The captive question

Captives remain a critical risk management took for most of Commercial Risk Europe readers and Solvency II has thrown up many questions about the viability and strategic direction of these structures in future. Karel Van Hulle, the architect of Solvency II at the European Commission, recently assured CRE that the different nature of captives has been accounted for in the Framework Directive and that national regulators will be required to offer them proportional treatment that reflects their simpler structure. But the rules are still not finalised and remain frustratingly vague for many captive owners and indeed even the regulators themselves that have enough on their plate before worrying about captives. To help risk managers work out what to do in preparation for Solvency II we held a seminar focused on this topic early last month in Frankfurt Germany in partnership with ECIROA, the DVS, BfV and BDI which generated some very useful and challenging debate.hideUncertainty still abounds as captive managers try to work out new rules for captives Captive managers believe that whatever the outcome for captives as a result of Solvency II, there will be challenges and opportunities, both for domiciles and for captive owners. At the moment, captive managers do not see any clear trends concerning movement of captives in or out of the EU as a result of Solvency II, but this may be simply because of the lack of clarity over the new regime. The much delayed Solvency II is due to come into force on January 1, 2014 and the final work such as approval or otherwise of internal models will commence from January 1, 2013. This was clarified by Karel van Hulle, the architect of the new capital adequacy and reporting regime for insurers, in an exclusive interview with Commercial Risk Europe at the end of October, just prior to our Captives and Solvency II Risk Frontiers seminar in Frankfurt. Until that point most in the market were rather confused about the timescale and suspected further delays would occur after it was postponed from the proposed original January 1, 2013 start date. For captive owners and their managers, the uncertainty is perhaps greater than for standard commercial insurers because it has yet to be made clear exactly how they will be included, whether they will be classed as a ‘special case’ through so-called proportional treatment as enshrined in the Framework Directive and whether national regulators will have time and resources to actually apply the principle of proportionality in practice anyway. Mr Van Hulle used the interview with CRE to reassure captive owners that proportionality would be applied and that they can relax. But, the captive owners present at the Frankfurt seminar and our subsequent seminar in Madrid did not seem convinced. Not surprisingly therefore the one thing that everyone can agree on is that the captive market will be affected by Solvency II but there are differing opinions from the various insurers, brokers and managers in the captive sector on exactly how it will be affected. For some, it will result in greater interest in captives, for others it will be a major challenge. A recent report from credit rating agency AM Best Solvency II to Transform the EU Captive Industry concluded that Solvency II ‘is bound to change the market environment dramatically for captive insurers, as parent organisations take a fresh look at captives’ role in light of increased regulatory requirements under the new regime. Regulatory capital requirements appear certain to increase dramatically—as much as three- to fourfold for EU-domiciled captives’. EU—in or out? Jonathan Groves [pictured, top], Manager—Continental European Risk Management, Chartis, said it remains a challenge. “Whilst it is becoming clearer what will be required of a captive post Solvency II, there are still lots of points to be clarified. For many, capital needs to increase (which may mean a capital contribution from the shareholder or a reduction in surplus) and operating procedures need to be more clearly documented and activities separated. Each adds cost. Therefore, whether to move or stay in the EU relates to what the cost benefit analysis looks like for an individual company,” he explained. Clive James, Director, Kane Group [pictured, bottom], said: “The perception is that Solvency II will increase capital cost, but in reality it will mean that a lot of companies will look at their captives more closely and make them more capital efficient. Each captive needs to be looked at based on its own merits. It will depend on what risks they are underwriting, whether they are fronted or not fronted. There is not one answer. The captive manager’s job is to analyse the structure and make sure the vehicle is located in the most appropriate domicile. I suspect that very few will move out of the EU.” Malcolm Cutts-Watson, Chairman, Willis Global Captive Practice, Europe & Asia Pacific, said he regards Solvency II as both a challenge and an opportunity for European captives. “To put this into context, Solvency II is a change in regulation of EU insurers, including captives, and as such is a challenge,” he said. “We have seen numerous changes to regulation across all domiciles and, whilst significant, Solvency II will be digested by the industry and business will continue. Our analysis shows over half our captive clients are adequately capitalised to meet Solvency II requirements. For the others, there are a number of mitigating tactics available to ensure solvency compliance. We are not seeing captives looking to move out of the EU to avoid Solvency II, as their strategy makes a EU domicile the right location,” added Mr Cutts-Watson. Charles Winter, Head of Risk Finance in Aon’s Global Risk Consulting practice, said that domiciles will continue to compete by differentiating themselves, with non-EU domiciles promoting the benefits of being outside Solvency II, and the EU and Swiss domiciles promoting the robust governance frameworks or potential for freedom of services-type business. “It’s probably fair to say that the entry hurdle for the EU will become higher than at present but it will remain the regime of choice for many. Similarly, those who do not need it will enjoy the lighter operating regime of offshore,” he said. “There is no right or wrong about whether the EU remains the best domicile and it’s on a client specific basis. There is additional compliance brought about, and a change in how things are done, but many of the processes referenced in Solvency II are going on already, just in a different form. We have seen moves both into and out of the EU and whilst Solvency II has been in the mix, there’s not a clear trend,” continued Mr Winter. The Principle of Proportionality Perhaps the biggest issue connected with Solvency II and captives is that of proportionality. How the principle will actually be applied is the big question because the answer will determine the capital and running costs of the captive and therefore its future viability. “This is the question we’d all like answered,” said Mr Winter. “Whilst simplifications are one route to captives under Solvency II, proportionality is potentially the more impactful. It won’t be practical to build or get approval for internal or partial models for most captives, so using the existing templates with proportionate detail looks to be important. Similarly, whilst governance structures have to be fit for purpose, the moving parts that make up most captives are simple and visible compared with commercial insurers, so we are hopeful that proportionality can be applied to achieve the intention of the directive,” he added. Mr Cutts-Watson said he believes that proportionality is a fair concept, but the difficulty comes when deciding to which captive entities it applies—true pure captives that write only first party risk, or other types of captives too. “What I think is important is that captives are viewed as true bona fide re/insurance entities operating to the necessary standards and not as quasi money boxes that don’t require proper regulating. It will be interesting to see whether Bermuda’s approach to differing levels of Solvency II equivalence between international re/insurers and captives is acceptable to the EU,” he said. Fronting Up? A major concern for captive owners has been the expectation that Solvency II will increase the cost of fronting. “We’ve seen fronting costs increase on the perception that Solvency II will place bigger burdens on companies’ reinsuring to an unrated insurer not within a Solvency II jurisdiction,” said Mr James at Kane. “We will be negotiating hard to keep the costs down to a minimum.” Mr Cutts-Watson said that, in theory, Solvency II should increase the cost of fronting because of the capital weighting allocated to the counterparty default risk associated with a captive. “In practice, fronting forms only a small part of an insurer’s book of business and therefore the capital issue is immaterial,” he explained. “Fronting insurers tell us that the domicile of a captive has no impact on security requirements of any fronting arrangement. So Solvency II, actually, is an irrelevance. Cost of fronting is often based on the overall value of the relationship with the insured. What it may do is encourage owners of direct writing captives to validate the business model when compared to that of a fronting arrangement.” Mr Winter also remains positive on fronting costs: “We are looking for business as usual and discussions with a number of major insurers suggest this is likely. There is an argument that for EU captives the position should improve.” Indeed, Chartis’ Mr Groves explained: “Global insurers that front have typically focused on the economic risks associated with fronting as opposed to only the regulatory risk. This is one of the reasons why collateral has often been sought. Given Solvency II operates on a risk-based framework, we do not foresee a major change to fronting.” PCCs the Solution? It has been suggested that one possible solution to the whole problem of captives and Solvency II is to switch to a PCC. According to Mr Cutts-Watson, “Although the EU regulators’ stance on solvency of PCCs is being refined, it looks as if cells will be able to operate below the minimum guaranty[guarantee?] fund as long as the core has sufficient capital. This will give capital savings to a cell owner compared with running a stand-alone captive. The cost of compliance will be shared by cell users and, again, will give a cost benefit compared to running a stand-alone captive. We see captive owners considering moving to a cell structure as a result.” But, once again, there is still uncertainty and ambiguity. Mr James said PCC structures may not necessarily be a viable option “because a lot of PCC structures are fully collateralised, albeit by a combination of capital and reinsurance, so they will be fully capitalised for their risk exposure. The jury is still out on how cell companies will be looked at—whether they will look at the whole lot or individual cells,” he said. Mr Groves pointed out that PCCs need to be separated into those where cells can access the core capital, and those that cannot. If the cell cannot access the core capital then the PCC provides no advantage from a Solvency II perspective. “The regulation is very clear on this. If access to the core capital is permitted by a cell, then a PCC would help manage the costs associated with Solvency II,” he said. Unfortunately, where all this leaves captive owners is unclear. With so much uncertainty, and little sign of any resolution in the near future, captives and their managers are left second-guessing the outcome. Nevertheless, most managers seem to be positive: either there will be little impact on captives, or if there is an impact, it can generally be managed. That is, of course, assuming that Solvency II comes into effect any time soon. Of course, it is important to be prepared as Mr Groves stressed during the Frankfurt Risk Frontiers seminar. But having been delayed already, and despite Mr Van Hulle’s assurances on deadlines, no one is holding their breath for Solvency II’s imminent arrival.

The captive question

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