Embrace your enemy

05-01-2016

Embrace your enemy

Solvency II was once regarded as bad news for captives in Europe. But the sector is adjusting to and even embracing the new rules, as a report by AM Best examines.

Solvency II was once regarded as bad news for captives in Europe. But the sector is adjusting to and even embracing the new rules, as a report by AM Best examines.

The future for European captives might not be as bleak as many people believe. Doomsayers are saying that the restrictive funding requirements set to be introduced under the EU’s Solvency II requirements will spell the end for this risk transfer model.

Initially, it appeared that captive owners viewed the Solvency II requirements as a burden due to the cost issues. Most captives employ few staff and have limited resources, so costs arise mostly in the form of outsourcing expenses.

But they may be speaking too soon. Global rating agency AM Best has examined the sector in close detail and reports that instead of calling in the removal men, many captives are actively embracing the new regime and using the implementation of the new rules as an excuse to overhaul their businesses.

An August 2015 report prepared by the rating agency, European Captives Increase Focus on Risk Management and Investments Ahead of Solvency II, reveals that: “For the most part, captives are not treating the regulations as merely a box-ticking exercise. Ahead of the introduction of the new capital regime on January 1, 2016, European captives rated by AM Best are using the information they have gathered to meet Solvency II’s qualitative and reporting requirements as an opportunity to also review their business models.”

An uneasy fit

It’s already widely accepted that specialist insurers such as captives are not well catered for under the Solvency II standard formula and that it is more geared towards the bigger insurance companies.

For larger insurers, using an internal model provides advantages but almost all captives will use the standard formula, which treats their limited diversification harshly.

AM Best declares that there may even be “some other limited knock-on effects of using the standard formula, as it may not properly reflect the captive’s risks and strategies”.

“AM BEST VIEWS IMPROVEMENTS IN THE CAPABILITIES OF CAPTIVES TO IDENTIFY AND QUANTIFY RISK, AS WELL AS TO UNDERSTAND AND MANAGE THEIR RISKS, AS POSITIVE DEVELOPMENTS."

What is undisputed is that Solvency II has been a wake-up call for captives and a major driver in placing them under greater pressure to justify their existence.

AM Best notes: “Parent companies have been reviewing their rationale for operating more than one captive and AM Best has noted a pragmatic response to mitigating the cost and reporting strain. For instance, parent companies with more than one captive have considered economic efficiencies by transferring risks to just one captive.”

Of course, if enough captive operators followed this line of thinking then there would be an inevitable knock-on effect for the numerous service industries that support the captive concept. Even for those captives that decide to adhere to the new rules there will be added pressures to diversify the business.

AM Best notes: “As Solvency II’s capital requirements under the standard formula will often be demanding to insurers that do not generate a large level of diversification benefit in the calculation, parent companies have also been reviewing the acceptance of new risks in existing captives to increase diversification. A captive that is able to accept different risks would ultimately be of increased importance to its parent.”
That’s undoubtedly the case as rating agencies like AM Best demand diversification as a risk management tool. But these efforts come at a cost.

An examination of AM Best’s rated captives discovered that they were of the opinion that the higher costs from increased requirements in terms of risk management and governance are offset by the benefits provided by a better understanding of their risk profile. In the longer term, Solvency II could even be seen as a positive development for captives since those that are able to expand their risk management capabilities will offer greater value to their parent companies.

“AM Best believes that captive owners, especially those whose captives are an integrated part of their overall risk management strategy and not just a financing tool, now take a more favourable view of the process, particularly as Solvency II aims to enhance and incentivise risk management,” says the report.

“AM Best views improvements in the capabilities of captives to identify and quantify risk, as well as to understand and manage their risks, as positive developments, especially as this has traditionally been a weaker feature of captives.”

Diversification

The drive for greater diversification is reflected in the attitude of some captive managers towards their asset allocation portfolios. Traditionally, the invested assets of a captive have often been linked to the parent, either through loan-backs, holding parental bond issues or in a somewhat looser sense by being invested in sovereign bonds in the parent’s domicile. Furthermore, investments have often been managed by the investment department of the parent company itself—AM Best has noticed that this seems to be changing gradually.

The rating agency has already seen changes in terms of rated captives’ asset allocations ahead of the introduction of Solvency II.

“Increasing numbers of captives now outsource their investment management to third party specialists in order to achieve portfolio optimisation. This is reflected in asset reallocations in order to achieve more diversification and by new exposure limits intended to reduce concentration and hence to lower capital requirements under the new regulatory regime,” it notes in the report.

It remarks that there is a synergy to be found with a captive’s investment strategy and its domicile. For instance: “If a captive has a parent that requires a substantial portion of assets to be loaned back, then the captive is likely to be domiciled outside the Solvency II catchment area. In contrast, those with a more diverse business portfolio may well choose a domicile based within the EU.

“Most captives will already be domiciled in a region—EU or non-EU— that best reflects their needs. However, the regulatory capital requirement aspects of Solvency II are not expected to be a constraint for most EU-based captives and, so far, AM Best has not seen any captives redomiciling as a result of Solvency II.”

Global effects

Although in theory, Solvency II will concern only captives based within the EU, the project will in reality impact industry practice globally and will influence regulators in other regions to adopt Solvency II-style regulatory regimes. It’s for this reason that the decision of where to domicile adopts crucial importance, as AM Best recognises.

“The choice of a captive’s domicile within the EU will be important because each national regulator will implement Solvency II with a degree of discretion over certain issues, which, for example, may affect the impact of investment allocation.

“Sovereign credit risk is one area where national regulators may differ in their treatment of internal models, and that will, in turn, affect how they apply standard formulas. This is because each national regulator will, in general, show a level of consistency towards how they supervise both. Therefore if, for example, a regulator is harsh on aspects of sovereign debt in internal models, then that is likely to feed through to its application of capital add-ons in the standard formula.”

There are currently considerable differences with regard to public disclosure between individual European states. In most continental European territories, there is a lower requirement for public disclosure of solvency data compared to the UK, for example.

Once Solvency II is implemented, the public disclosure requirements will be more uniform across the EU and will be somewhere between current continental European and UK standards. It will also impose new challenges and issues for a captive’s board of directors.

It will put on a legal footing the demand that they demonstrate a detailed understanding of the captive’s risk profile and its drivers.

AM Best says: “It’s a challenge that the boards of all EU insurance entities will have to deal with. Furthermore, under Solvency II, the credit risk charge is relatively high if an insurer cedes business to a low- or nonrated entity, and this might have an impact on fronting arrangements.”

Am Best, Solvency II, Europe

Captive International