1 January 1970Analysis

A tempest in a teacup?

America’s captive insurance industry is watching from the sidelines as Europe wrangles with the implications of the impending Solvency II directive. Whilst the strengthened regime will bring with it evident risk management benefits for European re/insurers and those opting for equivalency, it is as yet unclear what impact it will have on the continent’s captive sector. Questions continue to remain unanswered as to how far the regime will take into account the specific nature of closely held captive entities, and fears persist that Solvency II will be excessively burdensome for the non-commercial sector. Proportionality may yet be applied to the emerging regulatory system, but few captive commentators seem convinced that such an approach is a panacea to the impact of a broad-ranging regulatory mechanism, and recent results from QIS5 don’t paint a promising picture. Problems evidently remain, and unless captives are dealt with separately and appropriately, the implications of Solvency II for the captive sector—in Europe and globally—will likely be significant.

While European captives are bracing themselves for greater regulatory demands—that might, or might not, run the full gamut of Solvency II—across the Atlantic, US captives are weighing up the possible repercussions of Europe’s new regulatory regime. In the shortterm, it seems likely that they will be limited—if felt at all—but looking forward, it remains unclear as to whether more prescriptive measures in Europe will translate into greater regulatory demands in the US. And speaking with a number of experts in the captive field, clarity of thinking as to the likely impact of European regulatory developments on the US captive industry remains some way off.

Will it rock the boat?

Asked how—and even if—the US will respond to Solvency II, opinion is divided between those convinced that the US will be obliged to react to the pressure of the new directive, and those that believe the US will plot its own course. Tomas Wittbjer, board member of CICA, is one of those of the opinion that the European directive will have an inevitable impact in the US. Talking with him, he indicated that whether the US liked it or not, facts on the ground would dictate further development of the US regulatory regime that would inevitably bring it in line with European standards. Captives needed to be aware of developments in Europe, he said, because before long, US captives could well find themselves complying with European standards that their domestic regulators feel obliged to conform to. And with Solvency II, a ‘quantum leap’ from Solvency I—a regulatory regime he described as “similar” to the present regulatory environment in the US—it would seem that, from Wittbjer’s perspective at least, US captives will need to prepare for significant change. Wittbjer cited the convergence of international accounting standards as a case in point, and it seems that there is some expectation that a similar coming together of international standards in insurance could be in the offing, with Solvency II the benchmark for future change.

Addressing the issue, Vasilis Katsipis, general manager at A.M. Best, Europe, said that although “current indications are that we are likely to have some high-level convergence of opinions between the EU and the US”, the US is likely to be afforded “transitional equivalence” under the new Solvency II regime, thereby limiting the impact of European developments. This would mean that USdomiciled companies “will continue to be regulated based on the US standards and not based on Solvency II”, Katsipis said, although one would imagine that the transitional nature of such an arrangement will mean that something more permanent—and perhaps more demanding on US regulators—could become a part of the regulatory landscape moving forward. The US’s state-based approach to regulation remains a “key stumbling block” to the US achieving “full regulatory equivalence” Katsipis said, although the European regime could “accelerate the creation” of a national regulatory body in the US. But even following the creation of such a body, Katsipis said that he would nevertheless “not expect it to change the way companies are regulated in the US”.

Talking with John Rehagen, captive program manager at the Missouri Department of Insurance, he made clear that US regulators are expecting no “immediate impact in the way captives are regulated in the US as a result of Solvency II”. Rehagen agreed that “there may be some limited changes to regulation in the future to address any accreditation concerns with achieving equivalency”, but he indicated that—from his perspective at least—Solvency II will remain largely an issue for the European insurance industry, not those in the US. Karin Landry, managing partner at Spring Consulting Group, was of a similar opinion, indicating that although Solvency II would create some impetus for change in the US, it was unlikely to be immediate, except in the case of global companies with European captives, but rather have a long-term impact, and that the major driver of regulatory development has been the aftermath of the recent economic meltdown, rather than developments across the Atlantic. “In the short term, the US,” she said, “will do its own thing.” Landry did however agree with Wittbjer that “increased scrutiny of the insurance sector” was in the offing, and said that this was more as a result of the financial crisis, than any impending measures in Europe.

It’s a European thing

Addressing potential changes to the regulatory environment in the US, it is evident that some uncertainties regarding the future shape of captive regulation nevertheless remain. Whilst commentators in the US made clear that an approach that recognises the unique nature of captive entities will be a feature of the captive landscape, greater regulatory demands following the financial crisis could potentially dictate otherwise. Despite such pressures, Rehagen indicated that “captive regulation in the US will continue to evolve to meet the everchanging needs of the industry”, with the various US state domiciles evidently keen that they approach their captive entities in a way that is appropriate to their individual needs and requirements.

Tempering this view however is the notion that despite the unique nature of captives, catch-all regulatory developments—should they materialise in Europe and generate similar moves in the US—could prove excessively punitive for the sector. As Landry and Wittbjer made clear, it is essential that appropriate differentiation remains a characteristic of both the US and international landscape. Regulators would be wrong to demand captive diversification across “20 lines,with 20 different investment managers”, Landry said, addressing the potential demands of Solvency II, and instead need to maintain an approach that recognises the unique nature of captives regardless of pressures to strengthen regulatory oversight and control. Wittbjer was confident that the European regulators would recognise the unique nature of captives, but recognition might not necessarily translate into appropriate regulatory measures, and there remains an undercurrent of uncertainty as to exactly how captive entities will be handled.

Competitive disadvantage

Should regulatory demands upon the captive sector in Europe grow, it would seem that there is an opportunity for those in the US to take advantage of the new, more proscriptive environment across the Atlantic. Captives are by their nature lean, pared-down insurance vehicles, and any tightening of regulatory demands could well see captives reconsidering their captive domicile. Indicative of the potential threat posed by Solvency II to the captive industry is the number of leading domiciles that have opted out of Solvency II and equivalency. Those that have stayed away have made clear that they are taking a wait-and-see attitude to the new measures, but it would seem their stance is in part motivated by the uncertainty surrounding exactly how Solvency II will impact their captive sectors.

Guernsey, with its thriving captive sector, is one of those domiciles that chose to opt out of Solvency II, and talking with Martin Le Pelley, chairman of the Guernsey International Insurance Association, it is evident that its decision was in a large part motivated by the potentially punitive impact of European regulation on its insurance industry. With captive entities forming the vast majority of insurers on the island, and the “risk profile of captives quite different from those of traditional commercial insurers”, Le Pelley indicated that Europe’s “one size fits all” formula was inappropriate for the island’s sizable captive sector. Opting instead to continue with its own stringent, international regulatory standards, Le Pelley indicated that Guernsey’s captive sector is hoping to benefit from the burdensome regulatory framework in Europe and attract new business to Guernsey’s shores.

And the latest findings from QIS5 appear to justify concerns that Solvency II will be excessively punitive on captives, with a report from Fitch entitled QIS5: Insurers Capital Solid finding that “small niche insurers typically face more of a threat from Solvency II” than their larger counterparts, due to higher capital requirements and their inability to use internal models to measure their capital position. Captives appear likely to be caught in the net of such demands.

As Wittbjer made clear, “the cost of doing business has already increased under Solvency II, and if you are running a small insurance company like a captive, any relief from burdensome regulation is attractive from a competitive point of view”. Such concerns are already being factored into the calculations of those opting out of Solvency II, he said, and one would imagine that excessive demands upon European captives might encourage them—where appropriate—to consider US domiciles as an alternative.

Addressing the potential advantage of being outside of a tough Solvency II framework, Rehagen indicated that the flexibility of existing US regulatory measures could put US captives at an advantage when compared to their European cousins. “Most US captive domiciles have regulation that provides certain minimum requirements, but allows for flexibility based on the size and complexity of the captive programme.” Solvency II may well not include such give in its requirements. And as Rehagen made clear, “if Solvency II compliance does not provide a benefit to offset the cost, there may be some captives that choose to move from that domicile”. Landry was of a similar opinion, and suggested that a tough regime in Europe “might encourage global companies to reconsider their captive strategy”. If regulation in Europe becomes too onerous, she said, captives may well “decide to set up a US captive because there is more flexible regulatory oversight”. The US and its captive industry might potentially be the main beneficiaries of any heavy-handedness on the part of the European regulators, but treatment of captives remains murky. As Wittbjer put it when addressing whether a tougher European regulation would be a benefit to the industry in the US: “The jury’s still out.”

Safe hands

What does seem likely however is that co-operation between European companies and non-compliant captives will be complicated by the new directive, with those companies operating within the Solvency II framework obliged to treat captives in compliant and non-compliant domiciles differently. Wittbjer indicated that those captives within the framework will be “regarded as being sound re/insurance partners”, whilst for those outside, greater regulatory demands are more likely. Wittbjer said that for domiciles outsideSolvency II, the question will inevitably be: “How will the local [European] regulator look upon that insurance asset? Will it be regarded as a safe pair of hands?”

Being outside the European regulatory framework, such questions have obvious implications for the US. Should its regulatory environment be regarded as less stringent than Europe, then there could well be an impact on the pricing of business ceded by European business to non-compliant captives. As Wittbjer indicated, “it could well be more costly to cede business to a non-EU company than an EU one”. Such a situation would mean that although the cost of compliance could well be burdensome, those within the Solvency II framework will likely want to cede business to compliant insurance entities, rather than face greater regulatory demands on their international business. This could “cause distortions in relationships”, Wittbjer said, with the European parents of US captives potentially punished by European regulators. “Those that are within the Solvency II framework might have issues with, and place higher premium on placing premiums with, non-Solvency II equivalent captives,” he said. It would seem that despite the advantages of being outside a tougher regime, the situation for US captives with business ceded from Europe will nevertheless be complicated.

"Regulators need to maintain an approach that recognises the unique nature of captives regardless of pressures to strenghten regualtory oversight and control."

Addressing the ratings implications of such developments, Katsipis stated that “failing to ensure regulatory equivalence between the US and EU will affect companies domiciled on either side of the Atlantic. It will result in companies having to revise the profitability of their operations (given the likely increase in regulatory capital) and, in some cases, re-examine the viability of these operations.” This might or might not play into the hands of US captives, but changing circumstances will likely encourage some captive owners to re-examine the location and viability of their captive business, with obvious implications for the sector. As Katsipis indicated: “The impact on ratings is likely to be mostly driven by changes in strategy and profitability”, with the ripples from Solvency II set to impact parts, if not all, of the captive sector in the US.

Rehagen, for his part, gave a US regulator’s perspective, stating that there are “some international insurers with captives in Missouri that will be affected” by Solvency II, but saying that insurance regulators in the US would work with their captive partners to “incorporate international standards when appropriate”. With US captives predominantly representing American business, such concerns might not be as big a headache as would first seem, but it will nevertheless create some complications as the global industry moves towards greater international consensus on insurance regulation.

Muddling on

Addressing Solvency II versus the current US regulatory system, Landry indicated that “there is not one perfect way to regulate insurance companies”. Instead it seems that the US, Europe and the rest of the world will have to muddle their way towards a strengthened regulatory environment, which might or not might take into account the particular needs of the captive industry. While they do, US captives—particularly those with premium ceded from within the Solvency II area—can expect further, if not dramatic, regulatory strengthening, some of it emanating from Europe, but far more of it likely reflecting the specific concerns and developments of the US regulatory environment.