1 November 2016EMEA analysis

Strong risk management will help European captives with BEPS and Brexit: AM Best

Owners of European insurance market captives continue to see value in using their captives despite prevailing weak premium rates and widening terms and conditions in large sections of the general insurance market, according to an AM Best special report.

The report, titled “European captives demonstrate enduring appeal of alternative risk transfer”, notes that the expectation that captive owners would make more use of the open market during a soft cycle and place more risk through their captives during a hard market has not played out.

Instead, captives continue to play an important role regardless of the market cycle. Despite the enduring appeal of captives, there are challenges ahead for the industry, the report said.

“These include the Organisation of Economic Co-operation and Development (OECD)’s action plan on base erosion and profit shifting (BEPS) aimed at tackling tax arbitrage, the need for contingency plans for captives impacted by Brexit and an increasing regulatory burden, in an outside the European Union (EU),” the report stated.

“While the action plan introduced by the OECD to address BEPS issues is not particularly aimed at the captive industry, it does have significant implications for captive insurers, especially as its report made numerous references to the captive model as a potential source of profit shifting.

“Furthermore, it announced that more work would be undertaken during 2016-17 to establish specific guidance on the transfer pricing of financial transactions, which includes captive insurance arrangements.”

Mathilde Jakobsen, associate director and co-author of the report, said: “The European captives rated by AM Best are generally well-integrated in their parent’s overall risk management framework and are valued for the benefit they bring to the group’s risk management, independently of any savings on insurance buying.

“Typically, groups make use of their captive to centralise claims and loss information, allowing for more effective internal reporting and communication of such information within the group. The parent is then able to use this information to support its risk mitigation and loss prevention actions.”

Konstantin Langowski, financial analyst and co-author of the report, said: “Captives that are used simply as a risk financing tool will come under even more scrutiny by taxation authorities in the future.

“However, in AM Best’s opinion, the great majority of captives that currently hold an AM Best rating are being used as a platform from which the parent company’s enterprise risk management programme is implemented.

“Nevertheless, questions relating to the commercial purpose, pricing and substance of captives will have to be appropriately addressed in the changing tax landscape.”

According to the rating agency the improvement in risk management among captives, led by regulatory demands, is positive. A captive with strong risk management capabilities is likely to achieve more sustainable earnings and have a better understanding of its capital needs. In addition, strong risk management will help captives deal with challenges such as BEPS and Brexit.