Best’s Analysis Concludes Solvency II Will Transform EU Captive Insurers

Although it has been coming for more than 10 years, the European Union’s Solvency II regulations covering the community’s insurance industry is now virtually around the corner. Over the years there has been a great deal of discussion centering on how the new regulations will be applied to captive insurance companies.

A.M. Best has analyzed the applicable provisions, and has produced an extensive report, which forecasts that the “looming implementation of Solvency II is bound to change the market environment dramatically for captive insurers, as parent organizations take a fresh look at captives’ role in light of increased regulatory requirements under the new regime.”

The principle focus for the changes are new, and essentially stricter, regulatory capital requirements, as well as a greatly increased role for enterprise risk management (ERM). Best said that the capital requirements “appear certain to increase dramatically – as much as three-to fourfold for EU-domiciled captives.”

The study breaks down and analyzes in depth the various impact(s) the regulations will have on captives as follows:
• Most captives operate with multiples of the current regulatory capital requirements, but A.M. Best believes many owners will have to commit more capital to their captives under Solvency II.
• Pillars II [ERM] and III [cosumer protection and transparency] of the new regime will tighten standards for enterprise risk management (ERM), processes and reporting, leading to higher operating costs.
• Captives writing business inside the EU, but domiciled elsewhere, will find their fates tied to the achievement and application of regulatory equivalence with the new EU system.
• Since many captives operate as reinsurers, equivalence could be a key consideration, as some reinsurance business is already supported by collateral or deposits of reserves with a fronting company. [The term “equivalence” refers to those jurisdictions that have indicated they will adopt regulations similar to Solvency II. The EU is currently conducting equivalence assessments on Switzerland, Japan and Bermuda, but not on the U.S. Ultimately the assessments would determine if the regulations in those countries are sufficiently equivalent with the EU’s to allow them to write business within the EU.] Captive centers clearly have a difficult balance to strike between obtaining equivalence and remaining attractive to captives; decisive factors are likely to be how proportionality is implemented within the EU and the impact of collateral posting on captives.
• It is unclear whether proportionality – simplification provisions designed for smaller insurers – will apply to the captive sector, and each captive likely will be viewed on its own merits, given that proportionality under Solvency II is more about risk profile than size.
• Captives, to minimize the impact of Solvency II, should prepare for a worst case scenario – no grant of proportionality – and try to mitigate the new regime’s effects.
• Key steps would be participation in the European Insurance and Occupational Pensions Authority’s (EIOPA) [it is the successor to the Committee of European Insurance and Occupational Pensions Supervisors –CEIOPS] quantitative impact studies (QIS) and the parallel development of partial capital models that best reflect each captive’s risks.
• A.M. Best believes that captives able to obtain a secure financial strength rating should not have major difficulties adapting to Solvency II; strong risk-based capital, robust risk management and governance, close integration with a securely rated parent and effective reporting systems will leave captives well positioned to satisfy the demands of the new regime.

Best also points out that the “definition of a captive under Solvency II excludes captives that write third-party compulsory business or have policyholders who are not legal entities of the group, regardless of their materiality.

“Furthermore, if the latest proposals of Level 2 implementation measures were to be applied, they would also exclude captives that belong to a group owning a non-captive insurer or where the ultimate insured entity is not a member of the group. This is a particularly narrow definition but probably necessary for regulatory purposes, as it provides for a clear-cut demarcation between captives and conventional insurers.

“But even when the sole policyholder is the parent company and its affiliates, it can be argued that there are third parties who benefit from strict regulation and disclosure. This is particularly the case for liability lines and employee benefits.”

On a more general note, Best indicated that “insurance companies throughout Europe have been participating in the different QIS exercises [questionnaires sent to insurers for comment on the Solvency II proposals], with more than two-thirds of eligible companies having taken part in the latest, QIS 5. It is fair to say that the emphasis of development among the leading companies has started shifting toward the requirements of Pillar II [risk management] and away from the quantitative requirements of Pillar I [capital requirements].”

The captive sector has been lobbying the European Commission “to highlight the uniqueness of their business model and to further define proportionality as it applies to captives.”

Best also observed that, “while participation in QIS 5 increased dramatically among captive insurers, it still is low, with less than half the qualifying captives taking part in the exercise, a phenomenon also seen among other segments that have a high preponderance of small entities. Nevertheless, this can be a dangerous development for the sector, as it is likely to be among the hardest hit by the implementation of Solvency II.”

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Source: A.M. Best

Topics Carriers Legislation Europe AM Best Risk Management