We have all burned the midnight oil at some point in our lives, cramming for some exam or presentation. The next day, we would write the exam or do the presentation and all would be well with the world. What if, on that day, however, the professor who showed up to invigilate was from a different department and unfamiliar with the topic or curriculum, but proceeded to test us anyway? What if he decided to base his assessment on a course he taught ten years before, rather than the material recently taught? In a sense, this scenario has been prevailing with offshore insurance regulators for some time.
This has been a dramatic year for insurance in the Cayman Islands, which has not only seen the Cayman Islands removed from the FATF blacklist but has also seen a explosion in growth of captive formations.
However, a lot of events are occurring in rapid succession that either affect or will significantly affect the way global investors will do business in offshore financial centres (OFCs).
We are all aware of the Financial Action Task Force (FATF) and its crusade to improve global anti-money laundering regulations. But what about the Financial Stability Forum (FSF), the International Monetary Fund (IMF) and the International Association of Insurance Supervisors (IAIS)? How do they affect global regulation and will global regulatory standards uniformly improve as a result of their efforts?
To understand the impact, we first have to look back at the source of the change.
April 1994: At that time, insurance supervisors from around the world established their own association, the IAIS. The purpose of the IAIS was to improve co-operation, exchange information and develop uniform regulatory standards.
April 1999: The FSF was created by the G7 to examine the impact of regulation on global financial markets. The FSF, adding fuel to the OFCs' inferiority complex, promptly established a working group to consider the implications of OFCs for global financial stability and to make recommendations for addressing any concerns identified.
May 2000: A list of jurisdictions was published by the FSF based on responses from OFC supervisors and impressions of onshore supervisors.
October 2000: The IAIS finally ratified the Insurance Core Principles, which provide the benchmark to which the insurance supervisory regimes can be assessed. At this point, note the last word ‘assessed'.
To address concerns posed by weak regulatory environments, the FSF recommended a framework to encourage jurisdictions to adhere to relevant financial standards – the IAIS core principles. It also recommended that the IMF take responsibility for developing, organising and carrying out the assessment of OFCs' adherence to these standards. Although the IMF rejected the proposal, the IMF is performing reviews of global regulatory structures under its own mandate and, as we know, the FATF is performing reviews of global anti-money laundering structures.
There is no doubt that some OFCs have a deserved reputation for inconsistent standards. The generalisation, however, that all OFCs are poorly regulated is based on speculation and ignorance of fact. It is not fair to assume that all onshore regulatory environments are well regulated and, therefore, should not be used as a benchmark for judging OFCs. Earlier this year, Canada and the US were not compliant with more than a third of the FATF 40 recommendations. Is it true that onshore regulation is uniformly superior? In examining the Cayman regulatory environment, I find it hard to believe.
One of the problems is that, with the exception of a few regulatory authorities, most onshore regulators do not fully understand the concept of a captive. The focus of onshore regulation is solvency driven, through the IAIS doctrine of maintaining efficient, fair, safe and stable insurance markets for the benefit and protection of policyholders. As the majority of onshore insurance companies are stock companies writing third-party business, these guidelines make sense.
A captive in the pure sense, however, is an insurance company owned and operated by a policyholder for the benefit of a policyholder. Additionally, the shareholder will usually be represented on the board of directors.
To a large degree, the conflict is resolved. It can be assumed that it is not in the best interest for a parent-owned insurance company to post inadequate reserves or undercapitalise in-fact quite the opposite.
Furthermore, when was the last time you heard of an arbitration hearing arising from a claim dispute between the policyholder and management of a pure captive? Of course, not all offshore insurance companies are pure captives but the point is that the focus of offshore regulation is different because the nature of offshore insurance companies is different.
There is no doubt that the IAIS core principles are critical to stable insurance markets both for onshore jurisdictions and OFCs. However, the focus of overseas reviews should take into account the different nature of captives and stock insurance companies. For example, capital adequacy is important but lower levels of capital can be justified because pure captives tend to reserve at higher confidence levels than their onshore counterparts and the risks of non-payment of claims and adverse deviation is reduced, which, after all, is one of the main purposes of capital adequacy.
Of critical importance to the regulation of captives is 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 these principles are in place in the Cayman Islands and some other significant OFCs. A strong financial reporting structure is important, but a 200-page statutory return that enables the regulator to micro-analyse a company's results, as performed in some onshore jurisdictions, is not the most effective method.
A greater understanding of the reinsurance market and programme structures is important, as is an understanding that management is aware of its risk environment and has effected the proper controls. Thus, it could be argued that the principles of corporate governance and reinsurance are relatively more important to OFCs than the principle of financial reporting.
This style of risk-based regulation is a style that Canada, for example, has moved toward. The old style of regulation was to find contraventions in the regulations regardless of materiality and to meticulously reconcile data.
Then came Confederation Life, the largest insolvency in North American history. Over the years, a new style of risk-based regulation has developed in Canada, ironically based on the concepts already in practice in OFCs: a greater focus on business strategy and management attitude towards risk and the control environment. This can also be viewed as proactive rather than reactive supervision. In the Cayman Islands, for example, all amendments to a business plan are filed, examined in detail and approved, if prudent to the organisation's risk profile. The Cayman Islands, on-site inspection programme is comprehensive and focuses not only on anti-money laundering compliance but also on internal control environments and corporate governance. In addition, annual meetings with directors of captives are strongly encouraged, in which management strength is assessed and risk profiles are discussed.
Desire for regulation
Discussions with the owners of captive organisations, show there is a great desire to be properly regulated in a stringent but efficient manner.
No organisation should wish to be domiciled in an environment where the relevant laws do not exist or are not uniformly enforced. However, differentiating between material problems and non-material concerns is the responsibility of effective regulators and it allows resources to be mobilised quickly towards the real regulatory concerns.
In addition, the level of private-sector expertise accessible in offshore markets is exceptional. The audit firms, law firms and insurance managers understand their business far better than is generally realised and act as a second line of defence to the regulators. Why? Part of the reason is because they have been conditioned to be more creative in product structures and are also aware of their global responsibilities.
In the Cayman Islands, insurance regulation is efficient and effective. It can be argued that by enforcing the same principles onshore and offshore, with the same level of significance given to each principle, you can negatively impact effective regulation by focusing energy and resources in the wrong areas.
Whilst we require financial accounts to be audited, to obtain a fair and independent assessment of a company's financial position, I believe that the frequency of reviews on OFCs can be viewed positively and are necessary. My hope is that the assessments recognise the different business environment and products and that the assessments are independent. If this happens, one day in the near future global critics of OFCs will be obliged to recognise the efforts that have been made.