foreign primary insurer and the foreign subsidiary of the cell owner.
The Tribunal said Centriq’s argument was further weakened when it failed to provide a commercial rationale for including reinsurance risks in the same cell structure as the operational risks of the cell owner.
The Tribunal concluded that the Insurance Act’s policy of separating first-party and third-party risks aims to avoid conflicts of interest that may arise if both the internal risks and the external risks of a business organisation are mingled in a cell structure.
Although some reinsurance contracts might be first-party indemnity insurance, the Tribunal said this was not what Centriq proposed in its licence variation application. The application contemplated that cell owners would be insured by other foreign direct insurers, and those insured parties would seek to conduct reinsurance business with Centriq.
Additionally, the Tribunal rejected’s challenges to specific conditions in the licence variation decision. Centriq contested the requirement for prior approval from the PA before entering a reinsurance arrangement with foreign insurers, as well as the requirement for foreign insurers to enter a separate third-party cell arrangement. The Tribunal ruled that each of these challenges was unsuccessful.
The Tribunal underscored the importance of maintaining the separation of first-party and third-party risks to avoid conflicts of interest within cell structures. It therefore dismissed Centriq’s application.
