In the area of regulation, nothing less than the future of the offshore financial community is at stake, say Gordon Rowell and Tom Jones.

In the last five years, a series of events has occurred in rapid succession that has influenced the way global investors do business in offshore financial centres (OFCs). Focused attention from multilateral agencies seems to emanate from the increased interest in OFCs by the European Union and from US concerns over terrorist activities since September 11.

Unfortunately, the professed purposes of overseas organisations' increased scrutiny of OFCs are not always clear to regulators. It appears, however, that their pronouncements tend to concentrate in three key areas - money laundering, regulation and taxation.

The primary overseers that regulators now deal with include: the Financial Action Task Force (FATF); the International Association of Insurance Supervisors (IAIS); the Financial Stability Forum (FSF); the International Monetary Fund (IMF); the Offshore Group of Insurance Supervisors (OGIS); and other miscellaneous groups (Edwards Report and KPMG Review).

Each offers a different perspective, though some of their concerns overlap or even leverage off another organisation's focus and activities.

Money laundering
Financial Action Task Force (FATF)

A sub-group of the Organisation for Economic Co-operation and Development (OECD), the FATF was established at a Group of Seven (G-7) summit (now G-8) in Paris in 1989 to examine measures to combat money laundering.

The FATF comprises 26 countries plus two regional organisations, including the European Commission. In April 1990, the FATF issued a report containing 40 recommendations, designed to serve as a blueprint for action against money laundering, covering everything from law enforcement and international cooperation to regulation. It should be noted that post-September 11, a further eight items specific to terrorism were added to the FATF's 40 recommendations.

The FATF's purpose is to ensure that all countries address the following issues:

  • ineffective financial regulations (whether via loopholes or otherwise) that allow inadequate supervision of the financial sector including weak licensing, inadequate customer identification or excessive secrecy provisions;

  • commercial sector weaknesses such as identification of ultimate ownership;

  • obstacles to international cooperation at both the regulatory and judicial levels; and

  • inadequate resources for preventing, detecting and punishing money laundering.

    A number of jurisdictions, including the Bahamas and Cayman Islands, were initially blacklisted by the FATF. Both were removed from the list once a full examination of their anti-money laundering (AML) regimes revealed no significant deficiencies. It should be noted that both the Bahamas and the Cayman Islands have among the most advanced AML regimes in the world, built on comprehensive statutory requirements for both customer identification and reporting of suspicious activities.

    US Patriot Act
    Following September 11, the US Congress enacted the Patriot Act. It requires that all financial institutions (captive insurers have not yet been defined here, but should be considered potentially subject to scrutiny) must have affirmative AML programs in place, must check customers against the Federal Government's terrorist list, and must report any `suspicious activities'. Much of the terminology - and indeed the substantive requirements themselves - are still not well defined or adequately explained.

    Though such broad-reaching legislation is unprecedented except in times of declared war, it is anticipated that the legislative framework most OFCs already have in place will address most of the Act's mandates. (Further information on the FATF can be found at www1.oecd.org/fatf.)

    Regulation
    International Association of Insurance Supervisors (IAIS)

    In April 1994, insurance supervisors from around the world established the IAIS to improve cooperation, exchange information, and develop uniform regulatory standards in insurance regulation.

    In essence, the organisation attempts to define and promulgate `best practices' for insurance regulation. In October 2000, the IAIS finally ratified a set of insurance core principles that provide the benchmark against which the insurance supervisory regimes can be assessed.

    At present, 17 core principles - standards - cover areas such as licensing, sanctions, cooperation and corporate governance. (Further information on the IAIS can be found at www.iaisweb.org .)

    Oversight and review
    With standards in place, other organisations began to use these standards in assessing OFCs.

    Financial Stability Forum (FSF)

    In April 1999, as a result of instability in the Russian and Asian financial markets, the FSF was created as a G-7 initiative to examine the impact of regulation on global financial markets. The FSF promptly established a working group that released a report in March 2000, indicating that OFCs unwilling or unable to adhere to international standards could create a systemic threat to global financial stability.

    Essentially, the FSF has added its weight to the growing criticism of OFCs by demanding tighter supervision and closer cooperation with other regulators, to avoid becoming subject to sanctions. The FSF divided jurisdictions into three groups based on `perceived' weaknesses.

    At the present time, it is still not clear to OFCs what exactly are the underlying criteria behind the FSF's perceptions that some OFCs are poorly regulated. Further, no announcement has been made regarding what sanctions might be imposed and when.

    To address concerns posed by weak regulatory environments, the FSF recommended a framework encouraging jurisdictions to adhere to relevant financial standards. In the case of insurance regulation, these were the IAIS core principles. But lacking adequate resources, the FSF is relying on another organisation, the International Monetary Fund (IMF). (Further information on the FSF can be found at www.fsforum.org .)

    International Monetary Fund (IMF)
    During the last few years, the IMF has been carrying out a series of assessments called Financial Sector Assessment Programs (FSAPs) on both offshore and onshore regulatory regimes. The IMF uses FSAPs to assess countries' adherence to international standards, which in the case of captive regulation are the IAIS core principles. The process is straightforward. A team of IMF technical representatives visits a jurisdiction and assesses each regulatory sector against international standards in meticulous detail. This was a perfect fit for the FSF, which could use the information published by the IMF in its assessment of standards for OFCs.

    For the Caymans, these reviews are manifested in an extensive examination of adherence to international regulatory standards, and take about two weeks onsite for the regulators and their departments. The purpose of the IMF review is to identify weaknesses and offer technical assistance to strengthen perceived deficient areas. It is not intended to be a tool to identify and admonish weak regulatory regimes.

    It is likely that this review process will be complete for all OFCs by the end of 2003. For the major jurisdictions, including Bahamas, Bermuda, British Virgin Islands (BVI), Cayman, Guernsey, Isle of Man and Jersey, this process finishes in the last half of 2002. (Further information on the IMF reviews can be found at www.imf.org/external/np/mae/oshore/ )

    Offshore Group of Insurance Supervisors (OGIS)

    Dealing with the growing complexity and sheer volume of outside scrutiny has become a substantial burden for smaller jurisdictions.

    In response, they established the OGIS - an informal grouping of insurance regulators representing domiciles engaged in `offshore' insurance business. The OGIS was founded in 1993 under a written constitution.

    In the context of recent and current international issues, the need for OGIS has never been greater. Threats to the very existence (or at least the structure and methods of operation) of offshore financial centres engaged in offshore insurance business have intensified in the last few years. Membership of OGIS brings with it many benefits, a significant one being participation in a forum to exchange information and share in the experiences of each member and observer, allowing less mature jurisdictions to aspire to the highest international standards of insurance regulation.

    In this regard, OGIS is a very positive development in terms of dealing with the IMF and the IAIS. (Further information on OGIS can be found at www.ogis.net .)

    Edwards Report and KPMG Review

    One often-overlooked fact is that OFCs have been subjected to comparative evaluations and reviews on a regular basis, particularly in the area of regulation. Despite comments about weak regulatory frameworks, financial secrecy and poor cooperation, many jurisdictions have cooperated with these evaluations and received positive assessments.

    In January 1998, the British Government commissioned Andrew Edwards, a former senior official at the UK Treasury, to review with authorities in Jersey, Guernsey, and the Isle of Man their laws, systems and practices for regulation of their international finance centres, their combating of financial crime, and their cooperation with other jurisdictions.

    The result of the reviews, the Edwards Report, reflected a very positive picture of regulation in the Channel Islands and the Isle of Man.

    Similarly, in December 1999, as part of a white paper entitled Partnership for Progress, the British government appointed KPMG to undertake a review of certain British dependent territories including Anguilla, Bermuda, BVI, the Cayman Islands, Montserrat and Turks & Caicos.

    From the Cayman Islands' point of view, the report lent a degree of satisfaction in that it identified that the regulation of the Cayman insurance sector as generally meeting all relevant international standards. Despite this report and the continual assessments, however, it appears misperception and stereotypical opinions have not changed.

    Taxation
    In May 1996, the Ministers of the member states of the OECD called on the organisation to develop measures to counter the distorting effects of `harmful tax competition' on global investment and financing decisions.

    As a consequence, a 1998 report, Harmful Tax Competition: An Emerging Global Issue, was produced. It identified (what it referred to as) harmful tax practices and made recommendations to counter these practices. Interestingly, two members of the OECD - Luxembourg and Switzerland - abstained on the approval of the report.

    Fundamentally, according to the report, the absence of tax or the presence of a low tax rate is the starting point for any evaluation.

    The result of the report was to initially categorise 47 OFCs as tax havens in June 2000. It is important to note that very few OFCs are tax-free. Some of the Channel Islands have corporation tax, and most jurisdictions have consumption-based taxes, such as tariffs and customs duties.

    A series of unpredictable world events then affected the direction of the OECD initiative. Most relevant to captive owners is that in May 2000, both Bermuda and the Cayman Islands agreed to certain undertakings, basically involving transparency and cooperation. The effect of these was to remove any possibility they would be included on the OECD's tax haven list. It should be emphasised that these commitments have no adverse consequence to captives or their owners, and in fact, in this post-Enron world, clearly were a wise decision.

    Meanwhile, the change of Administrations in Washington led to the US effectively withdrawing its support for the OECD's objective of eliminating low corporate tax rate jurisdictions in May 2001. The US continued to press for anti-money laundering and exchange of tax information goals espoused by the OECD, however.

    The shocking events of last September 11 refocused attention on preventing use of the global financial system by terrorist organisations, leading to the enactment in October of the Patriot Act and reinforcing support for OECD aims other than compelling corporate income taxes.

    As a result of OECD negotiations with allegedly deficient jurisdictions, and after a softening of OECD procedures and demands due to `push back' by domiciles such as Barbados, only seven tax havens were `named and shamed' by the OECD last February: Andorra, Liberia, Liechtenstein, Marshall Islands, Monaco, Nauru and Vanuatu.

    As yet unidentified `defensive measures' are scheduled against these tax havens in April 2003 unless they conform to OECD requirements. It was agreed, however, that no sanctions would be imposed until all European Union countries satisfy the same standards asked of these tax havens.

    Future threats and challenges
    It might be useful to summarise some of the challenges faced by OFCs. Of critical importance to the regulation of captive insurers are: a rigorous licensing process; a strong anti-money laundering regime; effective reporting requirements; a broad range of sanctions; and sufficient and qualified staff to regulate the industry

    All of the IAIS and FATF principles are addressed in the major OFCs. Despite favourable assessments by KPMG, Andrew Edwards, the FATF and the IMF, however, OECD member nations continue to perceive OFCs as poorly regulated and uncooperative.

    It appears that this posture might still reflect anecdotal reputation issues that no longer apply to the more professional OFCs. Most OFCs have pledged their support to transparency in the global financial system, but have emphasised that this transparency must be based on reciprocity. In this regard, a number of jurisdictions, including the Cayman Islands and Bermuda, have entered into tax cooperation agreements with the US.

    OFCs have been under increasing pressure not only to regulate their respective industries but also to allocate resources to defend their style and method of regulation and participate in assessments. Over the last few years, we have seen increased emphasis on `know your customer' (KYC) requirements, adherence to IAIS standards, bilateral tax information disclosure agreements and generally increased standards, which in some cases are superior to their onshore counterparts.

    This strain on resources obviously comes with a cost. For instance, the Cayman regulatory staff has increased by 60% to meet these standards. The current insurance license fees are still absorbing the cost, but the process has led to a reduction in income to the domicile.

    The above initiatives require significant regulatory and compliance expenditures by financial centres. Relatively small OFCs have not yet reached the critical mass in their financial sectors to maintain the infrastructure required by these external organisations. The future captive market, therefore, is likely to be concentrated in those few jurisdictions that can set up and support a larger, more sophisticated infrastructure.

    Closing thoughts
    Captive owners desire to be properly regulated in a stringent and efficient manner. But assessing a domicile's compliance to these international standards requires that prospective captive owners fully research their proposed jurisdiction and ensure that it is the appropriate place to do business. There is plenty of material, as shown earlier, to support this research. It is true that financial crimes, including money laundering and fraud, pose threats to the global financial system, and that most jurisdictions are vulnerable. Tackling these crimes requires heightened attention to due diligence, better standards and improved cross-border cooperation from both onshore and offshore authorities.

    It should be encouraging to note, however, that the legal and regulatory framework which currently exists in a number of OFCs is exemplary.

    It can be clearly seen that many OFCs have taken steps to ensure compliance. In the process, OFCs have been held to international standards that the countries undertaking the assessing have not always been able, or perhaps have not attempted, to achieve themselves.

    There is no doubt that some OFCs have a deserved reputation for inconsistent standards. The generalisation that all OFCs are poorly-regulated is based, however, on speculation rather than fact. There are plenty of reviews and supporting evidence to the contrary. What is amazing is that despite these reviews, OFCs are still regarded as being uncooperative, secretive and poorly-regulated.

    It has been mentioned that for some, the scrutiny of OFCs is a political crusade to either erase OFCs altogether or at least raise regulatory costs so high as to drive OFCs from the international arena. Unfortunately, despite the open availability of positive information on OFCs, this is a battle that is likely to continue indefinitely with the future survival of OFCs as the prize.

    By Gordon Rowell & Tom Jones

    Gordon Rowell is head of Insurance Supervision for the Cayman Islands. Tom Jones, a partner at McDermott, Will & Emery in Chicago, helped draft the tax portions. An earlier version of this article first appeared in Captive Insurance Company Reports.