1 January 1970EMEA analysis

Solvency II: engage and differentiate

Talking with players across the EMEA region and beyond, it is clear that after emerging from a difficult few years, Solvency II continues to dominate industry discussion. Captives, domiciles and regulators are all struggling to respond to, and fully understand the implications of, impending regulatory changes and it seems that there is still considerable opacity regarding how Solvency II will impact the captive sector.

According to both FERMA (the Federation of European Risk Managers Association) and ECIROA (the European Captive Insurance and Reinsurance Owners Association), “the standard formulas [set out by Solvency II] are intended to be a conservative calculation of solvency capital requirements and are not appropriate for captives”. Captives are designed to be lean and mean. It seems that proscriptive regulation is likely to rob them of their ability to stay that way. In a joint statement, the associations stated that the data compiled during QIS4 was “not representative of the captive industry”; raising concerns that greater interaction with the regulators and a firmer grasp of the role of captives was needed.

Nevertheless, as Rudolf Flunger, head of regions & specialty for Swiss Re’s Corporate Solutions unit indicated, the insurance sector has proven itself remarkably resilient in the face of the wider economic environment and regulatory change in recent years. As Flunger outlined, the “challenging economic environment could have been much worse”, with the regulators and direct government intervention helping the world economy “avoid the worst at the cost of high fiscal debt”. The insurance sector, captives included, outperformed much of the wider financial sector, with many captives finding their capital jealously watched by parents looking to repair their balance sheets. Captives avoided the toxic debtsand meltdowns that characterised the banks’ difficult few years, although the instabilities in the financial markets—which Flunger characterised as “recovering, but volatile”—have meant that returns on the investment side will likely be muted for a time to come. Despite performing well, the wider crisis nevertheless prompted greater scrutiny of the re/insurance industry and captives find themselves caught in the regulatory dragnet.

Concerning the regulatory threat, Flunger indicated that the economic crisis had created significant consensus that such crises needed to be avoided in future. Regulation of the financial sector would form a part of this approach—with Solvency II taking a spotlight to the insurance sector. Flunger indicated that it was normal that, post-crisis, “regulatory aspects automatically move to a more prominent position” and it seems that Solvency II is no different. In fact, talking with anyone in the captive sector, it is clear that Solvency II is the issue prompting industry head-scratching across Europe and beyond. The major issue is: where do captives stand in relation to the regulatory regime and is the sector in a positive position? The trouble is, an answer will depend on who you ask.

Gordon Rowell, head of insurance at the Cayman Islands Monetary Authority, for example, made clear that as “captives do not bear the same risks as commercial carriers, it could be argued that the regulators’ approach to captives is disproportionately aggressive”. Others were in agreement with Rowell—with Guy Soussan, partner at Steptoe and Johnson, arguing that although the principle of proportionality should ease some of the regulatory burden placed on captives, requirements surrounding governance and management did not take into account the size of the re/insurance entity. Instead, smaller players such as captives would be obliged to meet similar standards to those of larger re/insurers better placed to cope with the regulatory burden of Solvency II .Proportionality, it seems, extends only so far. “Until the final legal framework for EU -domiciled captives is known, foreign captive domiciles may well have valid reasons not to engage with an equivalence assessment despite the prospects of a transitional regime,” Soussan concluded.

Dominic Wheatley, chief marketing officer at Willis International Captive Practice went further, stating that “Solvency II isn’t designed for dealing with captives”, despite the potential for proportionality, and argued that “proscriptive regulation is not helpful in a captive context”. Such comments suggest that should the full weight of Solvency II or the demands of equivalency be placed on the shoulders of captives, then many in the industry would struggle to cope with the burden. And this situation is particularly galling considering the relative success of the sector in the recent downturn and its value proposition in managing risk and capital—an integral part of Solvency II’s remit.

Concerns over the possible impact of Solvency II have echoed some way beyond Europe. While Bermuda and Switzerland have both opted to go down the route of equivalency, Cayman, Guernsey and the Isle of Man are among a number of captive domiciles that are taking a ‘wait and see’ approach to the regime. A significant factor in their decision is likely to have been related to concerns that equivalency might well prove to be excessively burdensome to their captive sectors. As Wheatley explained—“equivalence has a slightly ambiguous value for jurisdictions. There is still significant uncertainty, concerning value, heading and implications.” While admitting that “clearly some constraint is necessary—where the business is too risky or undesirable”, Wheatley said that “captives must be allowed to deliver on the reasons they were established”. Flunger echoed his sentiments, stating that “captives will have a difficult time delivering if the regulatory requirements are too heavy”. Captives, domiciles and regulators will be weighing up their position in the face of the regime.

Despite the concerns of the captive sector however, commentators agree that greater regulatory control is inevitable and even desirable, even if a second tier of regulation would be more appropriate for the captive sector. Shanna Lespere, director of insurance at the Bermuda Monetary Authority, made clear that there are significant positives to be drawn from the European regulatory regime. “Solvency II will promote high standards in all jurisdictions and is in the interest of global market stability.” Others echoed Lespere’s sentiments, indicating that Solvency II would help to establish a global benchmark for industry regulation moving forward.

What is clear from the concerns raised is the need for the global captive industry to continue to engage with ongoing discussions surrounding Solvency II. At present, the captive question has formed a rather marginal part of the regulatory discussion, but it is apparent from captive associations such as the FERMA, ECIROA and the Captive Insurance Companies Association (CICA) that the industry is making great efforts to present the captive case to European and international regulators. As Lespere made clear, “it is important that insurers, regulators and the market feed into the European debate”, and greater interaction with discussions such as QIS5 and the forthcoming QIS6 should be seen as an opportunity for the sector—both to differentiate its offering and to present the case for captive-specific regulatory measures. It is unclear as yet, whether captives will be specifically addressed by future changes to Solvency II, but many will be hoping that exceptions will be made for these invaluable risk and capital management vehicles.