Captives: the view from Europe

Some people have argued that the hardening market represents an opportunity for captives because the rising cost of cover encourages insureds to look for alternative arrangements. Do you agree?

Captives in general are risk management tools to be wielded by their owners, which become increasingly useful in a hardening market environment.

Especially in times where premium requirements go beyond technical pricing, captives can be extremely useful. In certain cases where a significant retention is a precondition for the placement of an insurance programme, a captive can bridge this request in order to still provide coverage for small group entities which otherwise would be effectively uninsured.

Captives can also play a more important role with respect to coverage elements that are no longer supported by the commercial insurance market.

A downside in such market developments is rising fronting costs, especially for reinsurance captives.

Typically those costs rise with increasing premiums as they are defined as a percentage of those premiums. We also see more strict requests of fronting insurers to collateralise the exposure they are fronting.

Increasing fronting costs and, in respect of collateralisation, the additional administrative workload, might lead to increased requirements regarding the feasibility of establishing direct insurance captives.

This is something which under Solvency II has become far more important. Whereas in the past fronting often was provided without the request of adequate securitisation, it now has an important impact on the requested underlying capital of a fronting company.

That’s why there is hardly ever any exception in case of fronting requests. Another way of partially escaping such requests from fronting companies is to get a dedicated financial security rating, which several captives already have.

So yes, the current market represents an opportunity for captives, and even might lead to further captive developments, especially regarding a potential increased interest in creating direct insurance captives.

You mentioned Solvency II. What impact has this had on the captives industry?

Solvency II has had a positive impact on the insurance industry, generally. It encourages insurance companies to diversify the coverage they write by reducing the capitalisation requirement as diversification increases.

These rules also apply to captives, making it expensive for a captive to provide a single line of coverage to its owner, as it exposes the owner to more risk than a balanced portfolio of unrelated risks.

Its impact on the captive insurance community has also been huge, but not completely positive. It introduces many new things for captive managers to consider, especially around governance, making the process far more complex than it used to be.

The European Captive Insurance and Reinsurance Owners’ Association’s (ECIROA) position is that Solvency II includes provisions that are unnecessarily burdensome when applied to captives. Captives are less complex than commercial insurance carriers, but the rules currently make no distinction between them.

This does have an upside. When captives are talking to their fronting companies or to their reinsurers, the fact that the two groups are subject to the same regulations simplifies those discussions. It means commercial insurance partners should have less reason to be nervous about the implications of taking on the captive as a partner.

But the downside outweighs this slight advantage. Solvency II is about consumer protection, which is a noble regulatory goal. However, captives usually have only one client, and no business with private consumers. Therefore there is no consumer protection justification for including captives in all Solvency II provisions.

There are differences in the ways national regulators apply Solvency II provisions, with some being stricter than others. That is another pain-point for captives, which cannot afford the large compliance teams commercial insurers employ to manage these differences.

ECIROA would love to see greater standardisation of the application of Solvency II rules across Europe as part of a broader package that carved out exemptions for captives from rules that are irrelevant to them.

Again, ECIROA is not against Solvency II in principle. What it wants is a more proportional treatment for captives—rules that address regulatory concerns that are really relevant to captives. We are optimistic that some adjustments can be secured.

The principles underpinning the rules are fixed, but it should be possible to amend some of the details of how and when the rules apply, including exemptions to some of the provisions for captives.

The current consultation process that has been launched by the European Insurance and Occupational Pensions Authority is used by ECIROA to explain in detail the specificities of captives and to convince them to lighten the full application of Solvency II rules for captives, where it makes sense.

What is the outlook for the captive insurance sector in Europe?

This is very difficult to predict. If the level of insurance costs remains high, it could become attractive for industrial groups of a certain size to study whether to set up a captive.

As already said, it could also be of interest for groups already operating reinsurance captives to think about the establishment of a direct insurance captive.

From my point of view it makes no sense to be fixated on the number of captives in Europe as such. The quality of the captives and their underwriting is much more important than the pure quantity.

The industry’s primary goal should be to ensure that captives are recognised as important risk management tools, which is one way companies can stabilise their insurance costs over the long term.

The focus towards their owners only should be reconsidered by the regulatory bodies. In light of the principle of proportionality, captives don’t need to be as strictly regulated as general commercial insurance companies because the risk of insolvency affects only their parent company groups and not private policyholders.

ECIROA does not argue against the Solvency II regulation but still uses all opportunities to reduce the need of, for example, extensive reporting and other administrative and unnecessary burdens for captives.

In the US, states are increasingly competing with each other to attract captives to be set up. Could we see European countries doing the same thing?

The picture is different in Europe and there does not appear to be a sense of competition between countries to attract captives. This is partly because Europe’s captives industry is much smaller than in the US, meaning there is not enough business to make it worthwhile for regulators to compete for that business.

In Europe we have one common regulatory system with Solvency II, without any chance of arbitration between the European member countries.

If a company is thinking about launching a captive in Europe, how should it think about where to domicile?

The starting-off point, when making decisions concerning the launch of a new captive, should always be to consider what the captive is trying to achieve. There are different reasons why companies create captives, which will lead to informed decisions about how it is structured and where it is domiciled.

As mentioned above, the regulatory system is the same in all EU member countries; a parent company has to check other good reasons or priorities to find the appropriate domicile.

Some companies create captives to be a profit centre for the group. For others the principal concern is managing group-level risk. In any case, in my opinion it is indispensable to have a comprehensive and careful feasibility study carried out before a captive is founded.

Udo Kappes can be contacted at: udo.kappes@airbus.com