1 January 1970Bermuda analysis

Striking the right balance with Solvency II equivalence

Bermuda’s decision to enter into Solvency II equivalence was an obvious choice for the Island’s sizable commercial re/insurance sector as it seeks to maintain its market-leading competitive edge, but its implications for Bermuda-based captives still have the potential to upset the apple cart. Much has been spoken about the impact that a potentially proscriptive regulatory regime would have on those captive sectors facing the full weight of Europe’s regulatory regime, with concern expressed that Solvency II’s full requirements would be inappropriate to the specific nature of captives. Some commentators worried aloud that Bermuda’s decision to enter equivalence might not have been the appropriate move for its sizable captive sector, but not so, says Richard Lightowler, a partner at KPMG in Bermuda, who indicated that although some additional burden was likely to be felt by the Island’s captives, the decision to enter into equivalence was nevertheless the right one. As Lightowler made clear, “there is a significant debate going on surrounding captives—certainly within Europe—as to whether the full weight of Solvency II is appropriate for captives”, but he said he was confident that the Bermuda Monetary Authority (BMA) would get the balance right when it came to applying its version of equivalence. One of Bermuda’s “major success factors has been in having the right regulation for the captive environment”, Lightowler said, indicating that after 40 years of captive experience, he believed that ultimately the decision to opt for equivalency would prove to be the right one for the Island.

And Steve Chirico, assistant vice president at A.M. Best in the US, was of a similar opinion, indicating that although there would be some implications for the Island’s captive sector, the general feeling was that the decision to enter Solvency II was the right one for a jurisdiction that has prided itself on being ahead of the regulatory curve. “As a domicile, you have to manage a position between being businessfriendly and having all the controls and oversight that mean your regulatory regime is viewed with confidence by the outside world,” Chirico said. Solvency II certainly offers the prospect of instilling confidence, and if it does become a global regulatory standard—which seems increasingly likely—then being ‘business-friendly’ may well entail the inclusion of European regulatory measures. Chirico indicated that with Europe moving towards Solvency II, he “fully expects” other global domiciles to have to “prepare some sort of response”. Bermuda, for its part, has “chosen a full response...that elevates the status of the domicile”, setting it apart from those outside the framework.

Exerting a gravitational pull

It would seem that positive differentiation is one of the key benefits that Bermuda captives will be able to draw upon from within the Solvency II framework. As Lightowler indicated, “high-quality companies look to high-quality jurisdictions”, and within Solvency II, Bermuda will find itself on the “right side of all the [right] lists”. In so doing, the Island can continue to attract those leading firms in corporate America, corporate Europe and, increasingly, corporate Asia that seek out, and seek to maintain their presence, in captive domiciles with an impeccable reputation. Chirico likewise highlighted the importance of reputation, stating that “any major global corporation is going to gravitate towards a domicile that is viewed as one of the best, or the best globally”. Bermuda fits just such a billing and its efforts to achieve equivalence will only strengthen its position as a domicile of choice for global corporates.

Meanwhile, the demands of what Chirico called “transparency and a belt and suspenders approach to compliance”—which received further impetus following the introduction of Sarbanes-Oxley—have led the board members of captive parents to knowingly seek out domiciles that are “compliance-oriented” and that conform to, and excel in their approach to, global standards. With members of the board signing their names to financial statements to certify that they are “factual and legitimate”, it is domiciles with “credibility” that will be looked to as the obvious destination for captive insurance entities, with those perceived to have a laissez-faire attitude to regulation passed over as unnecessarily risky.

Global momentum

Even without the evident advantages afforded Bermuda by being an exemplary regulatory domicile, it seems likely that Solvency II will create impetus for greater regulatory change internationally. As Lightowler indicated, the International Association of Insurance Supervisors (IAIS) is already preparing its responses to Solvency II, and its Statement of Principles—due to be published in October—is likely to be heavily influenced by European developments. “Expect much the same flavour of language and tone coming from the IAIS,” Lightowler said, making it clear that such international responses would “put significant pressure on other jurisdictions to play ball”. Those that choose not to will inevitably find themselves in what will become a second tier of global domiciles, he said. And whilst there may be some advantages to offering captive parents less strenuous regulation and oversight, it seems likely that few truly global corporates would opt for such a solution.

"As a domicile, you have to manage a position between being business-friendly and having all the controls and oversight that mean your regulatory regime is viewed with confidence by the outside world."

Chirico was of a similar opinion, and addressing the leading US captive domiciles—Vermont, Hawaii and South Carolina—said thatthey too would have to come up with a response to Solvency II. Much like Bermuda, they play host to the captives of a number of global companies, and will likely be obliged to respond if they aren’t to lose captives to more well-regulated competitive domiciles. Chirico said that regulation was already “pretty tough” in such US domiciles, but it seems likely that further momentum for change will be felt by such leading American domiciles.

Outside Solvency II

Not all domiciles will however opt for equivalence and there have been a few who have already decided that outside the regulatory framework is where they want to be. Such a situation will likely result in a two-tier system, and this could have an impact—if limited—on Bermuda’s captive industry. Chirico indicated that there was some expectation that certain of the more “marginal captives” might seek “alternative solutions” and less stringent regulatory waters in the face of Solvency II, but he was clear that Bermuda was unlikely to lose any substantive captive presence. “The issue will be with the smaller jurisdictions, which don’t have several hundred captives to act as a ballast of experience,” Chirico said. They may look to differentiate their offering from the competition, with unrated and cell captives potentially considering such less stringent jurisdictions. This could be an area in which Bermuda could potentially lose out, with those captives “too small to absorb any of the additional frictional costs” associated with equivalence opting to reduce the impact of regulatory demands by considering a move outside the framework. Not that such an outcome is inevitable, with Chirico indicating that Bermuda would likely respond by increasing its “use of cell captive legislation, which is already on Bermuda’s books and has been for a period of time”.

Addressing similar concerns, Lightowler said that those jurisdictions that have pointedly stayed out of Solvency II and equivalence have done so “with a very short-term objective of looking to retain their existing captive base and potentially attract others”. However, it was clear from reading between the lines in the conversation that he was of the impression that short-term gains were a poor substitute for a globally recognised regulatory standard. Bermuda can continue to count on such a standard as an ongoing and significant differentiator.

A proportional response

Nevertheless, equivalence will place some additional demands on Bermuda captives and a key balancing act that the BMA will have to get right will be in applying Solvency II in a way that is appropriate to the specific needs of the Island’s captives. In resolving this issue, Bermuda has Europe’s concept of proportionality to act as a point of reference, and both Chirico and Lightowler indicated that they were confident that the BMA would get the balance of regulatory demands right. “The BMA is completely onboard with the concept of proportionality,” Lightowler said, although he admitted that the “challenge for Bermuda will be in making sure that the proportionality principle that underpins Solvency II is appropriately applied to the captive sector”. To this end, the BMA is engaging with the captive sector on the Island and looking to build a regulatory framework tailored to its specific needs. It is an inappropriate and over-burdensome application of this principle that those outside Solvency II are hoping to seize upon, so the BMA will undoubtedly be taking great care to apply its impending regulatory regime in a way that will not damage its captive sector.

Whilst the application of Solvency II equivalence is already largely underway for the commercial sector, Lightowler made clear that the BMA framework “being developed for insurers in classes 1 through to 3 will recognise that they are very different animals”. He said that he did not foresee the “full weight” of Solvency II being applied to Bermuda’s captive sector, rather an interpretation that addresses the various concerns of the regime without being overly burdensome. And whilst the principles of Solvency II will evidently inform Bermuda’s take on captive regulation, Lightowler made clear that he expects a “different approach to capital perhaps and proportionate approachesto Pillar I, II and III”. Burrowing into the specifics, he said that an example of differentiation under Pillar II “may be the submission of a risk register in lieu of an ORSA [own risk and solvency assessment]”, with such an approach less burdensome and more realistic for the captive sector. Lightowler said that captive oversight under Solvency II would not require the same level of detail as that required in the commercial sector as “there is less need for policyholder protection in such bespoke transactions”, and with a consultation paper on the matter due this summer, he predicted the creation of a “less onerous capital model” than that being applied to the wider re/insurance arena for Bermuda captives. Lightowler indicated he was confident that despite impending changes to the way captives are regulated, there would be no “sea change” in the way the BMA deals with captives.

A depth of experience

Both Chirico and Lightowler were certain that despite concerns in some quarters that Solvency II will make additional demands on the captive sector, the extent of regulatory change is likely to be appropriate, shepherded as it is by the highly experienced BMA. In fact, rather than discouraging captive formation and retention in Bermuda, it is clear from speaking with them both that maintaining a progressive global regulatory environment will sustain Bermuda in its position at the top of the captive league table. As Chirico was clear, “you can be business-friendly and strict on compliance at the same time”. And with the BMA displaying “absolutely the appetite and the get this right” in the words of Lightowler, it seems that the 40 years of captive experience that has placed the Island in good stead up until now will enable it to navigate a suitable regulatory course for further captive growth going forward.