The Solvency II Directive will have wide-ranging implications for all insurers and reinsurers in Europe. Not least for the operation of captives. With the details of the Solvency II regime now emerging, captives should consider the potential impact of the new regime and prepare for implementation in 2012. Jonathan Teacher considers the main issues for captives and possible steps to smooth the transition to Solvency II.
While it is understandable that captives were not the focus of the European Commission’s Solvency II Directive, provisions recognising the different nature of many captives from commercial (re)insurers did not appear until late in the directive’s development.
A fundamental principle of the directive is that it is to be applied in a proportionate manner, permitting special arrangements to be made for captives. Since the Level 1 directive only establishes a framework, the key concern for captives will be how the regime will be implemented and its impact upon the sector.
It is anticipated that publication of consultation papers on the implementing measures with particular relevance to captives will accelerate through 2010. In the absence of the final rules, this article examines issues affecting captive industry participants and suggests steps that can be taken to prepare for implementation.
Owners and managers
It is important to appreciate that captives are not a uniform group. Some captives provide third-party (re)insurance cover in addition to (re)insurance to their associated companies. Within the meaning of the directive, a captive is a (re)insurance undertaking owned by an undertaking or group of undertakings (other than a (re)insurer or any of its affiliates) whose purpose is to provide (re)insurance cover exclusively for the risks of its owners and related group undertakings.
Solvency II will bring changes to key areas for many captives including the application of a risk-based approach to calculating their regulatory capital. Under the directive, a captive’s solvency capital requirement (SCR) can be calculated using the prescribed standard formula, the captive’s own internal model (subject to regulatory validation) or, in certain circumstances, a combination of the two.
The opportunity to calculate the SCR using an internal model that will better reflect a (re)insurer’s business than the standard formula is seen as a significant benefit. However, a captive’s ability to use an internal model may be restricted by the relatively high entry costs of developing and obtaining regulatory validation for it.
The consensus view is the SCR for many captives will increase, partly in consequence of reliance on the standard formula and the typically undiversified nature of captive business.
The Committee of Insurance and Occupational Pensions Supervisors’ (CEIOPS) Consultation paper no. 79 on the implementation of the standard formula proposes a simplified regime for captives for certain aspects of the calculation.
To use the simplified basis, a captive would need to satisfy criteria including a requirement that all its insureds and beneficiaries are legal entities and that it only underwrites risks for entities owned by its parent.
Concerns have been raised that the proposed criteria would prevent certain captives from qualifying for the simplified calculation.
Examples include a captive which underwrites third-party coverage such as employee benefits (where the insureds or beneficiaries are individuals) or risks for a 50/50 joint-venture vehicle between its parent and a third party.
A public consultation on the proposed criteria and simplified calculation is currently underway. The final advice on the criteria for the simplified calculation will be submitted to the Commission in January 2010.
The increased compliance burden of the Solvency II regime extends beyond its capital requirements. (Re)insurers will have significant obligations in respect of governance, transparency, risk management and compliance functions and may need to undertake a gap analysis to determine where they need to develop policies and systems concerning such functions.
It is not yet clear how these requirements will be implemented for captives and whether the principle of proportionality can be applied to matters such as:
- the fit and proper requirement for key employees; or
- the appointment of an actuary to provide opinions and report concerns to the captive’s management concerning the calculation of technical provisions, the overall underwriting policy and the adequacy of reinsurance arrangements.
The increased capital requirements, governance and management burdens that compliance with Solvency II demands will cause many European Economic Area (EEA) captive owners to assess the cost benefits of remaining in the EEA, relocating offshore or using alternative (re)insurance solutions.
Offshore domiciles are seen to offer advantages including lower capital and solvency requirements, reduced costs through simplified regulatory and compliance regimes, efficient administration and, generally lower corporate taxation rates. With Solvency II expected to increase all but taxation costs, the motivation to consider offshore jurisdictions is heightened.
Locating a captive (re)insurer offshore may have some disadvantages, however. International pressures are causing some offshore captive jurisdictions to develop their laws and regulatory systems to meet internationally recognised standards. Transparency is a particular issue and the International Monetary Fund and the Organisation for Economic Co-operation and Development are pressing for improvements motivated by states seeking to restrict tax avoidance through anonymous offshore structures. Despite improvements, the perceived increased reputational risk remains an issue for some jurisdictions in attracting captives. Captive owners may also have concerns with the stability, integrity and rigour of the regulatory and corporate governance systems of the offshore jurisdiction.
Significantly, a captive relocating outside the EEA cannot utilise EEA passport rights in respect of its (re)insurance authorisation. It would need to restructure its business to ensure it is appropriately authorised in all EEA states where it carries on regulated business. One method to achieve this is to write the business through an EEA-based insurer, which acts as a fronting entity.
In the captive context, with respect to EEA risks, a fronting insurer provides its passported licences to write the EEA business reinsured to the offshore captive, subject to appropriate transfer pricing, accounting and taxation treatment. As is the case now, 100 per cent fronting arrangements under Solvency II will be potentially more expensive for a captive that has no, or an insufficient, financial strength rating.
In the tight credit conditions of the past 18 months, accessing some popular forms of collateral (for example, letters of credit) has become more difficult. Increasingly, other types of collateral, such as the provision of a security trust by the captive’s parent, are being used. Without full collateralisation, the fronting insurer will not obtain credit (or full credit) for the reinsurance of its inwards liabilities accepted on behalf of the non-EEA captive and is likely to charge a risk premium for this.
Significant providers of reinsurance to captives should closely monitor developments. If many captives relocate outside the EEA, their reinsurers will need to review their distribution arrangements, regulatory authorisations and licences to ensure they may continue to offer reinsurance to the captive in its chosen jurisdiction.
Some offshore jurisdictions are expected to amend their capital, governance, transparency, risk management and compliance regulations in order to acquire ‘Solvency II-equivalent’ status so that their reinsurers maintain a competitive position. Equivalence would enable EEA-based (re)insurers to take fully equivalent credit for reinsurance placed with such offshore carriers.
Consequently, an EEA captive considering relocating offshore should take account of the risk that the selected jurisdiction attains equivalence and that it will not be able to escape compliance with the higher capital standards and administrative requirements imposed by Solvency II.
EEA captive owners can prepare in advance of the publication of final implementing rules by:
- evaluating the impact of Solvency II on their captive’s arrangements on a best and worst-case basis;
- calculating their captive’s SCR, assuming it falls to be established on the standard basis;
- considering its relocation options; and
- developing outline strategies for each outcome.
In so doing, they can commence formulating response options for implementation before the directive comes into force. To prepare for Solvency II, EEA captives, their owners, managers and other interested parties can take the steps noted above. As consultation papers are published, affected parties need to react promptly to assess the impact on their business.
The period between publication of the final Solvency II rules for captives and implementation of the directive is likely to be short, allowing limited time to adapt business models and implement any restructuring.
This article was first published by Insurance Day in November 2009.