Europe
What challenges do European captives currently face in the run-up to Solvency II’s implementation next year?

Dominic Wheatley: Captives domiciled within the EU will have to comply with Solvency II’s blanket approach to the regulation of insurance and reinsurance business. It is designed to deal with problems within the commercial market and therefore some of the requirements are simply disproportionately onerous for captives.

George Mangion: Preparation for Solvency II has been on the forefront of all regulatory activity during 2014 and will continue to be so in 2015. Solvency II may, under certain circumstances, call for higher capital requirements, enhanced governance and internal control procedures, and additional supervisory and public disclosure.

Solvency II is expected to increase consumer protection and establish more transparency for supervisors and investors. Nevertheless, the majority of Maltese captives serve a specific corporate risk financing and management purpose in the interest of the group of companies for whose benefit they have been established.

Therefore, generally pure captives (that is those that do not write third-party business) have another purposes. Under Solvency II, captives are will have to re-evaluate the use of their capital and explore new investment opportunities, among other things. This will inevitably lead to the incurrence of additional costs. Insurers have to prepare and disclose detailed quantitative reports to be in compliance with Pillar III, most of which will be of a technical nature and hence, require additional expertise.

Against this backdrop, PKF Malta is currently carrying out a survey among Maltese insurers (including captives and reinsurers). The survey shall recognise the major changes that companies had to undergo to follow Pillar II and III requirements, and ultimately to assess whether the proportionality principle applies to Maltese insurers. The survey results shall be delivered on 21 May 2015 at the 8th Annual Conference of Finance Malta.

William Dalziel: Solvency II is set to change the regulatory landscape for insurers in Europe. Between the requirements of the three pillars, insurers have been undergoing a top-to-bottom review of their capital management, risk modelling and analytical frameworks. The new regulations present challenges from an underwriting, reserving and investment perspective as they have been designed to ensure that insurers have sufficient capital to withstand adverse events, both in terms of insurance risk, and also economic, market and operational risk.

From an investment perspective, the new regulation will impose changes on portfolio modelling, construction and reporting that captives need to start addressing no later than Q3 2015. Aspects to be considered under Solvency II include:
  • Impact of asset capital weighting on asset allocation and portfolio modelling;

  • Availability and granularity of portfolio data; and

  • Risk governance.


  • Solvency II’s capital weighting model assigned to different asset classes may mean some insurers will need to set aside additional capital to allow for certain investments in their current portfolios. These capital weights will be imposed on securities based on factors such as asset classes, credit rating and duration.

    There is, therefore, a pressing need for captives to review their current portfolios to get a clear understanding of the impact of these changes on their expected returns on a capital-adjusted basis. Going forward, this will require performing capital-adjusted expected returns and volatilities, which minimise unrewarded risk and therefore optimise the use of the Insurer’s capital.

    The use of currency and duration matching, together with capital-weighted prospective asset returns and volatilities will be required to establish optimal asset allocations in the context of capital efficiency.

    Governance is a key theme throughout Solvency II. The underlying rationale of the legislation is to ensure insurers fully grasp the risk in their organisation. Therefore, captives will need to continually review market risk factors and, where appropriate, apply risk budgets to ensure the investment portfolio serves their business, not the other way around.

    Lorraine Stack:The majority of European captives are deep into Solvency II implementation and are in a strong position to meet the requirements of the new regime in 2016. Many had already implemented some of the governance and risk management aspects of the directive prior to 2014, so when the European Insurance and Occupational Pensions Authority (EIOPA) interim guidelines were introduced, these companies were ready to focus on the solvency requirement and the completion of the Forward Looking Assessment of Own Risk (FLAOR). The FLAOR exercise has allowed captive boards to see the alignment of Pillars I and II and the resulting impact on the Solvency Capital Requirement charge. In doing so, the process has improved risk awareness and the ability to manage risk more efficiently.

    Many captives are now addressing issues that may have been identified in the FLAOR exercise for 2014, and are completing any outstanding governance and risk management policy documentation.

    An issue on the horizon for captives is the area of regulatory reporting or the Pillar III aspects of the directive. Certain technical areas of the reporting process may present challenges for some captives. It remains to be seen if the principle of proportionality will be applied to captives in this area. Potential solutions are being worked upon and test reporting is being conducted in some domiciles this year.

    Marian Fenton: Although Guernsey is not in the EU (it is in Europe geographically) and as such, is not required to implement Solvency II, the island is updating its own risk-based, proportionate solvency regime in line with the Insurance Core Principles of the International Association of Insurance Supervisors.

    The challenges of Solvency II are in achieving the appropriate balance between increased governance and reporting requirements and captives’ essential nature as lower risk entities within the overall European regulatory universe.

    For the captive community, proportionality is a key principle in the application of Solvency II as it allows the requirements to be applied in a manner that is proportionate to the nature, scale and complexity of the business.

    Captive mangers play a pivotal role in supporting the captive board of directors, and the parent company in achieving a proportional, fit-for-purpose approach.

    The additional costs, resource and time requirements of this transition to the new regulatory framework do present challenges for captive budgets and have led to an examination of the strategic benefits that a captive delivers for the parent group.

    However, periodic strategic reviews of a subsidiary’s contribution to the wider group are a feature of modern economic life and a captive is no different in that respect. In fact, this type of examination is healthy and can identify new ways in which the captive can be utilised and remain relevant to the group’s overall goals.

    How will Solvency II’s capital requirements affect funding—will the cost be too high for captive owners, or do they already have this in the bag?

    Mangion: Malta is adopting the principle of proportionality for captive insurers. Malta’s captive managers are remarkably positive about Solvency II, perhaps because the end is in sight, and they and their clients have, in effect, done all the hard work. Solvency II will not only address insurance risk, but instead it will take into consideration a wider spectrum of risks when calculating capital requirements. A challenged faced by most of captive owners was whether they will opt for the internal model versus the standard formula to calculate the minimum solvency requirements.

    Captives have done the necessary tests and are poised for the changeover. Captive owners are confident that they have surpassed the learning curve and are now in the implementation period and shall reap the benefits of their thorough preparation. The common perception is that there is now a well-developed expertise in the cost-effective application of Solvency II to suit particular clients’ needs.

    Furthermore, the concept of risk-based supervision is spreading beyond the EU, so one hope that other offshore domiciles like Guernsey will be playing catch-up with the onshore EU domiciles.

    Stack: The first real indication of the directive’s capital requirements came with the fifth quantitative impact Study, conducted in late 2010. This exercise flagged anomalies, where captives with certain risk structures incurred large capital charges. However, the majority of captive results produced realistic capital requirements and captive owners have had time to meet the requirements in the lead up to introduction of the directive.

    Capital requirements under Solvency II are more complex and may indeed present challenges to entry for smaller companies, with the exception of those that were already in run-off, we have not seen captives closing or moving away from EU domiciles due to Solvency II. In fact, the certainty around Solvency II had a positive effect on recent formation activity across EU domiciles in 2014. We expect this trend to continue in 2015.

    Fenton: Captives tend to be conservative by nature, not just because of the regulatory framework that they operate in but in the very real sense they are an investment of the parent’s money, resources and time. For this reason captives have always been cautious investors of capital funds. The advent of Solvency II causes captives to look at their capital needs through a new lens and to understand the financial implications of decisions around investment counterparty selection and diversification.

    Through the forward-looking Own Risk and Solvency Assessment, captive owners and managers are gaining a better understanding of the capital cost implications of management decisions around areas such as:
  • Underwriting risk selection;

  • Loans/funds advanced to group companies;

  • Counterparty selection (both investment and reinsurance);

  • Diversification; and

  • Risk mitigation.


  • Where the initial results of this assessment in the 2014/2015 preparatory phase have highlighted issues for individual captives, they are actively looking at how they can alter aspects of their structure to get greater capital relief in a cost efficient manner.

    Wheatley: All captives based in the EU will have to comply with Solvency II’s requirement for insurance and reinsurance companies to hold sufficient capital to meet their obligations over the next 12 months with a 99.5 percent confidence level. This is unnecessarily burdensome for captives and may even render some captive business plans uneconomic and unviable.

    Unlike Solvency II, Guernsey’s new regime distinguishes between commercial insurance, reinsurance and captive insurance. As such, captives in Guernsey will have a minimum capital requirement of £100,000 and confidence levels of 90 percent. This proportionate approach should be very attractive to current and potential captive owners and especially those who still want a domicile within the European region.

    How are European captive owners managing their capital in a difficult economic environment?

    Stack: Generally speaking, it’s difficult to measure the impact of the economic environment on the captive sector. However, it is clear that captive owners remained fully committed to the use of their captive throughout the economic downturn.

    The captive played a critical role in the insurance and risk management aspects of the businesses and owners continued full compliance with solvency requirements. We do not believe that maintaining capital at the appropriate level has been an issue.

    Overall Solvency II will provide increased flexibility around captive investment strategy and many companies are revisiting investment strategy to potentially reduce Solvency II capital requirement. Also, companies are looking at potentially more efficient sources of capital, such as ancillary own funds. Where a parent is highly rated (BBB and higher), intercompany lending back to the parent can be very favourable from group perspective and provides an option which was not as broadly or consistently available under the Solvency I regime.

    Fenton: Captives, like other group subsidiaries, are expected to deliver value from their capital funds. The added challenge for captives is that they must do so in full conformity with the regulatory environment in which they operate. In many cases, cash flow benefits through intergroup cash pooling facilities provide the best use of funds to the group as returns on many low-risk investments are almost negligible.

    The key is in achieving a balance from a solvency capital perspective as such arrangements can carry a significant capital charge for counterparty default risk especially within an unrated group.

    As captive owners and managers become more familiar with the sensitivities within the standard model, they can best see how to diversify the management of capital funds.

    Dalziel: The current economic environment, in combination with impending Solvency II regulation, will present challenges ahead for European insurers.

    From an investment perspective, insurers have been altering the composition of their portfolios to maximise their capital-weighted returns. In the current low-yield environment there has been a tendency to increase exposure to higher-yielding, higher risk investments. However, with the impending Solvency II regulation, this tendency needs to be considered in tandem with the trade-off of increasing the amount of required capital. Only those businesses that enjoy a reasonably ‘fat’ level of shareholders’ excess reserves may continue to run with these capital-hungry assets.

    The regulation will impose capital weights on securities based on factors such as asset classes, credit rating and duration. Captives should consider reviewing their current portfolios to get a clear understanding of the impact of these changes on their expected returns on a capital-adjusted basis.

    These types of considerations have resulted in many insurers reducing their portfolios’ allocation to capital-intensive investments, such as asset-backed securities and long-dated high-yield bonds. There has been the major shift out of equities as they not only present a volatile return prospect but have a significant capital weighting under Solvency II regulation, rendering them inefficient on a capital-adjusted basis.

    Elsewhere, insurers have been increasing their allocation to investments that are less capital intensive, such as shorter-dated investment grade bonds and mortgage bonds. In many cases more capital is being allocated to government/sovereign bonds, which may not incur a capital charge, even with the current low-yield environment. From an accounting perspective, despite investments earning near record low yields, the valuation of the captive’s liabilities should move broadly in line the valuation of the investments, as the discount rates are also near record lows.

    With that said, one of the consequences of Solvency II is the temptation to ‘manage the model’ rather than manage the market. The best approach in the current environment therefore is to actively manage risk exposures in response to evolving macro-economic conditions, all the while taking into account regulatory demands.

    Mangion: In the midst of this concern of higher capital requirements and costs associated with satisfying all the requirements under the Solvency II framework. European captive owners should ensure that they work with insurance partners that appreciate the potentially significant increase in the capital and compliance requirements imposed on them by Solvency II. Maltese captives were required to conduct a during 2014 and submit the report to the Malta Financial Services Authority before 31 December 2014.

    The captive insurance industry has a long tradition of evolving and innovating to serve changing needs and new industries. For many the challenge brought by Solvency II is to see the wood for the trees. Last year was the year catastrophe bonds and insurance-linked securities (ILS) were taken to a new level. Catastrophe bonds have grown extensively, and now play a central role in market for catastrophic risk. It is not expected that catastrophe bonds and ILS will replace reinsurance but acts as complement to the reinsurance market. Malta is now the only state in the EU with cell legislation for issuers of ILS. It is targeting the ILS, catastrophe bond and reinsurance convergence sector.

    Wheatley: The new solvency regimes are pushing up the capital requirements for captives. However, this is restricted to secured assets and yet they are low yielding.

    As such, this is squeezing the margins for captives and therefore this undermines their economic viability especially in the context of soft conventional insurance units. In Guernsey, captives are addressing this by upstreaming to parents as a way to decrease the counterparty risk and enhance returns.

    Which captive structures are proving the most popular in Europe, and why?

    Wheatley: There were 85 new international insurance entities established in Guernsey during 2014. Some of these were established using limited companies but the vast majority were protected cell companies (PCCs) and incorporated cell companies (ICCs) and related cells.

    Guernsey pioneered the concept when it introduced the PCC in 1997 and therefore has built up significant experience and expertise in using cell companies within the captive insurance sector. In the last year we have seen a number of captive insurers established as ICCs to transfer pension longevity risk.

    For example, BT’s pension scheme has established a new insurance company, BTPS Insurance ICC, and enabled the transfer of a quarter of the scheme’s exposure to increased longevity and so hedged around $16 billion of liabilities. Similar structures have since been established by Towers Watson and PricewaterhouseCoopers to facilitate transactions for their pension fund clients.

    The ability to quickly and cheaply establish new cells is a major reason for the popularity of PCCs and ICCs and is behind their use within Guernsey’s fast-growing ILS market and the collateralised reinsurance segment.

    This has been enhanced by the fact that protected cells conducting collateralised reinsurance business are able to secure regulatory pre-authorisation. Guernsey’s regime has now been enhanced further by the publication of guidance notes on the use of transformer vehicles for insurance and reinsurance business.

    Stack: The traditional single parent direct or reinsurance structure is still the most popular captive arrangement. However, we are seeing interest in alternative structures such as PCCs and special purpose vehicles. The evolution of the captive model into these non-traditional structures essentially makes captives more accessible for small- and mid-sized companies as well as large organisations.

    We are also seeing growth in captive participation in multinational employee benefit financing arrangements, with several employee benefit captive programmes currently being contemplated or implemented in a number of domiciles.

    Captive usage in defined benefit pension financing arrangements is also a trending area; although most defined benefit pension plans are closed, many companies still face significant challenges in the management of legacy obligations. We expect to see further innovation involving captive structures in the pension area going forward.

    There also continues to be growing interest in the use of captives to insure trade credit, customer warranty programmes, and cyber risk coverage.

    Mangion: The PCC structure is one of the most popular structures for captives. Malta is the only EU country offering PCCs. A European captive gives insurers the opportunity to write insurance business for which they have been authorised throughout the EU under the European passport rights. The most important advantage of the PCC model is that an individual cell may carry out insurance business through a certain cell without having to go by the own funds requirements, through using the cell company’s core capital. In addition, cellular assets that are contained in one cell are only available to meet the liabilities of that specific cell.

    This results in the concept of segregating cellular creditors, meaning that cellular creditors contracting with the PCC in respect of a particular cell only have a right of recourse against the assets of that cell. Typically though, creditors of a cell may also have the right to secondary recourse to the core assets of the PCC, with the condition that the cellular assets of that particular cell to which the liability is associated with have been used up fully.

    A cell of a PCC does not have separate legal personality, and as a result, under the quantitative capital requirements of Pillar II, a cell will typically need to put up its own funds equivalent to the calculation of the cell’s notional solvency capital requirement. In addition, a PCC has the possibility to produce a single own risk solvency assessment for the entire PCC. The same applies to Pillar III reporting and disclosure requirements.

    Fenton: We are seeing a greater focus on reinsurance captives utilising net retention programmes and moving away from the structure of accepting gross risk and ceding this via the captive to the market or a non-European group captive. This change in strategy comes about as captives look to minimise their counterparty default and operational risk exposures and associated capital costs in the Solvency II environment.

    The compliance cost of operating a direct writing captive is also an area that we see companies critically assessing and in some cases the fronted solution provides greater value taking into account the risk retention needs and geographical risk distribution of the parent.

    What are European companies considering before they launch a captive? How has the reasoning behind formation changed in the years following the crisis?

    Mangion: The financial crisis of 2008 showed significant exposures in the insurance sector. Political, regulatory and financial uncertainty affected insurance market pricing, reinsurance level, investment policies and capital requirements.

    In its aftermath, regulators and insurers have devoted considerable effort to better understanding insurance risks. For many years, a number of multinational enterprises have embraced the opportunity to operate their own captive insurance company. Most of which were established to offer insurance coverage in circumstances where cover was unavailable or unreasonably priced.

    In fact, industries such as construction, manufacturing as well as professional services regularly face industry-specific risks exclude general liability insurance, errors and omissions policies, as well as reputation risks. In the last decade, small- to medium-sized companies have also learned that the captive insurance entities can provide them significant benefits, which include attractive risk management elements, asset protection from the claims of business and personal creditors, access to the lower-cost reinsurance market and insuring risks that would otherwise be uninsurable.

    A properly structured and managed captive insurance company could provide various other tax savings opportunities.

    In addition, the premium paid by the parent company can be invested and the return would be reserved and used in the event of a major future loss. Malta is well represented by a number of financial institutions, including well-recognised insurance managers and companies. Nevertheless, Malta continued to experience a healthy increase in captive business, particularly originating from some of the largest blue chip corporations.

    Malta’s captive insurance industry has the potential of growing with good reputation, an approachable and motivated regulator and a strong financial sector.

    Wheatley: Captives might be established for a number of reasons, including the insurance of unusual risks not catered for by the commercial market or where market capacity is limited, direct access to reinsurance markets, paying premiums related to the insured’s own track record and the retention of net premiums over claims.

    However, the financial crisis highlighted major failures of corporate governance and has brought about increased focus within the boardroom on de-risking companies.

    Establishing a captive improves the understanding of risk and the cost of risk management within a company and as such has been a major driver in the continued use of captives within Europe. Yet, the use of captives in Europe has not reached such deep penetration as in the US and this suggests that there is scope for further growth.

    I would expect the number of formations to continue to build across Europe as a result of current trends in corporate governance and risk financing technology. The trend being seen across many major companies is for the retention of larger and more complex risks, which need to be effectively managed from both a governance and financing perspective.

    This results partly from the limitations of the conventional insurance markets and partly from the increasing willingness of companies to retain risk as a result of the deeper understanding of their own risk that arises out of the enhanced analytics and improved financial modelling available today.

    Stack: The areas of consideration in captive formation have not changed in the years since the financial crisis, and still include the assessment of the appropriate level of risk retention and most appropriate captive structure and domicile, a cost benefit analysis, and an assessment of capital, legal and tax issues.

    What does appear to be changing is the level of sophistication with which these assessments are being made, increasingly involving the use of analytics to guide strategic risk planning. There is also a marked increase in interest around diversification of the captive model outside the traditional spheres of property and casualty, into non-traditional areas such as employee benefits as mentioned earlier. The captive option is increasingly being viewed as an enterprise risk management tool, which in turn has broadened the bandwidth of those in the assessment process, often including hands on involvement of stakeholders in finance and HR.

    Fenton: The value proposition for a captive is now very firmly at the root of any decision making exercise. The feasibility exercise that companies carry out prior to launching a captive is now subject to greater challenges from the relevant stakeholders and a captive proposition must be able to demonstrably deliver true benefit via:
  • Savings through risk management efficiencies; and/or

  • Lower total cost of risk.


  • Prior to the financial crisis, the potential of investment return on funds maintained within the captive may have been a strong motivator, but in the current economic environment that is no longer a persuasive factor.
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