Marsh
While the current regulatory environment in Europe means it is not ideally suited to innovation, Marsh’s Lorraine Stack says the first steps have already been taken towards a more sophisticated future for captives
What are the current trends for onshore captive domiciles?
Although captive growth was limited in the aftermath of the economic crisis, the good news is that it is starting to take off. New captives were added in Dublin, Malta, Luxembourg and Sweden in 2014, and we expect this trend to continue.
We have seen year-on-year captive growth globally in spite of the continued soft insurance market. The captive engine is now being adapted for use in more innovative ways and some non-traditional lines of coverage such as, cyber, trade credit, environmental risk, and employee benefits, are gaining in popularity.
Generally, we are seeing onshore domiciles increase the sophistication of their captives as everyone heads towards Solvency II implementation. Capital requirements are generally higher in these domiciles and calculation under Solvency II is becoming more complex. Most European captives were already well capitalised prior to emergence of Solvency II, so many were already sufficiently capitalised. Those that did see a rise in capital requirements had enough time to manage capital deployment in an efficient way. With complexity under Solvency II also comes the large positive of flexibility in terms of investment and capital, a flexibility that is driving an increase in sophistication.
As well as external pressures, captives are also coming under scrutiny internally as a more diverse list of stakeholders are becoming involved in the management of captives. Captives are not just within the remit of risk managers anymore, as treasury, finance and human resources involvement in captive operations is becoming more prominent.
How are your clients achieving this level of sophistication?
Many are looking to achieve this through organic growth by adding additional lines such as cyber, trade credit, and employee benefits. The beauty of employee benefits such as life, disability and personal accident is that, unlike property or liability losses that have catastrophic potential, the claims follow a high frequency, low severity pattern. In short, they are less volatile and easier to forecast.
While the popular method for insuring employee benefits is currently through risk transfer, it is less likely to be efficient at a group level. Many of our corporate clients are exploring the possibility of financing employee benefits via a captive structure, which will allow them to capture financial efficiency at group level while still maintaining a local administration structure through a fronting company.
On the captive side, the diversification in lines of business can mitigate volatility on its balance sheet. For example, an energy company that is running property and liability coverage through their captive could potentially experience quite ‘lumpy’ exposure—introducing employee benefits into the mix can act to mitigate that volatility on the captive balance sheet.
So what kinds of employee benefits are being put through captives?
Well, so far, implementation numbers have been on the risk benefits side such as life, disability and personal accident. However, another innovation we are seeing is the use of captives in pension financing.
While most defined benefit plans are closed, companies are facing significant challenges around legacy obligations, with huge balances that need to be managed for a very long time. So they are understandably looking for solutions.
We are seeing two areas of interest. Firstly, centred on the corporate objective—getting control of assets. This is basically an investment strategy under the control of local trustees.
Outside of the group there may be multiple plans across multiple jurisdictions, and different forms of governance in place, so corporates are trying to control assets, or even access surplus, by structuring a financing arrangement around a captive.
Usually, these are structured around a buy-in arrangement whereby the transfer of investment assets and management functions are made to a captive via an insurance contract. Essentially, the corporate convinces the trustee to purchase an annuity contract from a fronting insurer and that is then reinsured to a captive, which is how the funds are moved back.
The main feature of this pension arrangement in this captive structure is that it is very different from a traditional property and casualty captive. Customarily, the capital requirements would be linked to losses so you know if you have had a loss, as volatility is linked to physical assets or liability. On a pension arrangement the capital requirements are linked to investments and that is a far more dynamic control and monitoring that is absolutely key. The arrangements themselves are quite lumpy and difficult to control, and this is why surplus so important.
Only a small number of corporates have implemented such arrangements, largely due to challenges in terms of resources and capital outlay. However, interest is growing and we do expect to see further innovation in this area, particularly if interest rates improve.
The second form of pension financing, which is rapidly gaining popularity, is when the captive is used as a synthetic fronting structure to reduce costs in a longevity swap arrangement. So far, the activity around this has been offshore, particularly in Guernsey where a number of high profile transactions have recently been announced. We expect more activity in this.
In short, longevity risk is the risk that pensioners will live longer than expected, a risk that is often transferred out of schemes via a hedging arrangement involving a longevity swap.
The counterparty in such a longevity swap is typically an investment bank or life insurance company, which in turn reinsures the risk, and the reinsurance market (the ultimate risk-takers themselves) are driving the market terms and price.
From an efficiency perspective, it makes sense to cut out the fronting carrier altogether and substitute a captive as a counterparty in the arrangement. This potentially enables pension schemes to lower costs, increase flexibility and helps avoid transaction size limits driven by fronted credit and concentration constraints, as well as increasing price transparency. So far, UK companies are the early adopters for this structure, but we expect to see more in the future.
Have these arrangements developed organically within each particular domicile or has inspiration been gained from looking at other domiciles such as the US?
I think it is a bit of both really. It is inevitable that innovative notions will trickle down to boards from publications, events and reports, and these kinds of companies are sure to take note when they are in search of alternative solutions to complex problems.
Also driving activity are human resources and treasury personnel who are looking for improvements in efficiencies around employee benefit financing. They are looking to captives because the arrangements are well established and out there already for all to see, and as an added bonus, they happen to tick a number of the boxes that human resources routinely request.
Although not all domiciles will be affected directly by Solvency II, what are EU regulators’ attitudes towards these new lines of business?
On the multinational employee benefits side at least, as it is now becoming routine in many jurisdictions, we are seeing a great deal of acceptance. Two authorisations were sought in Ireland, where the regulator essentially looked at the applications through a Solvency II lens, yet both situations were straightforward. The first was a pension arrangement and the other was established for multinational risk benefits coverage.
In each case, despite Solvency I being in force legally, Solvency II capital calculations had to be submitted as part of the application. All the governance and supporting material in terms of the structure were in line with Solvency II principles, and both applications were successful. While we didn’t expect any difficulties at the outset, precedence has effectively been set making these coverages relatively routine from a regulatory perspective.
