Tuesday, 8 May 2012
In search of certainty
If there is such a thing as a buzzword for Solvency II, it surely must be ‘uncertainty’. Many in the re/insurance sector might have much stronger words to describe the whole Solvency II process, given the amount of time and money already spent on it. And possibly some of the strongest words would be expressed by those who own and manage captives because perhaps the greatest uncertainty of all has been faced by this part of the industry. The uncertainty is founded on some pretty fundamental matters.
Professor Joe Bannister, Malta Financial Services Authority
First, it is still unclear whether captives will be included in Solvency II, or be classed as a ‘special case’.
Second, it is also unclear to what extent national regulators will be granted the scope to apply the principle of ‘proportionality’.
Third, it is even unclear exactly when Solvency II might arrive. Implementation is currently planned for the beginning of next year, with ‘entry into force’ planned for the beginning of 2014 but few would be surprised if there was a last minute change to this as this has been something of a ‘moving feast’.
The big question for captive owners remain therefore: How should they prepare in the face of so much uncertainty? A further critical question is: What does it all mean for domiciles?
Not surprisingly therefore for captive owners, managers and domiciles, the very mention of proportionality, equivalence, Pillars and QIS5 can result in heavy sighs and exasperated shakes of the head.
The Solvency I and II process has been going on for so long, and with so little clarity, that, in the words of Clive Thursby, Senior Director, Market Development, AM Best—EMEA & South Asia, “It is a brave man who tells you what Solvency II will amount to and when it will take effect. We have (at least) 21 months for the goal posts to move again, and all sorts of special interests continue to seek changes to the proposed regime.”
He continued: “Even the definition of what constitutes a captive is open to interpretation, and several existing captives will not be recognised as such under Solvency II and will be treated as just another insurer,” he said. “Proportionality may be the source of some regulatory relief but it would be unwise for any captive to take this for granted.
Proportionality is not just about size but also risk profile, and the lack of diversification that a typical captive may be able to achieve.”
Like many others, Mr Thursby does not expect a truly level playing field to emerge.
In those countries where captives are a peripheral part of the insurance industry, such as the UK or Germany, no special treatment is likely. “But for countries where the captive presence is significant, such as Luxembourg or Malta, it is difficult to see the local regulator not trying his hardest to accommodate them,” he said. “Never rule out regulatory arbitrage, or the law of unintended consequences.”
Charles Winter, Chief Operating Officer and Head of Risk Finance, Aon Risk Solutions, said that while there has been some recognition of captives, “Solvency II is not going to be rewritten with captives at the forefront of anyone’s mind. Everyone is looking for guidelines but at the same time, they don’t want anything prescriptive. There have already been some noises about the degree of outsourcing that will be permitted—there is no firm position but it has been flagged that the full outsourced model that a lot of captives use, doesn’t sit comfortably with Solvency II even once you start applying proportionality.”
Again, it comes back to proportionality, and there is hope in the industry that this will be applied sensibly. “The details are yet to be made available but as captive insurance is a significant market internationally, it is expected a reasonable approach to proportionality will be forthcoming,” said Malcolm Cutts-Watson, Chairman, Willis Global Captive Practice—International.
“Interestingly, at a recent conference, Karel van Hulle, the head of the EU unit for insurance and pensions, implied that segmented equivalence would be permitted. It does, however, leave the question open as to the acceptability of the current definition of a captive applied by the EU, which many captive practitioners regard as too restrictive and would therefore only apply to a proportion of the captive industry.”
Captive owners could, of course, justifiably take a wait-and-see approach, given the delays. Solvency II will not come fully into force until 1 January, 2014, but many believe the date will be put back again.
Indeed, the crucial Omnibus II vote, which will finalise the transitional measures for Solvency II, has been delay-ed twice and will not happen until September this year.
Some are now talking of a possible delay in the introduction of Solvency II until January 2015. The truth is that the European Commission has other issues to distract it at the moment, not least eurozone debt.
According to Prof Joe Bannister, Chairman and President, Malta Financial Services Authority (MFSA), “Omnibus II contains wide-ranging provisions giving the European Commission powers to defer the implementation of significant features of Solvency II for up to ten years. These powers are, however, discretionary and firms cannot assume that, because the Commission has the power to delay implementation of a particular Solvency II feature, it will necessarily do so.”
Malcolm Cutts-Watson said there is no expectation of any mass exodus of captives from the EU as a result of the new rules. “Certainly we have not seen any indication of this from our clients under management,” he explained. “Most EU captives are already well prepared for Solvency II compliance. Smaller captives may reconsider their stand-alone operation and consider a cell in a EU PCC. The global captive industry is well prepared and sufficiently diverse to accommodate the needs of many different captive models. Some models are more well disposed to being domiciled offshore of the EU, others are not. There is plenty of capacity to satisfy all requirements.”
Domiciles have been greatly exercised by the issue of equivalence recently, but Clive Thursby said he thought equivalence may be seen as something of a red herring.
Bermuda is the only major offshore domicile outside of the EU that seeks equivalent status. That would mean that Bermudian insurers could freely operate in the EU under local supervision because it is deemed of an equal standing and offers obvious advantages to the island’s commercial international insurance and reinsurance community. But no other domicile seeks equivalence because they simply see no benefit, said Mr Thursby.
“Bermuda, the capital of the captive world, is likely to achieve equivalence but its application specifically excludes most of its captive sector. The murmurings from Brussels seem to suggest that this artificial distinction, notwithstanding that it runs counter to the main thrust of SII, may be accepted.”
The former Cayman Islands regulator added: “If so, this will raise an interesting dilemma as it will recognise the special features of captives, warranting different regulatory standards. However, EU-based captives should not take any comfort from such an outcome, which will have been driven by essentially political considerations—the European insurance market needs the support of Bermuda. The Bermuda authorities have cleverly pitched their application for equivalence in these terms, but EU regulators have other priorities and will not be pushing to favour captives in the same way.”
He said that if Bermuda fails in this quest and accepts full-blown equivalence, the captive fall-out is likely to be significant, and it will probably lose its market leadership, to the benefit of Cayman and Vermont.
He also pointed to the US and how it will be treated.
In its entirety, the US is the largest captive market with most states having enacted captive-friendly regulations. Again, if equivalence is sought, bifurcation is likely to be demanded and, again, politics will rule, said Mr Thursby.
“Perhaps the main significance of equivalence for captives will be that cessions from the EU to non-equivalent jurisdictions (eg by fronting) will be deemed inferior security under Solvency II with adverse capital charge implications. For this reason AM Best expects to see greater interest in captives being rated to counter this problem, and to gain the other benefits that a rating can provide,” he said.
Another rating agency, Fitch, said that it expects Solvency II to have varied implications for the EU captive industry.
Owners that retain captives in the EU will have to strengthen risk management and governance functions, and in some cases additional capital injections may be necessary.
As an alternative, said Fitch, captives could be re-domiciled to a non-Solvency II jurisdiction and write EU-based business through a fronting entity. In such a circumstance, Fitch said it believes that obtaining a credit rating on the captive could lower the overall capital cost.
“According to Fitch’s analysis, obtaining a credit rating on an offshore captive could, under the standard model, significantly lower the counterparty risk capital requirements levied on the fronting entity under Solvency II, and thereby reduce the overall capital requirements on an offshore structure,” explained Bjorn Norrman, Associate Director in Fitch’s insurance team.
Much depends on the word ‘proportionality’.
Professor Bannister at the MFSA said the Authority has always been convinced that the unique structure and sometimes small size of captives can leave them exposed to onerous demands under the Solvency II Directive, and that this justifies the application of the proportionality principle in their favour.
The challenge, he said, is to ensure that the special treatment of captives under Solvency II will not have a negative impact on commercial insurers and reinsurers.
He pointed out that general expectations for captives are quite positive. “The history of captives shows that changes in insurance legislation together with the key factors of cost, cover and capacity have provided the necessary impetus for the formation of new captives,” he said. “Solvency II will provide both opportunities and threats in terms of these key factors.”
Solvency II—Increased Costs
One threat that looks likely to become a reality is that Solvency II looks set to increase costs for captive owners, either in terms of capitalisation for those in the EU or in domiciles seeking equivalence, or in terms of additional administrative and compliance costs.
Capitalisation may be an issue for some but it may be the other costs that cause the most problems for captives, particularly smaller captives, and these have certainly been somewhat overshadowed by the concerns over capitalisation requirements.
Exactly how much Solvency II will mean in terms of additional costs is not easy to forecast, not least because of the lack of detail emanating from Brussels.
According to Willis’ Malcolm Cutts-Watson, it is impossible to estimate the level of increased costs. However, he said he believes a large proportion of EU captives have sufficient capital reserves built up under Solvency I and so will not require further capital injection. He said that a Willis review of its captives under management revealed that half had sufficient capital to continue with their existing business plan under the Solvency II regime.
“Operational costs are likely to increase but increased governance has become a global phenomenon and not just restricted to the EU,” he explained. “Solvency II is designed to provide increased protection to the consumer and inevitably there will be a cost, but also a benefit. Solvency II should be seen in the context of a global move to risk-based capital regulation across all financial services,” added Mr Cutts-Watson.
Nevertheless, there will be an undoubted additional administrative burden.
Solvency II encompasses three pillars—quantitative, qualitative and disclosure, with the latter two now firmly in the spotlight.
Solvency II is most often talked about in terms of capital adequacy. And certainly, it is important to have a better understanding of an insurer’s risk profile to more accurately define its capital needs.
But what has received less attention in a captive context is the likely impact of Pillars II & III, which in terms of management time could be the more burdensome, according to AM Best’s Clive Thursby. Pillar II covers risk management and governance and Pillar III disclosure.
The former will most likely involve increased cost, if only because of the need to document existing practice, said Mr Thursby. The latter could undermine the usefulness of a captive if it requires the release of confidential information into the public domain.
“The costs of running a captive have been increasing for some time, broadly in the name of corporate governance,” he said. “The relative simplicity of a captive operation, which underpinned the rationale for its use by stripping out the ‘unnecessary’ costs of the conventional market, is looking ever more like history.”
He explained that most captives are likely to be sufficiently well capitalised but some will require additional capital to satisfy Solvency II. Mr Thursby pointed to the QIS5 returns which suggest about a third of captives will need extra capital, although he did note that this was not the most representative sample.
The impact of Pillars II and III will potentially mean that for many captives, things will need to be restructured. Areas will need to be reported on differently, both internally and also externally to regulators. That will lead to costs.
Another much talked about area in relation to Solvency II is fronting. It was initially thought that for those captives based in non-EU domiciles, fronting costs would increase as a result of the capital weighting allocated to the counterparty default risk associated with a captive.
Under the new regulation, fronting insurers will potentially face higher capital requirements and may look to pass that increased cost on to their captive clients.
However, the general view now seems to be that fronting costs may not see much of an increase, and in any case, decisions about fronting costs by insurers will continue to be made on a case-by-case basis.
Aon’s Charles Winter explained: “Most of the big insurers that we talked to that front captives said that their main criteria is going to be what their security committee says, not whether a domicile is in a Solvency II regime or an equivalent one.”
The Captive Response
According to Clive Thursby there may still be doubt about what the endgame will be but the challenges that Solvency II throws up are not going away. “Denial is not an option for captives,” he said.
“Unfortunately, for most involved in this regulatory initiative, captives are an irrelevance. Despite concerted lobbying by ECIROA, Ferma and their like, and occasional soothing words from Karel van Hulle of the EC, the argument that captives are different has largely fallen on deaf ears at the European level. It is therefore important that European captive operators engage in a discussion with their own regulators to ensure that whatever discretion that Solvency II allows them will work in favour of the captive sector.”
He said that the well-managed captive will already be considering different Solvency II scenarios. “This will also shine a spotlight on the effectiveness and efficiency of this risk financing mechanism with, in some cases, painful answers,” he explained.
“We may find some fail this scrutiny test, but that will hardly threaten the continued existence of the captive solution. After all, if a captive is serving little purpose, when judged against corporate risk management objectives, its demise may be no great loss.”
One thing that is clear (one of the few things that is, with Solvency II) is that captive owners need to take a close look at their captive.
This will not necessarily be in terms of completely reassessing the captive solution (though that may be relevant in some cases) but certainly in terms of their capital efficiency and the best use of capital, and whether the potential administrative burdens make an alternative solution more attractive.
Charles Winter said that given the extensive analysis carried out by many captives as a result of QIS5, “those who have a capital problem know it already and can start making decisions to ensure they have enough capital under Solvency II. There has been a reduction in surplus in a lot of captives when they have applied the new Solvency rules, but it hasn’t been as catastrophic as people thought when it all started to be unveiled a few years ago.”
He pointed to a couple of areas where there has been some movement: “There have been some captives in run-off where the owners have wanted to accelerate the process to be sure that they are out of it before Solvency II comes along,” he said.
“Also there has been some acceleration of an existing trend for companies with multiple captives to look at consolidation. But in terms of seeing a mass movement of closing down captives, that certainly hasn’t happened yet,” added Mr Winter.
But it would clearly make sense for organisations with multiple captives to at least undertake a strategic review to identify whether it would beneficial to merge existing captives.
Malcolm Cutts-Watson said that captives respond in a strategic manner to their parent’s challenges and tactically to changes in re/insurance markets.
“They are adaptable and constantly evolving,” he said. “It is difficult to pinpoint where the next growth will come from, but you can be confident captives will respond and continue to grow as an important part of the global re/insurance industry, supporting and responding to their parent’s specific needs,” concluded Mr Cutts-Watson in a rarely positive manner on this often frustrating topic.
For the latest news, views and analysis on the rapidly evolving landscape for the European captive market come to the Malta International Risk & Insurance Congress on May 24 and 25 at the Hilton Malta. Attendance is free for risk managers but, at the time of writing, seats are rapidly filling up. To register for your place please mail Annabel White at firstname.lastname@example.org