1 January 1970

Captives poised for regulatory obstacles

Captive insurers are facing a number of actuarial challenges as a result of impending legislation. This does not just mean Solvency II in the case of European captives. Changes are also afoot in the wider accounting treatment of insurers’ reserves. In fact, over the next five years, captive insurers’ paths will be littered with regulatory obstacles.

None is bigger than the Solvency II Directive, due to come into force in 30 European countries in 2012.

In April 2009, the European Parliament and the European Council of Finance Ministers ratified the final wording of the Directive. This set the clock ticking on a whole raft of implementation measures to be discussed and agreed before it takes effect.

The Directive, which will introduce principles-based (rather than rules-based) regulation across Europe, is divided into three pillars. In July, the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS), the body charged by the European Union with implementing Solvency II, released no less than 23 consultation papers, weighing in at more than 1,100 pages in total, on various aspects of the Level Two (implementation) measures. That consultation period closed on September 11. Yet, there is plenty more to come, with a further round of consultations at Levels Two and Three expected to be released in late October or November.

Despite the continuing efforts of organisations such as the recently formed European Captive Insurance and Reinsurance Owners Association (ECIROA) to control the impact on captive insurers, particularly in the area of accepted actuarial simplifications, there is a plain truth. You cannot ignore Solvency II or think it does not apply to you, because it is clear that it will affect all captives, with the exception of those with a premium income of less than €5.0 million.

Even then, there may be grey areas due to exchange rate fluctuations. For example, a captive with a premium income of £4.5 million may have Solvency II applying to it one year but not the next.

"It is not fair that a captive should treated in exactly the same way as a multinational personal lines insurer under solvency II."

At its heart, Solvency II is about policyholder protection—which seems like a good thing for the reputation of the industry. Yet, many within the captive market have argued, understandably, that caveat emptor style, parent companies establish captives with their eyes open to the risks and therefore do not need the same level of protection. This is a strong argument where there are no payments to third parties, but considerably weaker when other parties are involved.

Solvency II challenges

So what does Solvency II mean for those captive insurers to which it applies? From an actuarial perspective, it will entail changes to the way insurers present their balance sheets, but more particularly, it will involve greater transparency in the way numbers are derived and presented as part of technical provisions. It will also require a formal and effective riskmanagement function to identify and then either mitigate or capitalise on the risks faced.

Clearly, however, it is not fair that a captive should be treated in exactly the same way as a multinational personal lines insurer, which is exposed to a large and diverse range of risks. This is why the so-called ‘proportionality principle’ is so important to captives. The principle affirms that the methods employed and the resources required to comply with Solvency II should be appropriate to the size of the organisation.

But this is not a ‘get out of jail free card’ for affected companies or groups. In fact, Solvency II should not necessarily be seen as only a burden on the companies to which it applies. It incorporates many elements of best practice that will help any insurance business, regardless of size, improve the way it is run.

Choice of route

One of the fundamental choices for companies that have to submit their Solvency Capital Requirements (SCR) under Solvency II to their regulator is whether to use the prescribed standard formula approach or to create an internal model.

For a small captive, it may seem to make sense to opt for the simpler standard formula. However, if you think the risk within your captive is below the industry average, there will be no way to reflect that using the standard formula. This means that you will probably need to hold more capital than you think is justified.

The acid test is to run your scheme through QIS4, the most recent quantitative impact study organised by CEIOPS. (Bear in mind that although it has been described as the ‘simpler’ standard formula, the QIS4 spreadsheets involve filling in up to 10,000 cells.) This will give you an indication of where you stand against your expectation. For those not yet ready, QIS5 will take place in the second half of 2010, based on the feedback received from QIS4.

Much as the idea of an internal model might seem unnecessarily burdensome for many captives, there are some sound reasons to not dismiss this option too quickly.

Simple models, of the type required by most captives, are relatively quick and easy to build and only require recalibration periodically. The model ensures that your SCR reflects the true nature of your portfolio. And irrespective of whether a captive decides to formally submit its solvency capital using a model, there are likely to be wider benefits. The model will aid decision-making in areas such as asset allocation and reinsurance purchase.

An internal model can also help with one of the more daunting aspects of Solvency II—the requirements for documentation and corporate governance. The model option gives you a considerable head start in this respect over the standard formula.

The resources required to run these exercises are clearly an issue for captives, a key point already raised by ECIROA, since Solvency IIstipulates that insurers must have appropriate actuarial, risk and corporate governance functions. however, the directive does allow for these functions to be outsourced.

Accounting standards

Beyond Solvency II, proposed changes to accounting standards for insurance reserves, and the actuarial implications of these, are also on their way. the timing is less clear here, although the scheduled implementation is 2013. the main thing to remember is that the changes apply across the globe, not just in Europe, to any size of insurance entity and to contracts that have the ‘look and feel’ of insurance contracts, even if they are not written by regulated insurers.

Like Solvency II, the impact of the changes will fundamentally affect the look of insurance companies’ balance sheets. the principal change is that organisations will have to hold reserves to take into account risk margins and the time value of money.

In essence, legislators are adopting the enterprise risk management approach of bringing reserves more into line with the risks inherent in the portfolio. What is certain is that the current practice of assessing liabilities, estimating reinsurance recoveries and inserting the net result into the accounts will go. In its place, insurers, or their actuaries, will be expected to generate explicit estimates of discounted future cash flows for liabilities with an appropriate risk margin to refl ect uncertainty.

This will mean some fairly significant changes to the way insurers go about their reserving and it would be inadvisable to try and sort these too close to the changeover. there could be some nasty surprises in store if businesses don’t understand what it means for the amount of capital they need to allocate for reserves.

Rather like Solvency II, however, the changes shouldn’t necessarily be regarded as simply a threat or inconvenience. Many companies miss out on the opportunity to extract more value out of reserving by failing to align technical reserves with the business they write. With the enforced changes that lie ahead, now is a perfect time to remedy that. furthermore, the current accounting treatment of reserves does companies a disservice, since it gives no concept of when liabilities will have to be paid and creates uncertainties about the true cash flows.

Over the next five years, it is inevitable that actuarial costs for captives will rise, particularly for those large enough to fall within the umbrella of Solvency II.

the need for compliance with the relevant new legislation is a given. Whether captives choose to do so in a way that potentially improves their management and performance in the longer term is a choice they need to make for themselves.

Karl Murphy is a partner within the international actuarial and business consultancy, EMB. He can be contacted at: karl.murphy@emb.com