Regulatory complexity, simplified

From the outside, Europe appears a single entity with a simple legislation process. From the inside, with 27 member states, 23 different languages, 11 currencies, a commission that prepares its directives, a parliament that approves them and a council, whose presidency changes every six months, that promulgates them, it is completely different. When the goal is to develop a new directive to regulate the insurance industry for the next 30 years with an ambition to become a world model, it is even worse. So let’s try to make it as simple as counting from one to five.

One directive

The Solvency II Directive will formally be transposed into national laws on January 1, 2013, replacing Solvency I, which is presently in force. Is there anything wrong with it? Not really. Throughout the major financial crises of the past 30 years, the capitalisation of insurance and reinsurance companies has proven sufficient to protect policyholders. So why change? To enhance policyholder protection, to improve competition among EU insurers by creating a level playing field and to finally have a regulatory system that takes into account risk models is the official answer. Large insurance companies, I suspect, have supported this initiative from its inception in order to eliminate smaller entities, mutuals and niche players. But the final result may not be to their liking, considering the huge amount of capital that the industry will have to come up with to meet the new requirements.

Two principles

The European Constitution and the Lisbon Treaty established two fundamental principles applicable to European legislation: the principle of subsidiary and the principle of proportionality.

According to the first, there is no need to legislate at a European level on issues of interest to a limited number of member states. Typically, captives owners could have used this principle to exclude captives altogether from the scope of Solvency II. After all, only a limited number of member states are significant captive domiciles (Luxembourg, Ireland and Malta being the largest) and local regulation is sufficient to ensure solvency and control. But captive owners and managers decided that it would be better to leave captives within the scope of the directive.

The intent of the principle of proportionality is that a “public authority may not impose obligations on a citizen except to the extent to which they are strictly necessary in the public interest to attain the purpose of the measure”. In other words, when the obligations of Solvency II will be applied to small insurance companies (including captives), consideration should be given to their size, nature and complexity to simplify them without compromising the final objective. Good. The problem is that, at this stage, nobody really knows how to transpose this principle into concrete measures. Does this mean that capital requirements will be adapted? Could calculation formulas of solvency capital requirement (SCR) be simpler? Risk management and controls lighter? Disclosure obligations reduced? Who will decide and on what basis?

Three pillars

The Framework Directive addresses three areas of concern for which it proposes regulatory measures. These are called the three pillars.

The first pillar deals with quantitative requirements, such as a calculation of minimum capital, SCR and technical provisions. This is where most of the discussions have taken place. Captives do not compare to other re/insurers. They have their own specificities, are not exposed to the public and should therefore be treated differently. The consequences of inadequate treatment may lead to a substantial increase in required capital and the closing down of many captives.

The second pillar regulates the governance of insurance and reinsurance companies, through internal risk management, audit and control. Here also the level of controls that may be imposed on captives is disproportionate and decidedly expensive. The third pillar will address supervisory reporting and public disclosure in order to achieve transparency. The problem here is the confidentiality of information retained in the captive. A reserve for a major liability claim, premium volume per line of business for example, can impeach competition regulation or have an impact on the holding company’s stock market value.

Four levels

Any new directive to be implemented in Europe has to follow what is known as the Lamfalussy process. Solvency II is no exception. Thisprocess involves four levels. At the first level, the European Parliament and Council of the European Union adopt a piece of legislation, establishing the core values of a law and building guidelines on its implementation. The law then progresses to the second level, where sector-specific committees and regulators advise on technical details, then bring it to a vote in front of member-state representatives. At the third level, national regulators work on co-ordinating new regulations with other nations. The fourth level involves compliance and enforcement of the new rules and laws.

Regarding Solvency II , the Framework Directive (level one) was voted into force in June 2009. Our lobbying efforts at that stage were successful in that captives were recognised as specific entities requiring special treatment. A captive is defined as “an insurance undertaking owned either by a financial undertaking other than an insurance or a reinsurance undertaking or a group of insurance or reinsurance undertakings, or by a non-financial undertaking, the purpose of which is to provide insurance cover exclusively for the risks of the undertaking or undertakings to which it belongs or of an undertaking or undertakings of the group of which the captive insurance undertaking is a member”. This definition was considered sufficiently broad to protect captive owners’ interests.

At level 2 (the present stage), the Commission is developing technical specifications. The Commission is assisted by the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS). CEIOPS issued numerous consultation papers in order to bring together comments. The one relative to captives (CP 79) has been strongly criticised by the Federation of European Risk Management Associations (FERMA) and the European Captive Insurance and Reinsurance Owners Association (ECIROA), the two associations representing captive owners, and the scope of captives that qualify for a simplified calculation of the SCR has since been significantly reduced. Direct captives writing compulsory third-party liability are now excluded. This means auto liability, environmental liability in certain countries and products liability for certain industries, among other excluded lines.

Five QIS

Quantitative impact studies (QIS) are launched by the Commission with the help of CEIOPS to test the impact of the formulas used in the calculation of the SCR. Four QIS have been conducted so far and the fifth one is presently under way.

If CEIOPS and the European Commission consider the results satisfactory, the formula will then be finally adopted and the directive transposed into national laws.

First analysis of studies conducted by Marsh and Aon indicate that the distribution of participation from captive domiciles is better than for the previous study, QIS4, conducted in 2009. Last year, 99 captives responded, of which 65 were based in Luxembourg. For QIS5, Luxembourg and Sweden have slightly increased their participation rate, but Ireland, Netherlands and Malta have a higher participation rate than QIS4 (up to 60 percent of active captives, excluding run-off captives). Overall in Europe, the participation rate of captives will probably be between 40 to 50 percent.

From a sample of Luxembourg and Ireland captives that responded, one can observe a slight decrease in the average solvency ratio, as calculated with reference to QIS5, but still approximately 13 percent of captives would be considered insolvent with the new Solvency II SCR calculations, compared to 21 percent under QIS4. More than 73 percent of captives have a solvency ratio between 100 percent and 200 percent, compared to 52 percent under QIS4.

Small captives have a lower solvency ratio than large ones. This is often due to the lack of diversification in investments (especially intra-group loans). It is also explained by less risk-bearing capital in more recently formed captives.

It seems that the results from QIS5 for captives will not be too different from QIS4. The main drivers of risks remain unchanged— non-life underwriting risk and concentration risk. The catastrophic risk contribution to the solvency capital requirement has decreased, due to the inclusion of risk mitigation effects; however, concentration risk remains still too important and not appropriately calibrated.

It is, however, too early to draw conclusions from these preliminary studies, and one will have to wait until the final results are published in the second quarter of 2011 by the European Insurance and Occupational Pensions Authority (EIOPA ), the new European insurance regulator, which will replace CEIOPS on January 1.

Conclusion

As indicated above, a lot of uncertainties remain regarding the treatment of captives under the new directive. Lobbying of associations such as FERMA and ECIROA along with the main European captive domiciles will be instrumental in 2011. Fortunately, the negotiation climate with the regulators is constructive. New developments on this important subject will be discussed in depth at the next FERMA risk management forum to be held in Stockholm, on October 2-5, 2011.

Pierre Sonigo is the secretary general of the Federation of European Risk Management Associations (FERMA). He can be contacted at: psonigo@gmail.com