The global captive regulatory landscape continues to evolve—and dynamically. Here, Jonathan Groves explores its likely direction and implications.
Insurance and reinsurance companies are operating in an increasingly complex regulatory environment. Similarly, purchasers of insurance are finding themselves in the position of responding to increasingly complex regulations. Regulatory change is being proposed, consulted on, passed into legislation or implemented on an ever more frequent basis. In this article, we will provide some additional insight into the effect of this changing regulation on captive reinsurers.
Regulation of insurers
The pace of regulation is increasing in both more and less mature insurance markets.
In Europe, the upcoming implementation of Solvency II represents the most significant change to insurance regulation in 25 years. It signifies a fundamental change to the operation, administration and regulation of insurers. Solvency II covers both professional and captive insurers. With captives being generally less diverse and maintaining a smaller capital base, the additional capital, extra governance and increased transparency requirements of Solvency II have the potential to affect captives more markedly than other parts of the industry.
Through equivalence—the adoption of similar legislation by different jurisdictions—Solvency II also has the potential to have an impact on insurance companies outside of Europe. For European insurers, purchasing reinsurance from reinsurers in non-equivalent countries will potentially lower the capital relief they receive from such reinsurance.
Argentina, for example, is currently implementing a regulatory change that requires insurers to repatriate their assets. Upon completion, Argentine insurers will be prevented from directly accessing overseas funds. While this directly impacts on international insurers and how they manage their investments, it also clearly affects captive owners as it is much harder for reinsurance premium for risks located in Argentina to be ceded to a captive.
After relaxing its reinsurance regulations a number of years ago, the Brazilian insurance regulator, the Superintendência de Seguros Privados (SUSEP), recently announced that it will again restrict the amount of risk that can be reinsured to entities outside of Brazil. After sustained lobbying from organisations such as the Federation of European Risk Manager Associations (FERMA), SUSEP moderated its approach, and requires only 40 percent of any reinsurance to be placed locally. Negotiation on an individual basis is currently the best method to manage the process—in a recent example there was an agreement to cede more than 99 percent of the premium.
In Russia, two recent changes to legislation have further reduced the potential for premium to reach a captive. These are the creation of a liability pool for casualty risks which are deemed ‘hazardous’ (this can be interpreted to include a premises operating a lift or escalator) and a potential limitation placed on reinsuring 100 percent cessions overseas.
Equally, with effect from February 1, 2012, Kazakhstan will effectively increase the retention of risk within a local insurance company. With energy being a major industry sector within the country, energy company captives will see a potential reduction in premium reaching the captive (although admittedly less risk will reach it as well).
An incidental impact
There are also peripheral changes that impact insurance placements in countries such as Ecuador. Although not in force yet, it is expected that a 5 percent tax will be imposed on funds remitted to entities outside the country. This measure does not impact just on insurance transactions, it also creates a cost for captive reinsurance programmes. Similar taxes apply in other countries, each eroding the premium that can be remitted to a captive under a reinsurance contract.
The continuation of non-admitted issues
The challenge to programmes involving non-admitted coverage also continues to grow. This applies equally whether it is a primary non-admitted coverage such as on a directors and officers policy, or an excess basis such as for a master policy providing difference in conditions or difference in limits. In countries where non-admitted contracts are permitted, for example, paying the applicable insurance premium tax to the local tax authority can prove problematic for a captive writing such cover on a direct basis. This can often arise due to simple administrative difficulties as opposed to any specific business reason.
Moving towards a compliant insurance programme can also present challenges. In instances where the insurance premium tax has not been paid for prior years, concern can arise over how this is best managed. The issue of remitting premium taxes has become more focused following the Kvaerner case. Although it was settled 10 years ago, in the Kvaerner case, the European Court of Justice found on behalf of the Dutch tax authorities that premium tax for Dutch risks had to be paid in the Netherlands, irrespective of the fact that the contract was placed in the UK.
The European Union, under its Freedom of Services regime, was among the first trade blocs to review this issue. The 2nd Non-Life Directive clarified the location of the taxable insurance cover, determining that it should be based on where the risk was located. This meant that premiums for global programmes had to be allocated by country in order that the appropriate insurance premium tax could be applied.
In countries where non-admitted insurance is not permissible, both insurance regulators and tax authorities are taking far more interest. This has been evident in countries such as Canada. Legislation such as the Mutual Assistance Directive in the EU also makes it much easier and quicker for tax authorities to gain and exchange information in order to identify non-compliant companies.
The impact of Solvency II is a significant concern for EU captive owners, as well as captive owners in jurisdictions that are seeking equivalence. Solvency II will change the way captives operate and, for a reasonable proportion, it may render the captive economically inefficient.
"The convergence of terms used by different captive domiciles can be confusing-- the own risk and solvency assessment (orsa) in Guernsey, for example, should not be confused with the orsa under solvency II."
However, some jurisdictions are taking a different line. The Bermuda Monetary Authority, for example, continues to pick its way through the equivalence process in the hope of not subjecting its captive owners to the full effect of Solvency II. Other domiciles are also making changes. Switzerland has enhanced the application of its legislation to captives, and codes of conduct are becoming increasingly popular. However, the convergence of terms used by different captive domiciles can be confusing—the Own Risk and Solvency Assessment (ORSA) in Guernsey, for example, should not be confused with the ORSA under Solvency II.
Managing the challenge
It is worth recognising that change may not necessarily be bad. Regulatory challenges in a global market are common and there is now a much wider awareness of the issues associated with arranging insurance contracts in multiple countries and the operation of a captive. This increased awareness has highlighted the value of dialogue and global partners in addressing these issues. This has ensured that optimum structures can still be arranged and the value of a global insurance programme and captive, in tandem, can still be recognised. That said, managing expectation internally, through the annual renewal process, is key.
So, how can this best be achieved and what action should individual insureds and captives be taking?
• Approaching a renewal as it expires is not likely to result in the early identification of changes that have occurred since last renewal. Look afresh at regulatory matters as if this were the first time placing the structure, to ensure that nothing is missed.
• A thorough investigation with your current broker and insurer as to what is their understanding of your position and specific circumstances should identify areas of focus. Where differences arise, part of this will be interpretation as well as personal experience.
• Consider the viability of the captive if the level of insurance premium reaching it is decreasing significantly. This can have a particular bearing on the equalisation reserve provision in a Luxembourg captive—an issue where we recently helped an insured to identify methods of restructuring. It is much better to do this before your chief financial officer asks the question.
• Manage expectations internally—last minute change, even when well intended, can lead to issues over demonstrating effective management, not to mention cost implications.
• Partner with insurers that have extensive experience on the ground in the countries where you operate. Owning the network creates a more effective embedding of the knowledge and the ability to keep up to date with the intricacies of legislation as it changes.
• Make certain your broker and insurer both understand captives. This understanding needs to be more than knowing what a captive is. Your broker and insurer should understand the mechanics of what drives its use and when are the appropriate and inappropriate times to use a captive. Crafting a solution together will ultimately prove more effective than simply buying a product.
• Liaise with your captive regulator. This is not something that can be delegated to a third party as, ultimately, it is your company. Equally, by engaging with your regulator, you can increase their understanding of your issues which can be an important aspect of managing a company within a risk-based environment.
With regulation having an impact on captives both directly and indirectly, keeping up to date with ongoing changes is vital. As a financial tool that has been tested in multiple arenas, including the most recent financial crisis, captives continue to demonstrate value as part of a global insurance programme. Staying nimble will ensure that this continues to be the case while opening up opportunities as markets change and harden.
Jonathan Groves is head of Chartis’s Continental European risk management group. He can be contacted at: firstname.lastname@example.org
EMEA, Chartis, regulation, FERMA, Solvency II