The rise and rise of PCCs

Marsh’s 2014 Captive Benchmarking Report showed that 34 percent of all captive investments are in parent loan books, 31 percent in fixed income, 30 percent is retained in cash and the remaining 5 percent was classified as ‘other’.

While this data reflects the position of captives worldwide, and not just those subject to Solvency II, it is likely that European captives invest similarly.

If these findings are true, it could be argued that parental loans are not necessarily the most prudent form of investment, or in the interest of policyholders.

Prudent investors would avoid adding to enterprise risk and would not invest in a business that is itself the source of the risk that the captive underwrites.

Time for an appraisal

The advent of Solvency II may provide the impetus for captives to review their asset allocation policy to generate the most efficient use of capital under the rules.

On the other hand, the predicted increase in funding requirements under the new EU requirements may mean that the captives model itself is caught in a capital squeeze and may be uneconomical in some circumstances, for some owners.

Such a scenario could see a switch of tactics, where the provision of a protected cell company (PCC) could be the way to go. Nigel Feetham, a partner at Gibraltar-based law firm Hassans, certainly feels that is a distinct possibility.

“In a post-Solvency II world, I see a real boost for the use of PCCs by captives in a number of areas,” he says.

“First, where the PCC cell is used for ‘fronting’ with appropriate contractual clauses in place and is not retaining any risk within the cell, the PCC would demonstrably mitigate Solvency Capital Requirements (SCRs).

“So, too, where captive promoters carry on segregated business through separate cells with individual policies that set a limit on the amount of the indemnity—all things being equal, its maximum capital requirements should never be more than that limit. Here the PCC offers a very flexible structure that an ordinary corporate does not.”

The view from Guernsey

Kate Storey, an advocate with Guernsey-based solicitors Appleby, also sees the sense in adopting the segregated cell approach and believes it is a tactic that is gaining traction.

“Captive owners are considering cost efficiencies of transferring risks to a single captive, which can be a PCC, with the different risks segregated in separate cells within the legal entity,” she says.

“In Guernsey, the minimum capital floor requirement applies only to the overall PCC rather than in respect of each cell and the core of the PCC.”

Feetham warns that the numbers of traditional captive entities could even reduce as the capital burden imposed by Solvency II moves these structures into uneconomic waters.

“Under current rules a captive can effectively obtain certain exemptions for loan-backs of capital to the parent company but I do not believe these will be available under Solvency II. That will make a big difference to captive owners,” he says.

“The second area is a fact which I think is suddenly dawning on many captive owners around the world, namely that the captives might be around years after they are put into run-off. In a PCC all the cells should be sharing in the running costs (directors’ fees, secretarial, audit, plus the additional governance cost under Solvency II), and this considerably reduces the operational cost of running a captive in comparison to a standalone company.

“I have been working with PCCs for 15 years and these are just a few examples. I can think of more. Solvency II is an opportunity for PCCs rather than a challenge. I can therefore see finance directors of large corporates embracing their use more in the future than they have perhaps done in the past,” he says.

Guernsey is not subject to EU law and as such is not seeking equivalence under Solvency II. Its regime is less prescriptive on capital assessment procedures and it was also one of the first jurisdictions to pioneer the captive concept as far back as 1997.

Storey believes that, with a predicted increase in funding for captives scheduled in Solvency II, a contraction in the numbers in captives and a gain for PCC structures can be expected, and is in fact already happening.

“Due to the burdensome capital requirements of Solvency II, which do not cater well for specialist insurers such as captives, the insurance industry has seen a growing interest in rationalising captive structures and use of the PCC to do so,” she says.

Guernsey is looking to capitalise on this by adopting a less demanding regime than the EU is set to enforce, she adds.

“Instead of seeking equivalence under Solvency II, Guernsey has committed to fully complying with the Insurance Core Principles of the International Association of Insurance Supervisors, and has introduced a new solvency regime with a 90 percent value at risk (VaR) confidence level for captives (as opposed to 99.5 percent under Solvency II).

“Guernsey law provides mechanisms for migrating existing captives to Guernsey, as well as amalgamation and schemes of arrangement for merging multiple captives into a Guernsey-based company, including a PCC.”

So will the funding demands of Solvency II spell the end for the non-PCC captive entity?

“Yes,” is the emphatic response of Feetham, “for the simple reason that it might no longer make economic sense because of the higher cost of capital (higher capital requirements).

“Under current rules a captive can effectively obtain certain exemptions for loan-backs of capital to the parent company but I do not believe these will be available under Solvency II. That will make a big difference to captive owners,” he concludes.