Most large corporate groups include a captive insurer but almost one-fifth of those "captives" are dormant.

Solvency II - the European Union's "Directive on the taking up and pursuit of the business of insurance and reinsurance" - will apply directly to most captive insurers domiciled in the European Economic Area. It will also have a material impact on many captives domiciled in other parts of the world.

Some of the changes have been well publicised. It is clear, for example, that captive insurers can expect a substantial increase in their capital requirements. However, some issues have attracted much less attention. For example, Solvency II will force many captives to revisit their fronting and reinsurance arrangements, and the cost of these arrangements could increase substantially.

What is a captive insurer?

Captive insurers, or "captives", are insurance companies. They are typically used by industrial and commercial groups to "self-insure" some or all of the group's property, motor, product and other risks. In addition, they are used to insure deductibles - the excess on a company's commercial insurance policies.

By the standards of the commercial market, captives are small. While most commercial insurers write business across a wide range of risks for a large and diverse group of policyholders, captives tend to write cover for a handful of risks and their only policyholders are the companies in their group.

How do captives work?

A number of approaches are used. One of the most common is for a group to insure its risks with a "fronting insurer" based in the same jurisdiction as the group. The fronting insurer passes some or all of the group's risks back to the captive, which is often based off-shore. Many captives pass some or all of the risks they (re)insure onto a reinsurer.

This kind of arrangement is used for several reasons:

  • Captives are often based off-shore so they can take advantage of lighter touch regulation and lower rates of tax;
  • A fronting arrangement is often used because:
    • In some jurisdictions, it is compulsory to insure certain risks (for example employers' liability) with a local insurer. Where that is the case, the fronting insurer provides the insurance required by law, while the captive (re)insures the underlying risks
    • It can create greater security for policyholders and those who might claim against them
    • It gives the captive access to the fronting insurer's facilities for tasks that are difficult or complex for the captive to carry out, but routine for a commercial insurer. Calculating, administering and paying Insurance Premium Tax is a good example.

How are captives formed and operated?

Like most insurers, captives are usually limited liability companies, although in some jurisdictions they can be part of a protected cell company.

A captive is managed by a board of directors, which makes decisions on its behalf.

Some captives have a small staff and operate like other insurers. But most use group staff and group services for some functions and outsource the others to a captive management company.

Why do corporate groups have captives?

Until recently, captives were thought to offer many substantive benefits. For example, they have been used:

  • For capital efficiency reasons - corporate insurance premiums can be substantial. Paying them to a captive can allow the group to effectively retain its premiums and secure investment returns on them
  • To reduce insurance premiums - if the group wants to insure high frequency, or low frequency but severe, risks, commercial rates will be high (if cover is available at all). Captives can usually offer lower premiums by eliminating some of the frictional costs that come with using the market. Groups often buy insurance through a broker and many insurers reinsure their risks through a reinsurance broker. However, a captive's fronting arrangements are usually low cost and eliminate the initial broker's fees. In addition, the captive's established relationships with the reinsurance market can often eliminate the reinsurance brokers' fees.
  • To smooth fluctuations in insurance premiums and cover - the normal market cycle generates fluctuating premiums and changes in the level and type of cover available. A well capitalised captive can smooth these changes out
  • To help group companies meet their insurance needs more precisely - the insurance market cannot always provide cover for the particular risks a group wants to insure. When the market does provide cover, it may come with a large excess, a cap that is too low and a range of unacceptable policy exclusions. A captive may be able to meet a group's insurance requirements precisely. Whenever that is the case, it can effectively remove what would otherwise have been an uninsurable risk from the key group company balance sheets.

Some of these benefits are still extant, but some are not - some parts of the insurance market are 'soft' at the moment, so premiums are lower and cover is broader than it might otherwise have been. Some of the remaining benefits will be lost when Solvency II compliance begins on 1 January 2013 (see below).

Does Solvency II apply to European Economic Area (EEA) captives?

Solvency II will apply to EEA captives in broadly the same way that it will apply to other EEA insurers and reinsurers (see recital 10, articles 13(1) and (2) and article 14 of the Solvency II Directive).

Captives will, or at least may, be able to take advantage of a number of Solvency II captive specific simplifications. They may also be able to rely on the Solvency II Directive's principle of proportionality, which applies to each of the Directive's requirements (see article 29). In particular:

  • Each firm's regulator will be required to have regard to the nature, scale and complexity of the firm's activities when it establishes the minimum frequency and scope of the firm's supervisory reviews (see article 36 of the Solvency II Directive)
  • Each firm will be required to have a system of governance that is proportionate to the nature, scale and complexity of its operations (see article 41)
  • Each firm will be expected to conduct an "own risk and solvency assessment", which takes into account its specific risk profile, approved risk tolerance limits and business strategy. To enable it to do that, each firm must have processes in place that are proportionate to the nature, scale and complexity of the risks inherent in its business (see article 45)
  • A firm will be able to use simplified methods and techniques to calculate its technical provisions if that is necessary to ensure the actuarial and statistical methods it uses are proportionate to the nature, scale and complexity of the risks it insures (see article 86(h))
  • A firm will be able to use simplified calculations for specific sub-modules or risk modules in the standard formula, if the nature, scale and complexity of the risks it faces justify that and it would be disproportionate to require all insurers to apply the standard calculation (see articles 109 and 111(l))
  • (Subject to regulatory approval) a firm will be able to use "undertaking specific parameters" instead of the standard formula parameters to calculate its life, non-life and health underwriting risks (see articles 104(7) and 110 of the Solvency II Directive).

While this clearly introduces a degree of flexibility, it also introduces uncertainty. Each "nature, scale and complexity" assessment will be different, and each assessment will require the firm to make a judgment the regulator might not accept. Nevertheless, in most cases, the Directive allows firms to make their own assessments and, in many cases, it effectively requires them to do so.

What impact will Solvency II have on EEA captives?

Solvency II is likely to require EEA domiciled captives to:

  • Materially increase the amount of regulatory capital they hold - a three or four-fold increase in the minimum capital requirement for captives may be common. This is because captives are often exposed to a narrow range of high frequency, or low frequency high severity, risks. They also have a narrow policyholder base, can be heavily exposed to a small number of significant counterparties and tend to have investment portfolios that lack diversification
  • Materially alter and (re)document their internal governance and outsourcing arrangements. Like other EEA domiciled (re)insurers, captives will be required to:
    • Create and maintain a Solvency II compliant governance system that includes appropriate organisational and reporting structures as well as appropriate risk management, internal control, internal audit and actuarial functions; and
    • Carry out regular "own risk and solvency reviews" before reporting the results to the local regulator.

Because captives tend to be lightly staffed, these requirements may be disproportionately expensive for them to comply with; even after the principle of proportionality has been applied (see above).

  • Prepare and publish an annual report which describes:
    • Their business and its performance
    • Their system of governance, and whether it is adequate for their particular risk profile
    • The risks the captive is exposed to, as well as commenting on risk concentration, mitigation and sensitivity
    • The way the captive values its assets, liabilities and technical provisions
    • The way it manages its capital and investments
    • The level of its minimum capital and solvency capital requirements, and whether it has been able to maintain capital to meet each of these throughout the year.

This list of information is likely to be more extensive and more sensitive than anything a captive has had to collate and publish before.

Does Solvency II apply to non-EEA captives?

Captives based in Bermuda, Switzerland and the United States may have to comply with a new regime which is equivalent to Solvency II, although the detailed rules will be different in each jurisdiction. Where that is the case, the impact may be similar to the impact on EEA domiciled captives (see above).

Captives based in other jurisdictions that serve corporate groups domiciled in the EEA will be indirectly affected by Solvency II. In particular, those captives may be required (for commercial or regulatory reasons) to:

  • Materially alter their fronting arrangements and (perhaps) pay a higher fee for the cover and services provided by the fronting insurer
  • Post collateral in the EEA or with the fronting insurer
  • Change their reinsurance arrangements. For example, captives domiciled outside the EEA and in a jurisdiction that is not Solvency II equivalent may find it beneficial to use an EEA reinsurer so the captive and the fronting insurer can take full credit for the reinsurance without the reinsurer having to post collateral.

What does this mean? See our action points for guidance on some of the options to consider in response to these challenges.