Irish regulator promises fair and proportional approach for captives

Captive representative groups have become increasingly concerned that the advice given to the European Commission by CEIOPS will not give national regulators the incentive or freedom to apply the lighter capital and management requirements that was stipulated in the original Framework Directive.

The Directive stated that captives should be dealt with on a proportional basis that would water down the rules to reflect their simpler structures and business mixes. The subsequent advice given by the Committee of European Insurance and Occupational Pensions Supervisors to the Commission, however, appeared to severely limit the ability of regulators to apply the lighter approach.

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FERMA, ECIROA and leading captive managers Marsh and Aon became so concerned about the increasingly hard-line approach of CEIOPS towards captives that they recently urged their members to write to national finance ministers and lobby their national regulators to return to the original intent of the Directive.

To date little has been heard from national regulators on the issue and this in itself has helped deepen the fears of captive owners.

But, Mr. Elderfield said during a speech he gave last week at the European Insurance Forum in Dublin that the inherent risk profile of most captive insurers is ‘significantly different’ from other insurers and this needs to be recognised by regulators when they calculate capital and management requirements under the new solvency regime.

“Captive insurance is at its core inherently an exercise in self-insurance by a corporation. It’s important that the implementation of Solvency II reflects that different risk profile. As a result, we have been a strong advocate of taking the concept of proportionality that exists within Solvency II and applying it to the captive sector,” he said.

Mr. Elderfield, who became head of the Irish regulator after leading the Bermuda Monetary Authority in its effort to be recognised as equivalent by the European Commission for Solvency II, said that Ireland has already started an overhaul of its approach to financial regulation.

He said that Ireland had decided to ditch the ‘artificial’ distinction between rules-based and principles-based regulation. “It’s clear we need to have a mixture of both and take an approach rooted in a clear understanding of risk,” said Mr. Elderfield.

The regulator said that the new Irish approach will involve the development of a regulatory model that allows for the level of ‘supervisory engagement’ to be calibrated to the inherent risk and impact of a particular firm or sector.

“This is consistent with the underlying intent of Solvency II and its application to the captive insurance sector provides a case in point,” explained Mr. Elderfield.

The regulator said that the European guidance on proportionality is still being developed and will be relatively high-level. “The devil will be in the detail of the application of Solvency II at the firm-specific level,” he said.

Mr. Elderfield said that for many captive owners it is the Pillar II management requirements that may be more ‘daunting’ than the basic capital needs.

“We recognise that the uncertainty facing captives can be unsettling. We appreciate in particular that the Pillar II provisions of Solvency II may look daunting to a captive in terms of the obligation to prepare an Own Risk and Solvency Assessment (ORSA),” he said.

Mr. Elderfield said that that the topics that will be covered by the ORSA are ‘pretty fixed’ and include matters such as a firm’s overall solvency needs, its internal risk tolerance limits and compliance with solvency and technical provisions.

But, Mr. Elderfield pointed out that regulators will have the chance to be flexible and promised that the Irish authority will adopt a ‘common sense’ approach and give regulated firms a ‘fair hearing’.

“The format of the ORSA is not prescribed and can be interpreted in light of the proportionality principle. In this respect we are committed to taking a common sense approach. Captives will be permitted to develop ORSA material that covers the requisite ground in a fit for purpose manner,” said the regulator.

“As a result, captives that take the time to put together a sensible assessment of the various Pillar II risks will receive a fair hearing from my staff. And frankly, if the first effort isn’t great, we are prepared to be pragmatic and work with firms in an iterative process to see the ORSA is improved over time,” continued Mr. Elderfield.

As concrete evidence of this commitment Mr. Elderfield said that the Financial Regulator is prepared to work with the Dublin Insurance Management Association (DIMA) to assess a small number of captive ORSAs on a pilot basis and use this for broader industry feedback. “This way DIMA’s members will have a clearer picture of what we view as good practice and where we think more work is needed,” he said.

Insurance buyers are not just worried about the impact of Solvency II on captives though.

There is also a big concern about the impact of the new capital regime on the insurance companies that provide them with their coverage, a reduction in their capacity offered because of higher capital charges and higher prices.

Very little explanation has come from CEIOPS about why it has decided to significantly toughen the capital requirements it advised the Commission to adopt earlier this year compared to last year, other than the experience of the credit crisis that clearly damaged the banks so much more than insurers.

Mr. Elderfield expressed a refreshingly positive attitude towards the systemic risk posed by insurers that he recognises is very different to that posed by banks. But, he also stressed that this does not mean that regulators should be lenient on the insurers and believes that they must be particularly tough on internal models.

“I am cautious about over-learning the lessons of the banking crisis for the insurance industry. Insurance companies are inherently different from banks and, while there have been some notable exceptions, many insurance companies have weathered the financial crisis in a relatively better position than their banking counterparts,” said the regulator.

“However, one lesson that does apply to insurers is the need to take a sceptical and challenging view of a firm’s internal risk management practices, including the use of internal models,” he continued.

Mr. Elderfield reminded delegates that Solvency II provides an option, subject to regulatory approval, for insurers to calculate their solvency requirements by employing internal models.

He also pointed out that, in this respect, the Solvency II provisions are more liberal than those contained within the banking regime, Basel II.

The banking system, upon which Solvency II is based, prescribes the maximum level of diversification that may be recognised in a model. Solvency II does not set similar restrictions and it is up to the insurer and their supervisor to agree the level of diversification that may be permitted, he explained.

“This is an important point, because recognition of diversification effects can lead to a significant reduction in solvency requirements. A key area of debate between regulator and firm will therefore be how an insurer approaches its analysis of correlation and therefore the level of diversification that is permitted,” said Mr. Elderfield.

The regulator pointed out that the banking crisis has shown how, in times of intense stress, correlations can shift towards 1 and apparent diversification can disappear.

And he said that a similar effect can manifest itself in insurance because tail events can demonstrate unexpected correlations between different lines of insurance, as was evidenced during the terror attacks on the United States in September 2001 or Hurricane Katrina.

“I suspect that many insurers still have some way to go to refine their models to make the grade for regulatory approval. Modelling catastrophic events is challenging, for example, and reinsurance companies can be dependent on poor data quality from underlying cedants,” said Mr. Elderfield.

“Under our new risk-based regulatory approach, I am asking the staff to be more challenging and assertive where this is required. In cases of high impact insurance companies that are proposing to rely on the use of internal models, I will be encouraging such a challenging approach, particularly if significant reductions in solvency requirements are at stake. We are prepared to hand out pass marks, but only if insurers have done their homework properly,” he continued.

Mr. Elderfield said that the subject of systemic risk deserved a paper in itself. He noted that solvency regimes can cause a convergence of methods and calibrations which poses its own danger. For this reason Pillars 2 and 3 of Solvency II are ‘most important’ and will receive an increasing share of attention as the project evolves, he said.

He also said that a ‘healthy debate’ has developed about whether some types of insurance company pose systemic risk and therefore require enhanced regulation perhaps on a par with systemic banks.

“As noted above, I am cautious about too readily reading across banking standards without taking account of the particular characteristics of insurance balance sheets. But this is an issue that merits further discussion on another occasion,” said Mr. Elderfield.

The Irish insurance supervisor said that he recognises that one of the biggest challenges brought by the new capital system will be to ensure that the supervisors themselves are up to the job. He also said, however, that regulators in countries such as Ireland must polish up their act to ensure that they are able to meet new demand that may arise from the changes.

Mr. Elderfield said that his authority has geared up the level of resources that are committed to Solvency II implementation and, crucially, hired new actuaries. He said that he intends to set up a dedicated policy team to deal with prudential insurance matters and work closely with CEIOPS, and will continue to do so as it transforms itself into one of the new European Supervisory Authorities.

“All this means that Ireland is on track for Solvency II implementation. We recognise that insurance companies around the world, both within the E.U. and outside, are measuring up their options as to their optimal structure to be ready for the Directive,” said the supervisor.

“Solvency II provides important passporting benefits for insurance companies from whatever base they choose in the E.U. and it is already clear that firms are reorganising their corporate structures to take advantage of these privileges,” he continued.

And, the authority in Ireland is also taking the opportunity to review its authorisation processes so that it will be prepared to more efficiently handle applications from firms from within the E.U. or from third country jurisdictions, he said.

“If insurance companies decide to re-domicile to Ireland or to re-organise their E.U. operations to use Ireland as the hub of their activities, we will have an efficient process that can ensure high prudential standards are maintained when firms seek to act swiftly on the commercial choices thrown up by the Directive,” said Mr. Elderfield.

“Our challenge as a regulator, then, is not only to ensure that we tackle the implementation of Solvency II in a risk-based way. It is also to ensure that we have the resources, market understanding and improved processes to respond efficiently to the commercial changes that are just around the corner,” he concluded.