With yet another delay in the introduction of Solvency II in the EU, Bermuda exempting captives from equivalent supervision and Guernsey simply not bothering, interest has fallen sub-zero and one might suspect that regulatory fatigue has taken hold of the captive insurance and reinsurance world.
With yet another delay in the introduction of Solvency II in the EU, Bermuda exempting captives from equivalent supervision and Guernsey simply not bothering, interest has fallen sub-zero and one might suspect that regulatory fatigue has taken hold of the captive insurance and reinsurance world.
Far from it! Rather than waiting for the fog surrounding Solvency II to lift, companies are already addressing second order effects and are moving on to focus on more practical business matters. Now, how is this possible?
Over the last few years, a comprehensive and consistent framework emerged for central corporate risk financing, including captives. Key components include:
Economic substance: Court of Justice for the EU’s (CJEU’s) Cadbury Schweppes-ruling
Transfer pricing: OECD guidelines
Premium allocation: CJEU’s Kvaerner ruling
Best practice standards: International Organization for Standardization, Committee of Sponsoring Organizations of the Treadway Commission, Captive Insurance Companies Association, et al
Insurance and reinsurance supervision: Swiss Solvency Test, EU Solvency II, EU Reinsurance Directive.
This ‘meta-framework’ in essence simply promotes substance over form, strong risk management and good corporate governance. While Solvency II clearly has been a major catalyst, it arguably isn’t a driving force behind this.
Against this fairly traditional background many risk managers have started reviewing how they structure their central risk financing. Specific considerations include:
Rising premium and corporate income tax rates
Counterparty credit risk
Liquidity requirements
Investment restrictions on ring fenced assets
Increased administration expenses and management time
Compliance and reporting
Corporate governance.
Adaption of corporate risk financing via captives is mostly driven by second order effects of Solvency II, specifically, credit and concentration risk-related to loan backs, reinsurance asset risk and protection of underwriting, ie, renewal capacity. As a consequence, one would expect:
More homogeneous limit structures with reduced peak risks
Reduced reinsurance to unrated or lowly rated counterparties
More single captive structures and fewer pure fronting captives
Introduction of target capital adequacy ratios of around 125 to 150 percent of Solvency II requirement
More active capital management with introduction of dividend policies
More active underwriting portfolio steering to control level of equalisation reserves and deferred tax
Increased focus on composition of shareholders’ funds/available capital
More diverse board composition.
Beyond self-insurance via captives, companies are carefully thinking about the value of insurance and are considering alternatives where available and sensible. Many may also choose risk financing options that are entirely outside the regulated insurance and reinsurance space. Again, as a consequence, one would expect:
Further increase in the number of protected cells
Renewed interest in structured insurance with embedded captives
More frequent structured uninsured risk retention on balance sheet such as optimisation of deductibles, virtual captives and risk trusts
Increased interest in pecuniary interest covers
More active involvement of insurance department in liquidity/working capital planning by the treasury department.
The results can already be seen today and anecdotal evidence suggests that these trends will likely accentuate in the coming two to three years.
While the finalisation and introduction of Solvency II may be in the distant future, surprisingly it seems to already be yesterday’s news for risk managers, captive owners and captive insurance and reinsurance companies. That’s good news.
