Captives need improved counterparty and cat risk proposals under Solvency II

In its annual report on the global captive market which is timed to coincide with RIMS, the main US risk management conference, Marsh said that both these critical areas remain uncertain because they will be subject to further refinement following the results of QIS5, the latest impact study carried out by the European Insurance and Occupational Pensions Authority (Eiopa). According to Marsh, counterparty risk is a key area for captive owners because a significant number of European domiciled captives formed in the last 20 years are used to provide fronting insurance for their owners’ European operations. Marsh said that some of the risk written by these captives is retained within the European domiciled captive but added that a significant portion is reinsured to the owner’s main captive which is usually located in either one of the offshore or US domiciles. It also pointed out that, in most cases, the non-European captive does not have a financial rating.hideThe problem, according to the broker, is that for European captives that operate on this basis, Solvency II as currently planned effectively takes no credit for such reinsurance. The captive would therefore be capitalised as if the purchased reinsurance assets did not exist, said Marsh. The broker also noted that the proposed Counterparty Default Risk module used for QIS5 drew criticism from most countries. “The calculations demanded by the module were widely perceived as being extremely laborious and complex, especially in view of the fact that the charge demanded for counterparty risk by the SCR standard formula is quite limited,” stated Marsh. “A number of countries reported criticism of the treatment of unrated counterparties, including counterparties with no rating but a positive experience of past transactions, which was perceived as being disproportionate. This issue is particularly important for captives and their owners and may have the greatest impact on future fronting insurance costs,” continued the report. The second main outstanding issue that will impact European-owned captives is catastrophe risk, said Marsh in its report. Most industry experts agreed that the current proposals made by Eiopa to the Commission for how Solvency II should work in practice allocate a higher weighting for catastrophe risk than is needed and is too complex to calibrate. In its response to QIS5 the Commission said that it agreed with industry pressure groups that further work on cat risk is needed. The area is particularly important for captives according to Marsh because the QIS5 results found that catastrophe risk accounted for 79% of the non-life underwriting risk component for captives compared with 44% for all the insurers that took part in the survey. Marsh said that both the natural and man-made catastrophe elements in Solvency II as planned attracted a broad range of comments. “For example, in the fire sub-module, a number of undertakings (especially captives) in one country took the view that the maximum loss was the policy limit and not the largest total insured value (TIV). A 100% loss was not believed to be a likely scenario. Along with the counterparty default risk, this is the element of the SCR calculation that is likely to cause most difficulty for captives and their owners,” explained the broker. Another area in need of further work for captives according to Marsh is the risk margin calculation that again seems overly complicated. “Very few undertakings across Europe reported having used the full calculation approach for the valuation of the risk margin. Almost all supervisors noted that a full calculation was often too complex and time-consuming for undertakings, with some pointing out that the relative immateriality of the risk margin means that it does not justify such difficult calculations. The average risk margin reported for captives of 7.01% contrasts with 5.72% for all non-life undertakings,” noted the broker. And of course as consistently reported by Commercial Risk Europe over the last year or so, risk managers are still confused about how the principle of proportionality enshrined in the directive that should allow local supervisors to treat them more lightly than standard insurers will actually be applied in a fair and consistent way. “Many countries felt that further guidance on the proportionality principle and the use of simplifications would be useful. Some felt this was necessary in order to ensure simplifications were not used inappropriately, although others emphasised that this had to be balanced with sufficient flexibility in the criteria to ensure that simplifications could be used where needed,” stated Marsh. The good news is that Eiopa has acknowledged along with the Commission that further work is required on counterparty risk and catastrophe risk and will probably deliver updated proposals by mid-year, noted Marsh. The Commission is also thought to be working on a clarification on how proportionality could be applied. Marsh said, however, that national supervisors could help risk managers prepare with some local guidance. “In the meantime, what would be welcome would be some clear statements from the European regulators in whose jurisdictions these captives are located as to how they intend to apply the principle of proportionality to captives,” suggested the broker.

Captives need improved counterparty and cat risk proposals under Solvency II

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