A period of adjustment for all
When Solvency II finally came into effect at the start of 2016, the market watched with interest to see what effect it might have on the risk transfer landscape.
After so many years of waiting and anticipation, which also allowed re/insurers the time to prepare and adjust ahead of the new directive, a strong argument could be made that the change to the industry should be minimal, and that companies should have made necessary adjustments in advance.
While this was true in some sectors, in others dramatic changes have been seen. In the run-off sector, for example, the number and size of deals have increased exponentially since Solvency II came into force.
The logic seems to be that many larger insurers had drawn up strategic plans in this regard but waited until the directive was in force before fine-tuning them against live capital models and then finally implementing them.
In the captives space, there are several challenges and dilemmas that remain unresolved as things stand.
A number of experts forecast an increase in the number of captives requiring a rating in the aftermath of Solvency II. One of these is Fitch Ratings, as Donald Thorpe, senior director insurance, Fitch Ratings, explains.
"If Solvency II is not applied by regulators on a consistent basis we will end up with domiciles split between those who are ‘captive-friendly’ and those who are not." Peter Mullen, Aon
“When Solvency II was adopted, Fitch anticipated there would be a greater demand for ratings by captives assuming premium from fronting insurers who were subject to Solvency II. Our expectation was based on the capital charges imposed by Solvency II on unrated reinsurance recoverables,” Thorpe says.
However, by the second half of 2016, this prediction had not yet materialised—although he added that is not to say it will not happen at all.
“While Fitch’s view has not necessarily changed, we have not yet seen the increased demand for ratings we expected. It’s difficult to say why this happened. It may be captives are satisfying the capital requirements in other ways (eg, by posting collateral against the recoverable) or it may be that their focus has been on more pressing aspects of the Solvency II implementation,” he says.
He adds that it is too soon to tell how Solvency II may reshape the captives sector in the long term; he believes there will be a period of time during which the industry continues to adjust to the new requirements.
“Eventually, we think the industry will determine the best way to comply with the new requirements. However, Fitch believes there will be a period of time where the industry explores various solutions to determine which work best,” he says.
Horses for courses
Another big question for the industry has been how different captive domiciles adjust to the new regime, as it is largely up to individual jurisdictions as to how they interpret and achieve equivalence if they seek this, and how it then applies to the captives sector.
Bermuda, for example, has been praised for its approach to Solvency II, achieving, as it has, a two-tier approach. It has achieved equivalence with Solvency II for the purposes of its larger, commercial insurers and reinsurers, but its captives are exempt, allowing them to be subject to a much lighter regulatory touch.
Peter Mullen, chief executive of captive and insurance management operations at Aon Corporation, says that while he believes that most captives have already reconciled the impact of Solvency II—many achieving this several years before it fully came into effect—question marks remain over the way some regulators will deal with the regulations in the longer term.
“The impact of Solvency II on clients happened a few years ago for the most part,” Mullen says. “Any client who knew they would no longer see value from their captive in a Solvency II environment has closed down.
“This year the biggest impact of Solvency II was on the managers whose role it is to take away as much of the stress from regulation as possible so the client’s captive can continue to deliver value to the parent. Any manager who has not been tooling up for this in the last few years will be struggling to keep pace.”
Malcolm Cutts-Watson, managing director of Cutts-Watson Consulting and a specialist in captives, agrees. He adds that the regulation has forced individuals to get a better handle on the risks their captives are taking on.
“It has forced management and boards of EU captives to understand, and then comply with, the three pillars of Solvency II. The positive benefits of better understanding and controlling all risks of the captive have been offset by cost and complexity of disproportionately heavy regulation of these low risk vehicles.
“The implementation date of January 1, 2016 was a damp squib; all the hard work was completed in final quarter of 2015,” he says.
Mullen adds that domiciles that get it right on the regulation front will become increasingly important as domiciles for captives. “For example, the main reason for Guernsey’s success—and this applies to other successful domiciles—is regulation that is appropriate and proportionate, coupled with strong support from the local government,” he notes.
He believes that not all jurisdictions will adopt the correct approach. “My concern is the proportionate application of Solvency II to captives in Europe. This is something we have lobbied for for many years and if Solvency II is not applied by regulators on a consistent basis we will end up with domiciles split between those who are ‘captive-friendly’ and those who are not,” he says.
The challenges are not unique to Europe and Mullen notes that even in countries that do not fall under the remit of Solvency II, this could become an issue. In the US, for example, he believes that there is so much competition between onshore states for captives business, there is a danger that smaller, under-resourced regulators will overreach themselves.
“In the US, I’m concerned there are too many domiciles and the tax base generated by captives who domicile there will not be enough to support a strong captive regulator,” he says.
“Captives are becoming more complex and the major domiciles work hard to keep their regulatory framework current so I worry about the newer domiciles keeping up. Outside of insurance regulation, new exposures are often incubated in captives—a good example of this would be cyber risk, and regulators need to keep pace with a fast-changing risk landscape.”
Coming back to Europe, Cutts-Watson agrees that the way different domiciles adjust will be watched with keen interest. But he adds that some of the changes predicted have not yet transpired.
“Predictions of mass closures or redomiciling of captives into or out of the EU have proved so far to be false—as we expected. Will offshore domiciles look to achieve SII equivalence? We don’t think so, but we admire Bermuda’s creative solution of a bifurcated regulatory regime.
“Our view hasn’t changed since the Solvency II discussion began. It has meant a massive change but the captive industry digested this in the same way as it has managed other regulatory changes: slowly and one bite at a time!”
Nevertheless, Cutts-Watson believes captives have a bright future both inside and outside Europe.
“The future for the captives industry looks bright as long as we can attract the right talent to the business. Captives are becoming more complex and the risks which our clients are exposed to are also more complex, interconnected and fast-moving,” he says.
“Our challenge is to respond to this client need by delivering measurable value. The captives industry has a great reputation for innovation and we need to work hard to keep this reputation intact. This includes all players in the space, including the regulators.”
Cutts-Watson says that in many ways, adjustments to Solvency II are only just starting.
“Solvency II is by no means ‘done and dusted’ for those boards and managers of captives and small insurers within the EU, which are mainly located Dublin, Gibraltar and Malta. Now the real work begins to backfill the necessary processes, procedures and controls required,” he says.
“One captive manager told us, he thought it would take another year to fully integrate the changes. Captive boards should satisfy themselves this is happening.”