With Solvency II upon us, captives are facing an uncertain, and industry bodies say unfair, future. Will the directive impose unreasonable capital requirements that late concessions to captives have not gone far enough to redress?

The EU Solvency II Directive is attracting a great deal of anticipation as it goes through the final stages of fine-tuning before it is transposed in 2012. Bodies representing captive groups are lobbying hard to ensure that captives receive fair treatment under the new laws. Many are concerned that, without this, captives’ capital requirements could increase substantially.

So, what effect will Solvency II have on captive domiciles around the world? Those within the EU could find their competitiveness compromised should the regulatory regime prove too onerous a burden.

But there are also potential advantages, such as the ability to use fronting mechanisms without penalty. And beyond Europe, offshore jurisdictions are also debating whether to apply for equivalence as they consider what it could mean for their own ability to attract and retain captives going forward.

Deep impact

Solvency II was the industry’s answer to Basel II in the banking sector – a principles-based approach to regulation where the onus is on insurers to prepare their internal models and to take an enterprise-wide approach to risk management (ERM). The aim is to more closely link risk and capital. Under the Own Risk and Solvency Assessment (Orsa), companies are required to assess their own solvency needs and to present the results to the supervisor.

While it did not initially cater to captive insurers, the final text of the directive now contains numerous references, but stops short of spelling out how captives might be treated under the new regime. In fact, many captives, if they are small enough, will not be subject to Solvency II, which states that insurance entities must have gross premium income exceeding €5m ($6.39m), or gross technical provisions in excess of €25m, to fall within its scope.

According to the directive under CP79, it will “take account of the specific nature of captive insurance and captive reinsurance undertakings. As those undertakings only cover risks associated with the industrial or commercial group to which they belong, appropriate approaches should thus be provided in line with the principle of proportionality to reflect the nature, scale and complexity of their business.”

While it recommends a proportional approach to regulation, industry bodies believe the rules will not work in practice. In a joint letter to the ministries, Aon, Marsh, Eciroa (European Captive Insurance and Reinsurance Owners’ Association), Agere (Association des Gestionnaires de Réassurances), Ferma (Federation of European Risk Management Associations) and Mima (Malta Insurance Managers Association) warned that the directive could be damaging to the future of the captive industry in Europe.

“The introduction of Solvency II without recognition of the simplicity of captive structures will have a dramatic impact upon the captive community, leading to increased costs for all and possibly the demise of some,” the letter states.

Under Solvency II there are two key approaches to assessing solvency requirements. Companies can build their own model or they can adopt the standard formula. Smaller captives will have no choice but to go the standard formula route, as very few have the budget to create a bespoke internal model, although it is possible to get partial model approval if an element of a captive’s business model is not reflected in the standard model.

Captive insurers are concerned that future amendments to the standard formula could undermine their fair treatment. In its preparations for the fifth impact study (QIS5), the Committee of European Insurance and Occupational Pension Supervisors (Ceiops) has been criticised by industry bodies for tightening the rules governing the standard formula approach to capital requirements. This has been seen as a knee-jerk reaction to the financial crisis.

According to the industry bodies’ joint letter, dated 26 January 2010: “The proposed standard formulas, when applied to captives, result in much higher levels of prudence for captive undertakings than for commercial insurers and reinsurers because the current formulas are not adapted to the business model of captives. Both the formulas and the corporate governance principles need to be simplified and aligned to the captive business model.”

Political endeavours

The Dublin International and Insurance Management Association (Dima) has been working hard behind the scenes to ensure captives will get fair treatment under Solvency II. This includes several meetings with Ceiops, representatives from the European parliament and head of the European Commission’s insurance and pensions unit, Karel van Hulle.

Captives based in Ireland have taken part in the third and fourth impact studies and plan to participate in QIS5, Dima chief executive Sarah Goddard reveals. “Dima has attended numerous meetings, workshops and hearings on Solvency II in Brussels, with the European Commission and parliament, and Frankfurt, with Ceiops, over the past few years, representing the captives’ position as well as other sectors of the international reinsurance market,” Goddard says.

Shaping the new regulatory regime so that it adequately reflects the needs of all parties was always going to be a political endeavour, says Kane consultant Clive James. “The issue with Solvency II is that it’s only when people start to dig deeper that they will discover there are unique areas that may be difficult to include within the general scope of the regulation,” he says.

“Within the EU, the three countries that are really looking at captives are Malta, Luxembourg and Ireland, and with the best will in the world, if you look at the power base within the EU, those three countries are not part of that.”

He thinks it is too early to tell how captives will be affected by Solvency II, with much riding on the final definition of what a captive insurer is being accepted by the new regulations and the level of proportionality. For the non-EU domiciles, the ‘equivalents’ approach has not yet been finalised.

QIS5 should bring clarity but, until then, captive insurers can only speculate on how it will affect their capital requirements. Should the definition be too narrow and fail to allow for the different risk profiles and reinsurance arrangements undertaken by captives, parent companies with European captives may be forced to rethink their risk transfer arrangements.

“People in the captive industry are unhappy because many do not qualify for the captive simplifications that have been proposed under Solvency II,” Lane Clark & Peacock insurance consulting partner Charl Cronje says.

“This is because of an exclusion for third-party liability risks, as well as a technical restriction that may affect ‘fronting’ arrangements and insurance of certain employee benefit risks. Therefore, even the simplifications that have been made available for captives are not going to apply in many cases. Solvency II may turn out to be quite tough for captives.”

There have been recent indications that capital requirements will not go up as much as had been originally intended under QIS5. In its draft specifications for the fifth impact study, Ceiops confirmed that it had taken on board some of the industry’s concerns.

“The big news is that the European Commission has started to intervene and has relaxed or simplified a large number of the proposed requirements. Hopefully this will be good news for the bottom-line solvency capital requirement of many insurers,” Cronje says.

“The direction of Solvency II so far has been very much governed by Ceiops and they’ve stuck very strictly to theoretically correct approaches, even where they gave unpalatable results. What we’re now seeing for the first time is a more pragmatic overlay as the European Commission starts to take control. On the other side of the coin is the additional complication and a concern that the rules keep changing.”

Relocation, relocation

If the final regime proves to be a burden on captives, this could influence where future captives are likely to be set up. Parent companies may simply choose to shut their captives down. Or should captives writing third-party risks fall under Solvency II’s definition of an insurance company, they will struggle to comply with the new regime. Such captives may have to relocate.

“The prospect of setting aside considerably more money and time for regulatory compliance will lead companies to consider setting up their insurance vehicles outside the EU,” rating agency AM Best predicted in a July 2009 report titled European captives – a growth market during a challenging time.

“This will be more of a consideration for start-ups, and there is anecdotal evidence that Guernsey and the Isle of Man have already seen an increase in enquiries about captive formations as a result of the pending directive,” says the report. “It is inevitable that domiciles outside the EU will see a pick-up in interest, as Solvency II represents an enormous change to the framework for insurance business in general.”

But captive domiciles themselves are facing a growing dilemma. Those outside the EU have the option of applying for third country equivalence. This means they can put in place a regulatory framework that is equal to Solvency II and apply to be recognised as an equivalent jurisdiction. Some think this would resolve some issues, particularly where the parent company is based inside the EU. But others worry that tighter supervision would affect their competitiveness.

Traditionally, many European parent companies have passed on risk to their captives based outside of the EU via fronting arrangements. Here, a commercial insurance company will underwrite the risk and issue the policy but then pass on 100% of the risk and premium to the captive. For big clients, they are happy to do this for a small arrangement fee. But that could change.

“Under Solvency II, the fronting insurer will potentially suffer a penalty to their own Solvency II capital requirements,” Cronje explains. “So, an arrangement that was previously very cheap for the fronting insurer to provide might become more costly.”

“One way around the problem is for the captive to also be EU-based, although it still then needs to maintain its own capital levels in line with Solvency II,” Cronje adds. “Another is for the offshore regime to apply to become recognised as a third country equivalent – a special designation under Solvency II where overseas regimes, if their regulatory regime is deemed by Europe to be up to scratch, can be treated as equivalent. A third solution is for the captive to obtain its own BBB credit rating.”

Guernsey is creating an Own Solvency Capital Assessment (Osca) and the Isle of Man is developing a risk-based capital regulatory approach. Tellingly, Bermuda is only applying for third country equivalence for its class 3 and 4 insurers (commercial insurance and reinsurance companies) and not for class 1 and 2 insurers, which is what captives come under. This will ease fronting concerns for the island’s reinsurance market, which underwrites a lot of business from the London and European insurance markets. However, it will do little to help captives with European parents.

“There is, at present, no attempt to include classes 1 and 2, into which captives fall. This is not surprising because these classes have very light-touch regulation,” Cronje says.

“The problem that Bermuda and other territories have is that if they were to introduce a regime as tough as Solvency II, they might achieve equivalence but they might also chase their local business away.

“It probably will not make sense for all territories to attempt equivalence, and the Bermuda story demonstrates that point. However, at present, the offshore territories are sticking to the story that they intend to do all they can to embrace third country equivalence in the fullness of time.”

Winner takes all

As Europe edges closer to its new insurance legislation, captives and captive domiciles will be watching closely to discover how the regime will affect their future competitiveness. “I get the sense that Ceiops was never that keen to make exceptions for captives,” Cronje says. “There is the appearance of concessions for captives but without it having much effect in the real world.”

Those fearing burdensome capital requirements could opt to set up outside the EU, possibly considering emerging domiciles in Latin America and the Middle East, or opting for more established captives markets – both onshore and offshore.

But, should Solvency II adopt a broad and all-encompassing definition for captives, EU parent companies may decide they are best served by remaining in a European or equivalent market for their captive insurance. In both scenarios, there will be winners and losers as the stricter solvency standards take hold. GR