Steady course through stormy regulatory seas

Virtually every area of the financial services industry has been embroiled in the economic downturn. However, the captive market has held up remarkably well despite all the challenges. While many once great financial institutions have collapsed, or turned to various governments for aid, the captive industry has generally managed to avoid bad publicity.

The number of new captives has slowed however. Companies’ desire to set up their own insurance vehicles has understandably waned in the past couple of years as businesses have been more focused on simply surviving the economic storm. Formations have therefore been sluggish during the recession, but as the dark clouds start to lift, captives should be well placed to experience growth.

Of course, there has been an impact from the credit crisis on the captive market. For instance, parent companies have been expressing greater interest in the nature of their captives’ investments in the wake of the economic downturn. The credit crisis has also resulted in companies tapping their captives as a potential source of cash. As it is becoming increasingly challenging to raise money in the market, cash-constrained companies looking for alternative access to funds may be tempted to explore this route to release capital.

Captives may also find their resources stretched by fronting companies. Fronting insurers have been increasing their fees in 2009 or asking for higher letters of credit (LO Cs) and collateral. Banks are similarly demanding higher rates for providing LO Cs, particularly if an unsecured level of credit is being used.

This increasing desire for certainty and the need to unlock capital could result in companies looking to pass on their entire captive, or part of it, to a third party.

A number of insurance run-off specialists are consequently establishing themselves in the captive takeover space. The captive buyout market is bubbling just under the surface, but this is set to escalate and could eventually attract the interest of private equity investors and venture capitalists.

Changing regulatory landscape

There are plenty of other challenges ahead for the industry. Solvency II is unquestionably the biggest hurdle in the medium to long term for European captives, and although the new Directive does not come into force until October 31, 2012, it is already causing a stir within the captive community.

There is much uncertainty about how the new Directive will ultimately play out. Captives will be judged under a ‘proportionality principle’, reflecting the fact that they are less risky than conventional insurance companies. But there are as yet no firm details on exactly how they will be treated.

Some industry members consider the regulatory and compliance burdens on captives to be disproportionately large, especially in light of the fact that the risks covered by most self-insured vehicles are usually more straightforward than those covered by an insurance company. While the general feeling is that the regulatory regime needs updating, parent companies may decide to shut down their captives as a result of Solvency II.

Solvency II is also changing the landscape of the captive community outside the European Union (EU). Parent companies that want to keep their captives but avoid higher capital requirements and greater regulatory compliance may look to set up their captives elsewhere. The growing financial and administrative burdens of compliance will drive some captives out of the EU, possibly to domiciles such as the Isle of Man and Guernsey, which are exempt from EU directives.

While Solvency II applies to just Europe, it will have profound implications for the regulation of other captive domiciles around the world. It has raised the bar and could become the global benchmark. This means that other domiciles around the world may have no choice but to follow suit and implement more stringent regulatory requirements.

If they do not make standards more stringent, captives in non- EU domiciles may be perceived to be less well regulated. To avoid being perceived as ‘second-class domiciles’, other jurisdictions are already making changes. For example, Guernsey is creating its ‘Own Solvency Capital Assessment’ and the Bermuda Monetary Authority is modernising its regulatory structure.

Premium increases are not as high as many industry figures had initially predicted, partly as a result of the reduced demand for insurance during the recession as companies cut costs. There also is too much insurance capacity in the market. Yet despite the variety of challenges, the captive market is well positioned to prosper in the year ahead.

There are signs of a pick-up in captive formation as certain lines of business are seeing a jump in premiums, leading companies to seek alternative insurance arrangements. Many of these companies had looked at creating captives in the past and are now revisiting those plans.

European regulators and captive managers are seeing an increase in enquiries across the board, but certain lines of business are attracting the most attention. These are notably liability risks, such as professional indemnity for the financial services industry, which have been subject to a harder market.

Emerging market growth

There also has been an interest in captive formation from emerging markets. Companies based in Latin America and the Middle East, which have previously formed few captives, are now looking at alternative risk models in Europe. A.M. Best expects other less developed markets, such as Africa, to also look at establishing captives, particularly in Europe.

It is still early days, but there appears to be a shift in risk management in developing regions, which could be being driven by increasingly sophisticated knowledge and better advice from insurance brokers.

The insurance industry also is adapting its models to cater to the demand from new customers through the development of takaful (Sharia-compliant) captive structures, for example.

"The captive buyout market is bubbling just under the surface, but this is set to escalate."

The interest in captive formation is now so globally widespread that the Middle East region—notably Dubai, Qatar and Bahrain—is also attempting to build a captive presence. However, growth is unlikely to be as explosive in these newer domiciles as in the more established markets, such as Luxembourg, Guernsey, the Isle of Man, Dublin and Malta. These will continue to be the main captive domiciles as they have more experience and an existing infrastructure.

Growth in the captive market is likely to be fuelled largely by the formation of protected cell companies (PCCs) rather than through the creation of pure captives. There are numerous reasons for this. PCCs are much easier and cheaper to set up than pure captives and require less time from management to run. They provide greater flexibility to the parent company but deliver the same type of benefits as a wholly owned captive.

It is not surprising that there has been a slight degree of caution attached to cells in recent years, considering that they are a relatively new arm to the captive market. A small question mark has hovered over whether PCC regulation would stand up.

To date, there has not been any major test of whether each cell owner is completely ring-fenced. Nevertheless, there is a good level of confidence in this structure, and an estimated 40 domiciles now play host to cells.

While there has been an increase in queries about the formation of captives or cells as a risk-financing alternative for companies, it remains to be seen whether these will translate into an actual rise in the numbers being set up.

Yet despite all the uncertainty, the captive market will continue to develop because of the inherent advantages of self-insuring. The industry is in good health, and as economic conditions improve, the captive community should thrive.

Yvette Essen is head of market analysis at A.M. Best. She can be contacted at: yvette.essen@ambest.com