In the second section of a two-part article, Brian Foley suggests that it might be an opportune time for the Irish regulatory authorities to think about monitoring captive insurance companies differently from mainstream re/insurers

The Insurance Regulatory Information System (IRIS) ratio tests are the tools that the US National Association of Insurance Commissioners (NAIC) has adopted for financial supervision of insurance entities. In Europe, the regulator is more interested in monitoring the solvency level of an insurance company. The European Union (EU) has specified a statutory minimum solvency margin that a company's free assets (which in the case of Irish captive insurance companies generally comprise shareholders' funds) need to exceed. The solvency margin is determined by formula as a percentage of premiums or claims, with an adjustment based on the ratio of reinsured losses.

The guarantee fund is equal to a third of the solvency margin calculation, subject to certain fixed minima that depend on the classes of business written by the captive insurance company. Should the shareholders' funds fall below the level of the guarantee fund, the company is required to submit a remediation plan to the regulator.

In March 2002, the European Parliament issued a directive (2002/13/EC) that made changes to the solvency margin and guarantee fund calculations.

The adjustments to the solvency margin calculation were relatively minor; for instance, the previous claims basis limit was 26% of the first EUR7m of claims and 23% thereafter. The EUR7m threshold was raised to EUR35m. From the perspective of smaller Irish captives, the changes to the minimum guarantee fund were much more significant. Previously, many small companies that did not write credit business were subject to a fixed minimum guarantee fund of EUR400,000. This minimum fixed amount has now increased to EUR2m.

The new regulation applies to any captive insurance company authorised after March 2002, to 2004 and subsequent Irish statutory returns. It will also apply to all captive insurance companies starting with the first financial year after 31 December 2004.

The captive database was tested using the old and the new EU solvency margin and guarantee minimum fund calculations. In each case, the ratio of shareholders' funds to the higher of the solvency margin or the guarantee fund was computed, and we termed the resultant percentage the captive's 'solvency score'. Under the old EU regime, the average solvency score was a very healthy >800%. Three of the companies in the database fell short of 100% of the solvency margin test at the end of 2002. Each of the three 'fails' had shareholders' funds above 85%, so they all exceeded the 75% trigger point for regulatory intervention. One of these companies is in run-off, while a second enjoyed a substantial capital injection in 2003.

The Irish regulator requires a newly authorised captive insurance company to maintain at least 200% of the EU solvency margin for the first three years, at which stage the company can apply to reduce this requirement to 150%.

Substituting the new EU solvency margin formula and guaranteed minimum fund criteria in the solvency score calculation results in a drop in the average solvency score from >800% to 410%. Moreover, the number of captive insurance companies that no longer have an adequate solvency margin jumps to ten. Viewed another way, approximately 20% of Irish captive insurance companies may require some form of capital injection before the end of 2005 to meet the new EU solvency standards. Almost invariably it is the 'minnows' that are affected, i.e. those companies that will be subject to an increase in the level of required guarantee fund from EUR400,000 to EUR2m. Of course, it should be kept in mind that this is a snapshot view at the end of 2002; a hardened market has generated insurance profits, so the picture may be better for a number of these companies.

Nevertheless, for small captive insurance companies that wish to stay small, Ireland may no longer be the European domicile of choice. Table 1 (previous page) illustrates the distribution of 'solvency scores' under both sets of EU statutory minimum solvency margin rules.

The fact that the average solvency score and the 'upper quartile' solvency score are of similar magnitude indicates the presence of a dozen or so larger, relatively well-capitalised captive insurance companies.

The UK Financial Services Authority (FSA) published Consultation Paper 190 (CP190), 'Enhanced Capital Requirements and individual capital assessments for non-life insurers', in July 2003. These risk-based capital proposals are deemed to come into effect after 31 December 2004.

The specific proposals include:

- a new risk-based minimum regulatory enhanced capital requirement (ECR); and

- a regime whereby the FSA will review firms' assessments of their capital needs and give individual capital guidance (ICG) to firms. Each individual company's ECR calculation is made up of asset risk, reserving risk and underwriting risk components.

The FSA engaged actuary Watson Wyatt to help quantify the risk factors to be employed in the ECR calculations. Watson Wyatt's report to the FSA, entitled 'Calibration of the general insurance risk-based capital model', sets out the risk factors and describes how they have been derived.

The report, available on the FSA website, contains a table of the average capital requirement implied by ECR as a percentage of net premiums separately for companies with premium volumes above or below £10m. For example, the average ECR for a small company at a 99.5% confidence interval (1 in 200 risk of failure) over a five-year timeframe is 132% of net premium. For a larger company (over £10m in net premium), the comparable ECR requirement drops to 105% of net premium.

If this simple ECR benchmark is applied to the database of Irish captive insurance companies, we find that the 'solvency bar' has been raised substantially.

The average solvency score drops to 168%, and 18 of the 50 captive insurance companies do not have sufficient capital under simple CP190 criteria.

On this occasion it is not just the smaller captives that are affected; some of the larger ones might have to make sizeable capital injections to successfully negotiate CP190 solvency hurdles. It is important to point out that this is a very crude application of the ECR methodology. Since there is a large number of moving pieces in an individual ECR calculation, each company's actual ECR will likely deviate, perhaps substantially, from the simple ratio of net premium benchmark.

Graph 1 (left) illustrates the shift in the distribution of solvency scores from regime to regime. It can clearly be seen that 'the herd is heading west' with each successive change in solvency regime. The blue distribution in front (old EU solvency) shows a clump of values around the 500%-550%, with nine captives exceeding 1,000%. The purple distribution in the middle (new EU solvency) features a mode of nine at the 200%-250% level. In the case of the yellow distribution in the background (FSA CP190), almost half the observations are in two cells, namely 50%-100% and 100%-150%, and only a single captive manages to score more than 1,000%.

Of course, CP190 is a UK standard and as such does not apply to Irish-domiciled companies. However, many observers believe that the Irish Financial Services Regulatory Authority (IFSRA) cannot afford to wait for the EU solvency II directive, and should introduce some form of risk-based capital requirement for Irish insurance companies in the near future.

It is not just Irish direct writing captives that will feel additional regulatory heat over the next couple of years. In April 2004, the European Commission published a draft directive on reinsurance regulation, proposing 'fast track' guidelines for regulation of reinsurance companies broadly similar to the requirements for direct-writing companies. The solvency margin formula is not specified in the proposed directive. However, the solvency criteria may be more stringent than those set for direct-writing insurance companies. The directive refers to possible 'class enhancement' (up to 50%) for certain reinsurance classes or types of reinsurance contracts.

After conversations with a number of industry observers, received wisdom is that the likeliest timeframe for introduction of EU reinsurance regulation is late 2005/early 2006.

How will the Irish captive industry fare given all this additional regulation?

Should a single parent captive insurance company be subject to the same standards as a publicly traded insurance company? To maintain Ireland's attractiveness as an international domicile, maybe the Irish captive community should lobby for some form of dual track regulation of captives and mainstream insurance companies similar to the situation in certain US jurisdictions such as New York.

The old Chinese maxim "may you live in interesting times" could certainly be applied to the Irish captive industry at the moment, and the hot issues currently appear to be:

- Ireland is perceived as a more expensive place to do business than other domiciles;

- higher solvency requirements for direct writers will adversely affect Dublin's captive industry;

- the EU reinsurance directive, if implemented in its current form, will have significant repercussions for Dublin-based reinsurance captives;

- actuarial opinions of reinsurance captives are a good idea;

- the introduction of IAS accounting/Basel II will make prospective captive owners less likely to establish operations in Dublin;

- the introduction of IAS accounting/Basle II will add substantially to the cost of running a captive in Dublin;

- the potential for UK captives to be treated as controlled foreign companies (CFCs) could be a blow to Dublin;

- Dublin lags behind other European locations when it comes to marketing itself as an attractive domicile for captives;

- the lack of protected cell legislation is a substantial barrier to increasing captive business in Ireland;

- the Irish regulator is doing a good job and is seen as pro-business;

- the addition of the ten accession countries to the EU offers an opportunity for additional business in Dublin;

- Malta and Gibraltar are making inroads into business that would have gone to Dublin in the past; and

- the Irish captive industry needs a cohesive pan-company marketing plan.


A copy of the 2004 Irish captive financial benchmarks report produced by ProAct Consulting may be requested by visiting the website