With the first working document expected this autumn, Praveen Sharma considers how the Solvency II Directive might affect captives.

At the beginning of 2000, the European Commission embarked, together with the member states, upon a fundamental and wide-ranging review of the European solvency system for insurers (the Solvency II project). This review, in due course, is likely to have a major impact on the framework for insurance supervision initially within the EU and perhaps later internationally. Its objective is to establish as soon as possible a solvency system that reflects the true risk profile of an insurance company and its products (such as derivatives and alternative risk transfer) whilst avoiding undue complexity.

The current solvency system within the EU, which has been in place for some 20 years, is a fixed-ratio solvency system, taking into account the solvency margin based on a set of rules for calculating the minimum capital prudent rules relating to the calculation of both the technical provisions and the assets supporting the liabilities. Although recent Solvency I rules changed certain parameters, the old system has remained relatively unchanged.

It is now accepted that this approach should be modified for all EU insurers towards a more risk-based capital approach, akin to the Basle II three-pillar structure. As in the banking sector, there has been a growing dissatisfaction among insurance companies and regulators with the approach to establishing the solvency of insurance companies. The primary objectives of this initiative are to maintain market confidence, provide appropriate protection for consumers and policyholders, raise consumer awareness of financial matters, and fight fraud. It is anticipated that these proposals will affect captive insurance companies as well, since no specific exemptions for captives have been suggested.

Quantitative benchmarkThe first pillar would contain rules on financial resources - prudential rules on technical provisions and capital requirements. This could involve setting up a quantitative benchmark for an acceptable level of prudence in provisions for outstanding claims. It is presumed that any concept developed to set provisions for outstanding claims would be in accordance with the International Accounting Standards Board (IASB) proposals for accounting for insurance contracts. On the question of capital requirements, it is anticipated that this would be determined after taking into account underwriting risk, market risk and credit risk. Insurance companies would be required to have a two-tier capital structure - a `target capital' which will reflect the economic capital needed by the company and a `safety net level' which will be a trigger for ultimate supervisory intervention.

The second pillar would contain a set of measures aimed at enhancing internal risk management in insurance companies. In this respect it would focus particularly on internal controls, risk management and risk monitoring by prudential supervisors. Although the existing Community Insurance Directives require companies to have sound administrative and accounting procedures, and adequate internal control mechanisms, it is recognised that they are extremely general and inadequate. The introduction of a two-tier system would be supported by precise rules on risk assessment methodologies to be applied by local supervisors.

The third pillar would comprise a set of rules (mainly on transparency) designed to encourage market discipline. The IASB draft rules on accounting for insurance contracts contain a proposal for financial reporting obligations and therefore the Commission considers that a prudential system could not add value to the efforts of the IASB. Nevertheless, insurance companies may be required to provide policyholders with significantly more information.

It is hoped that the Solvency II project would provide an excellent opportunity to harmonise the disparate prudential rules and practices that presently exist in the member states. Insurance companies have expressed the need for more homogeneous rules to avoid distortions of competition. Better harmonisation of the European prudential systems should also strengthen the case for mutual recognition and cooperation between supervisory authorities.

Much of the solvency system is and will continue to be based on the accounts of insurance companies. Unfortunately, the delay in drawing up International Accounting Standards on Accounting for Insurance Contracts is giving rise to difficulties in planning the Solvency II project. However, in the longer term, and despite the uncertainties still associated with the IAS project, the Commission considers that the best solution would be for a prudential system to be based on international accounting standards applicable to all insurance companies in the EU. The statements required by the supervisors would thus be the company's financial accounts plus any additional information or simple reworking. This approach would be an effective catalyst for the harmonisation of risk measurement and prudential supervision methods, and would remove the current burden on companies to produce different national regulatory and accounting statements.

In conclusion, there is much work to be done by the European Commission in this regard and it is unclear at this stage how captives resident in the EU, and in those jurisdictions that may implement the EU Directives, would be affected. If a captive is required to follow the Solvency II provisions it may increase not only the capital required to support the various risks retained, but also the administrative burden and potential costs of management. Additionally, a captive may be required to implement reasonably sophisticated risk management systems to measure and model the full range of complex risks and exposures that it might face. The captive may also be required to perform an internal assessment of financial resources to ensure that it has enough capital to mitigate the risk of financial difficulties and potential insolvency.

Generally, a captive is set up as a risk-financing tool with the minimum possible capital and cost base, whilst enabling a reduction in overall insurance spend by its sponsors. Unfortunately, the proposals in their current format could potentially lead to an increase in overall costs and management time without providing added value benefit for the sponsors of the captive.

In comparison, a number of US states have introduced specific regulations which are different from the laws governing traditional insurance companies. This difference allows the sponsors of the captives to pursue a flexible corporate risk financing strategy without being lumbered with rigorous regulatory and compliance responsibilities - and the associated costs - whilst managing the expectations of the senior management and the insurance market.

It would be desirable therefore if the Commission could recognise the special arrangements that generally exist between a captive and its sponsor. Consequently provisions should be made either to exempt captives from certain aspects of the current proposals and/or to implement specific rules for captives. Both of these aims could be achieved without necessarily diluting the primary objective of the Solvency II project.

The Commission intends to issue its first working documents, outlining the proposal for a directive, by autumn 2003. Risk managers should consider a comprehensive re-evaluation of the benefits of using a captive as part of the overall risk-financing strategy and the impact thereon of not only the current proposals for Solvency II and the IAS proposals on Accounting for Insurance Contracts, but also the directive to be issued later in 2003 for the supervision of reinsurance companies.

Praveen Sharma is a Senior Consultant at IRMG; praveen.sharma@irmg.com