1 January 1970Analysis

Concerns, confusion and commercial carriers

Guenter Droese, chairman of the European Captive Insurance and Reinsurance Owners Association (ECIROA), is in a combative mood when discussing Solvency II. It is evidently an issue close to his heart: in his role as head of Europe’s leading captive association he is concerned about the treatment captives face under current Solvency II proposals outlined by the European Commission (EC) and the European Insurance and Occupational Pensions Authority (EIOPA). As Droese was at pains to make clear, captives appear—for the time being at least—to be being given a low priority in the Solvency II discussion process that is helping to shape the scope and interpretation of the regime.

“The Solvency II discussion process is meant to have been a democratic one, but it has so far proven to be far from that,” Droese said. “Instead the process has been very much focused on legal concerns and technicalities, with discussions dominated by those who can afford to invest time, money and manpower to voice to the EC their own particular concerns.”

Smaller and medium-sized players such as captives, mutuals and niche insurers are struggling to get their voice heard in the process, he said, and have had limited chances to discuss with the regulator their comments on the impending regime. Droese added that there was concern among those within the captive community that while they are being invited to comment, there was no certainty that theirviews were being given sufficient consideration. “It seems that there are some high-level people discussing Solvency II with the regulators, but the rest of the community—captives included—are not being given the same opportunities.”

There are concerns over Solvency II’s final make-up, and the possible application of differentiation and proportionality—key issues with a bearing on the captive sector. Will captives be treated in the same way as commercial carriers? Is differentiation a likely outcome from the ongoing discussions, and does EIOPA understand the specific demands of captives, are all questions that Droese and the wider captive community have raised.

“Our main target here at ECIROA is to get proportionality accepted within the Solvency II framework, which will help to differentiate captives from commercial carriers,” Droese said. “While the EC has accepted in principle that proportionality needs to be applied within the Solvency II framework, they are yet to define exactly what it means and how it will be applied.” Such uncertainty has left captives in a quandary as they consider the likely ramifications of the impending regulatory measures.

Droese said that although captives accept the need for Solvency II, there is concern regarding the level of sophistication being applied group-wide. He said that there was a hope that regulation would “allow deviation from the highest level of sophistication based on the nature, size and complexity” of the entity, and that Europe would not simply apply measures that are a fit for the “big 15 insurance companies in Europe” to all firms within the re/ insurance space. “The rules need to be more specified and tailored to the needs of the individual companies,” he said.

"It is important to recognise that captives are being regulated by competent authorities who understand their business, such as Bermuda and Luxembourg."

Not helping matters is the fact that EIOPA and its predecessor, the Commission of European Insurance and Occupational Pensions Supervisors (CEIOPS), have been tested by what has been, and remains, a mammoth task. With the resources the European regulators currently have at their disposal, “preparing the paperwork for what will become a complicated legal agreement must be very difficult”, Droese said, adding that the evolving re/insurance landscape and issues over linguistic interpretation were creating further complications. “They have an enormous task to understand the market in such a way that it can prepare and deliver a perfect directive.”

As it is, captives face a one-size-fits-all regime. How this will affect individual captives and domiciles remains to be seen, although Droese is bullish that in spite of the regulatory burden, captives will remain a significant part of the European re/insurance landscape. In spite of the regulatory headwind, Droese believes “the majority of captives will survive. It will instead be a matter of adjusting to Europe’s regulatory demands”. There will be higher costs involved in the first few years, he said, particularly when it comes to documentation, but much will depend upon the approach of the individual regulators in Europe and how they apply the Solvency II guidelines and help insurance companies overcome any hurdles.

Much will depend upon “the acceptance by the local regulator of what captives are providing them in terms of documentation and proof of compliance. We cannot yet say whether captives will be fairly treated under the Solvency II regime because we have yet to see how the local regulators will apply the rules. Final acceptance is important, but its application and the perception of proportionality may well differ from country to country”.

At the same time, EIOPA has included captives alongside commercial carriers in having to resolve a list of concerns that includes capitalposition, market risk, counterparty risk and portfolio risk. But as Droese made clear: “Captives can quite easily calculate their maximum exposures.” On capital adequacy, he said that many deploy letters of credit issued by the parent to strengthen their capital positions. “The question is whether this ability to issue letters of credit is taken into consideration in the capital adequacy calculations of Solvency II.”

At the same time, captive portfolios are far simpler than those of their commercial cousins. Captives can limit their risks and catastrophe exposures by arranging appropriate reinsurance policies. They are also structurally more flexible in their management of risk and capital and are able “when they renew their programmes at year’s end, to adjust their capital position so that the programme has sufficient capital for regulatory requirements”. They act as their parent companies expect them to and remain largely detached from the wider market. The trouble is, this reality is “not really reflected in the findings of the commission”.

EIOPA’s discussion process has also—as yet—failed to take into account pillar 3 requests on disclosure, Droese said, with suggestions that Solvency II will require levels of transparency that are not desirable within the captive space, both from a commercial and a data protection standpoint. He argued that the disclosure of claims and losses would probably be read only by claimants or competitors, and that although EIOPA has indicated that it understands the captive sector’s concern, “no-one is putting anything in writing”.

It is important to recognise that captives are being regulated by competent regulatory authorities who understand their business, such as Bermuda and Luxembourg, he explained. “The Bermuda regulator has been dealing with captives for 40 years. They understand how captives function, their needs and why they have, on occasion, failed.

“There is a link between regulatory control and market success,” Droese said, with oversight a necessary control on the market. The problem is that Europe’s current approach seems to be falling somewhat short of what is needed. As Droese made clear: “We need to introduce controls that are sophisticated, and that take into account the full intricacies of the market. Solvency II is the proper direction, it just needs to be risk-sensitive and take into account the needs of the captive sector.”