Solvency II has been a concern for EU-based captives since its conception back in 2001/2. It was not conceived with captives in mind, and the feeling has always prevailed among the EU industry that it is being accidentally involved in, and adversely affected by, legislation that is not fit for most captives’ purposes.
Solvency II has been a concern for EU-based captives since its conception back in 2001/2. It was not conceived with captives in mind, and the feeling has always prevailed among the EU industry that it is being accidentally involved in, and adversely affected by, legislation that is not fit for most captives’ purposes.
The shadow that Solvency II casts over the EU captive industry was extended late last year with the disclosure that the directive probably would not be implemented in full until 2016 (it had previously been expected to become effective on 1 January 2014).
However, postponement does not mean more time to vacillate. The directive’s delay could in fact be positive because it allows captives to gradually and properly adjust their governance structure, and make changes to their programme during the next renewals, before the directive’s eventual implementation. “Captives could therefore avoid the potential costs of non-compliance or the extra costs of a fast-paced implementation,” says Marc Paasch, head of financial institutions at Marsh Risk Consulting.
“For existing captives, there are no real monetary costs directly attributed to the delay in implementation of the directive—in fact one could argue that the delay saves costs for the period that the new Solvency II regime is delayed,” affirms Gerard Connell, vice president at Marsh Management Services in Dublin.
And captives can still partially implement the Solvency II requirements before the official implementation, adds Connell. Any significant monetary costs incurred to date by captives relate to fees paid to service providers for the Pillar I, QIS5 Solvency Capital Requirement (SCR) calculation test conducted in 2010, and initial Pillar II gap analysis and implementation.
Connell says: “For those captives which produced a higher SCR result under Solvency II than under the present Solvency II regime, the delay in implementation gives them more time to raise the additional capital or restructure the business to achieve the required SCR under Pillar I.”
More preparation, more uncertainty
Not everyone sees the directive’s postponement so positively. Though the delay itself should not necessarily cause additional costs, it could mean that undertakings will have to go through a longer phase of preparation, which could possibly cause additional costs, says Carlos Montalvo, executive director of the European Insurance and Occupational Pensions Authority (EIOPA), one of three European supervisory authorities.
“Under the assumption that preparation is a one-off exercise and it takes more resources than when Solvency II will be operational, this would mean additional costs, though this assumption is not a straight-forward one.”
Indeed, Paasch concedes that the situation is complicated for some captives because some
domiciles have required captives to perform Solvency II exercises like the Basic Solvency Capital Requirement (BSCR) or SCR calculation. “Captives domiciled in such countries have therefore to comply both with Solvency I and some of Solvency II requirements, which is a double cost,” he explains.
Also, the insurance industry should not neglect the reputational cost that the delay may bring to the Solvency II project as a whole, argues Montalvo. “Solvency II makes as much sense today as when we started, if not more, and doubts should never be on the convenience of a risk-based framework. So let’s move ahead.”
Similarly, Derren Vincent, executive director at Willis Management in Gibraltar, argues that the main cost to captive owners of the directive’s delayed implementation is a loss of momentum in terms of ensuring that they are prepared for Solvency II. “One could be forgiven for taking the foot of the gas while certainty over implementation date and clarity over detailed measures is awaited,” he says.
And though the directive’s delayed implementation provides captives owners with more time to prepare, it extends the uncertainty around the impact of the finalised regulations, says Martin Le Pelley, compliance director at Guernsey-based Heritage Insurance Management. EIOPA is already pushing for the application of Pillar II by national insurance regulators from 1 January 2014, but some regulators are unsure about how to apply Pillar II in isolation, he says. “Furthermore, Pillar II is likely to be more of an issue for captives as the requirements for internal audit and actuarial involvement may be quite onerous for them.”
The hazy concept of proportionality is another problem, he says. “Proportionality is little understood by regulators, or else it’s open to interpretation, such that there may be disagreement between the licensee, manager and regulator about the risk associated with the various governance aspects for captives.”
However, Vincent Barrett, managing director at Aon Global Risk Consulting, argues that EU-based captives will develop greatly in spite of any delays to parts of the directive’s implementation. This is because they are subject to regulatory influences aside from Solvency II. “Most captive domiciles have adopted the International Association of Insurance Supervisors’ (IAIS) ‘Insurance Core Principles’ (ICPs) which are broadly similar to the Pillar II requirements of Solvency II,” he says.
As a result, improvements in corporate governance and risk management can be seen as a global initiative and so the delays in Solvency II have not had a huge impact on cost for captives per se, adds Barrett. “Furthermore, the recent announcement by EIOPA regarding their planned interim measures for 1 January 2014 mean to a large extent Solvency II will
be implemented next year.”
How to proportion proportionality?
A continuing point of contention for EU-based captives regarding Solvency II is around the issue of ‘proportionality’, the extent that it will be applied to captives, and what it would actually mean in practice. Although there have been few useful formal concessions for captives, the impact of Solvency II on captives will depend on how each jurisdiction translates its requirements into national law, and how its insurance regulator then applies those requirements to captives, says Mike Poulding, director at The Poulding Consultancy.
This lack of clarity over how regulators might apply proportionality to captives could lead to regulatory arbitrage, says Connell. “The general lack of any clear guidance from regulators on the matter could lead to the risk of divergent application of the principle in the different EU domiciles, thereby perhaps undermining the harmonised regulatory framework that Solvency II is meant to be.”
But Connell says he is optimistic that proportionality will be applied for captives to elements of the capital costs under Pillar I, reducing the initial capital requirements for low-risk captives.
Based on the principle of proportionality, some simplifications have already been allowed for the calculation of specific sub-modules or risk modules of the standard formula. Paasch gives the example that small captives can use simplifications for the calculation of the best estimate for unearned premium provisions. “If inter-company loans represent a high proportion of their investments, some captives could also reduce their capital requirement for concentration risk by implementing a specific contract with the parent company, subject to their regulator’s approval,” he explains.
No specific simplifications have been granted regarding Pillar II or III of the directive. For reporting, the guidelines issued by EIOPA give little flexibility to captives for implementing a simpler approach, says Paasch. However, the directive’s governance requirements have not defined a precise structure or process that should be implemented, so captives can propose to the regulator their own views of a proportional governance system, he adds.
For Montalvo, the application of proportionality to captives comes down to common sense, meaning in some cases it will apply, but not in others. “The regulator acknowledges the need of implementing the very same Solvency II principles and requirements in a different way. This should allow, for example, for a simplified treatment of captives, and also specific simplifications in the Standard Formula only for captives.”
Montalvo adds that captives are still insurers and so need to follow the same corporate governance and risk management standards as all the other insurers under Solvency II. “This concept is nothing more and nothing less than bringing common sense to the implementation debate,” he says.
Short and long-term challenges
One of the short-term challenges is the need to put an effective actuarial function in place, says Poulding. “It looks likely that this will be required by 1 January 2014.” The recent EIOPA consultation document on the guidelines on preparing for Solvency II outlines a number of issues that will need to be tackled shortly. These include corporate governance, forward-looking risk assessment (previously Own Risk and Solvency Assessment), submission of information to the supervisor and pre-application for internal models, notes Poulding. “Over the medium term, ie, by 2016, captives will also have to be in a position to calculate and meet the new Solvency II capital requirements,” he adds.
Paasch, however, says that the most pressing short-term challenge for captive owners is the shift of focus in the matter of captive management. “Solvency II asks the directors to manage their undertakings with a strategic multi-year approach that takes all risks into account. This paradigm underlies the directive and is formalised through the ORSA process,” he explains. Captive owners are therefore required to have defined a mid-term strategy. But this is a challenge because captives are a risk management tool for their parent companies and follow their evolution, so they have not always pre-defined a risk appetite or a multiyear business plan, Paasch says.
Implementing a compliant governance structure and improving data management (regarding confidentiality, integrity and traceability) are also two important challenges, though they should be achieved in the next two years, Paasch claims. “Pillar II and III require essentially a one-time effort; maintaining the new governance and reporting system will not be a significant challenge over the next years.” However, he says that in the longer-term some captive owners may be concerned about their ability to keep meeting the capital requirements in an ongoing economic crisis.
Time to act
Despite the uncertainties surrounding the nature of Solvency II, its implementation, let alone its final impact, captive owners should not passively wait and see how the regulation unfolds. Paasch says that captive managers can assist captive owners in adjusting and completing their governance framework, for example, by providing their expertise in internal processes, data management and compliance. Captives can also rely on them for assuming some new tasks or functions required by the directive. But Paasch adds: “Strategic decisions and the shift of approach still have to be made by the captive owners; defining a risk appetite and a mid-term business plan, in a multiyear approach, is under the responsibility of the board of directors.”
Regulators can provide captive owners with feedback regarding what their captive has achieved, for example, in terms of SCR calculation, governance structure or ORSA process. But Le Pelley says that captive owners should be asking regulators how they will be applying the proportionality principle to minimise the risk of over-regulating a low-risk captive. “They should be asking how and when the Level II implementation measures are being written into the jurisdiction’s law. There is a risk that if a jurisdiction leaves it too late to enact the Solvency II implementation measures they may poorly draft key aspects of the legislation, or else not cater adequately for their market.”
Montalvo affirms this point. He says: “The most obvious question to ask is, ‘How do the national authorities intend to apply the proportionality principles for captives?’”
But maybe it is wrong to ask how the proportionality principle will be applied. Captive owners could instead propose their own approaches and initiate a dialogue with regulators, suggests Paasch. “The first ideas proposed to authorities could become the model for the next year’s.”
