A bright future for captives

During the past two years, captive owners as well as the managerial intelligence around the captive industry have been discussing, testing and planning how to tackle the ‘new’ requirements under Solvency II.

The main objective of captives over the years has been to provide an intelligent tool which allows the parent company to carry part of its own corporate risks within this instrument. They have been used to achieve a better overall performance including, but not only, to save cost and to outperform the traditional alternative of placing 100 percent of all risks in the insurance market.

In the various domiciles, additional advantages have been used to distinguish markets but the basic idea of a captive is optimisation.
How much will this target be changed with Solvency II in the European domiciles? Our expectation is, not at all. We should distinguish between the hot dish which is served and the moment of eating. The difference between these two moments can be explained—and I will not get tired of emphasising this—with the application of the principle of proportionality.

All worries and fears are justified when we read how much the European Insurance and Occupational Pensions Authority (EIOPA), the European Commission and local supervisors (as the administrative bodies which have to implement and conduct control over insurers) are shifting to a rules-based legal environment which broadens and, to a certain extent, misuses, the general approach of the principle-based European Directive. They believe it is necessary to determine the conduct and all other individual features of insurers to avoid their insolvency or bankruptcy.

The initial main targets, to increase the consumer protection level and market transparency, are secondary. The financial crisis happened just in time to change the principle-based approach into these rules-based requirements to avoid insurers going insolvent/bankrupt.

Don’t fear the overkill

However, captives need not be afraid of this ‘overkill’ of requirements. The industry has proved over a long period of time that in the best interests of the parent company captive boards, including external captive managers and other experts, ran these special purpose vehicles in a responsible, accountable and reliable way—in short, a very professional manner.

The same experts will now determine how many more requirements a single captive has to fulfil, bearing in mind that the supervisor needs to understand the business plan and the way in which the processes and activities of the captive company are managed in detail.

The Protocol on the Application of the Principle of Subsidiarity and Proportionality, Article 5, European Treaty reads: “Draft legislative acts shall take account of the need for any burden, whether financial or administrative, falling upon the Union, national governments, regional or local authorities, economic operators and citizens, to be minimised and commensurate with the objective to be achieved.”

Every captive’s management should be able to convince the local supervisor that the objectives will be achieved. This includes a new, different approach under Pillar 1, which is definitely more professional than the Solvency I approach. Under Pillar 2 it will be a challenge to explain why an Own Risk and Solvency Assessment (ORSA—now Forward Looking Assessment of Own Risks [FLAOR]) will or will not provide additional insight based on a very simple and transparent business model which doesn’t have the complexity, size and huge number of risks of professional insurers.

Captives may insist that the ORSA is—without the volume of risk variety of professional insurers—not needed as a separate quantification process but rather as narrative information.
Today in a lot of captive domiciles actual documentation provided to the supervisor by captives is more comprehensive than in some European countries. This additional workload needed to prove the captive’s compliance will cause some higher cost initially, but this should lessen in subsequent years.

The Pillar 3 reporting requirements for captives have to be implemented once in the requested format but again this workload will be mastered rather easily. Confidential information such as sensitive reserves are not to be disclosed; this has always been accepted by all regulators and supervisors we have met.

Do we need a second narrative report under Pillar 3 as a duplication of the information provided under Pillar 2? Again, the development will show how much the captive management’s persuasiveness will succeed to minimise the volume of reports. There is no need to duplicate work, at least according to the IAIS’s May 2015 draft Application Paper on the Regulation and Supervision of Captive Insurers.

The volume of information which has to be checked and approved by local supervisors will need additional workforce on the authorities’ side. How do they ensure that these newcomers have sufficient expertise to judge whether the principle of proportionality can be applied or not, knowing that even some of the experienced supervisory auditors sometimes struggle to understand this principle?

To sum up: we don’t expect that captive owners will either move their captive to other domiciles or close business activities down. Some corporations will use the introduction of Solvency II to merge existing captives (often ‘inherited’ from other corporations which have been taken over). The most positive aspect and consequence of Solvency II will be the until now underestimated advantage to underwrite and carry employee benefits risks of the company’s own employees.

The positive impact is multiple: (a) corporate governance needs to align benefits for the same functions and responsibilities cross-border; (b) insurance cover advantages provided by a broader wording; and (c) the actuarial diversification impact to employ the subscribed capital more efficiently.

All of these possible advantages will encourage a substantial number of captives to increase the optimisation of the risk management performance of their owner.

Guenter Droese is chairman of ECIROA. He can be contacted at: guenter@droese-partner.com