Vincent Barrett, Aon
3 March 2021Feasibility studies analysis

Captives in Europe: playing catch-up

Even before the impact of COVID-19 had been fully felt there was much debate in the industry about the nature of the current market conditions and whether they could be accurately described as hard, or merely hardening.

Regardless of where you stood in that debate in early 2020, “there is no question it is a hard market now, and will remain one for several more renewals cycles, at least”, according to Vincent Barrett, Aon’s regional managing director for EMEA and head of captive insurance operations in Dublin.

“I don’t think there is any huge appetite in the industry to relax provisions for captives.” Vincent Barrett, Aon

In fact, it may be both hard and hardening. “The market may continue to get harder, because carriers are still losing money and they are not making as much supplementary investment income as they have in the past,” Barrett explains.

He points to a “general restating of underwriting principles among many commercial carriers” and a general “lack of willingness to deviate from those principles” which is leaving many clients with a problem when it comes to obtaining the coverage they need.

This trend is coupled with rising prices, with rate increases of around 30 percent or more in many lines, and increases across all lines of business. Even accounts that have experienced no losses for years have seen the price of coverage soar.

All of this adds up to a significant opportunity for captives. There are, Barrett estimates, around 6,100 captives currently operating, globally—around the same number as there were in 2012.

“After 2012 we saw most of the increase in the number of captives coming from 831(b)s, but a lot of those have now fallen away,” he observes.

In the current market, that number could start to increase again.

“For the last 10 years it has been so relatively easy to place most risk, the terms have been generous and the cost-effective, it was a difficult case to make to retain risk when it was actually more cost-effective to transfer it,” notes Barrett.

“Risk management always has the option to either keep, mitigate or transfer risk. Right now the transfer option is looking very expensive, so that makes the other two options look more attractive.

“Businesses already spend a lot of money on mitigation, so retention is the obvious place to start. It is essentially betting on yourself and that always feels as though it makes sense.”

It is not only the hardening market that is piquing increased interest in captive insurance. Such vehicles are evolving in line with the changing make-up of the global economy, and particularly with the increasing importance of intangible assets, says Barrett.

“Captives are very effective at incubating risks, managing them from a risk financing perspective and also learning more about emerging risks,” he notes.

“A business with a captive has an advantage when it goes to the commercial market and can show detailed claims data, and that has been the case since the 1950s.”

Taking time to get it right

Barrett says the number of captives that exist in Europe is a testament to how much value businesses get from them. This is especially striking, he notes, considering how soft rates have been for the past 10 years, and how relatively scarce occurrences such as mass terrorism and large-scale weather events have been.

“Now that rates are hardening we will expect to see significant growth in the number of captives in the EU,” Barrett predicts.

“Risk management is reasserting its relevance in a way that perhaps it lost a little in the last 15 years or so because of the extended soft market,” he adds.

“In Aon’s ‘ Reprioritizing Risk and Resilience for a Post-COVID-19 Future Report, 49 percent of respondents agreed or partially agreed that their companies’ boards plan to review the ongoing performance of a captive insurance company, and 46 percent agreed or partially agreed that the board will investigate the feasibility of new captive solutions.”

In the US, figures released by the numerous state domiciles indicate this trend is already well under way.

“The hardening of the market and fall in capacity happened more quickly in the US, so risk managers there felt the problem earlier,” Barrett explains. With many European companies having excess cash on hand and access to cost-effective credit, they are in a strong position to think about launching captives, he says.

The lag time between the initial idea to investigate the possibility of launching a captive and actually making that happen tends to take longer in Europe, Barrett notes. “In Europe there was also a greater variety in the different regulatory and tax regimes to choose from, which makes the decision about where to domicile more complex,” he says. “There are a lot of country-specific issues to navigate.”

European companies that already have a captive will typically have considered all of these factors already, making it easier for them to react more quickly, he notes.

Domicile selection is a significant factor that needs to be thought through, and geography plays a big part in this, in terms of language, culture, proximity and time zones, says Barrett. “A captive is an extension of a company’s risk management function, so the further it is away from the group, the harder it is to integrate, while the closer it is, the more tactical relevance it will have,” he says.

While the US has a plethora of reputable onshore captive insurance jurisdictions to choose from, the differences between the European jurisdictions are arguably greater, making the decision particularly important.

Barrett says: “Ireland is great for pan-European programmes and also has a strong relationship with the US. Malta is the only jurisdiction inside the EU with PCC legislation.

“Gibraltar can write directly into the UK. Liechtenstein has the ability to write EU and Swiss risk directly, Luxembourg is the only European domicile to allow equalisation reserving, and Sweden and the Netherlands provide logical homes for the captives of parent companies headquartered there.”

All these options are in addition to Guernsey, Europe’s premier captives domicile in terms of numbers. “Guernsey is a very innovative jurisdiction,” notes Barrett. “It was the first to use protected cell legislation, it has been a leader in using longevity swaps, it is a leader in insurance-linked securities, it allows non-admitted coverage. It is a jurisdiction that will continue to innovate. All of this counts in its favour.”

The breadth of offerings in Europe reflects the different needs of European companies, explains Barrett. “Each jurisdiction has its core competency, each has developed the way it has for a particular reason,” he says.

The composition of the captives industry also looks a little different in Europe compared to the US, although single parent captives remain the backbone of the industry on both sides of the Atlantic, he stresses.

Outside of this, Europe has seen more growth in cell captives than the US, while the US has more group captives, notes Barrett. This is partly because groups are much harder to do in Europe, because of Solvency II and the increased regulatory burden and capitalisation requirements it introduces.

“The group captive concept doesn’t seem to be perfectly transferable to Europe, though the Isle of Man or Guernsey could develop the idea given the more flexible regulatory environments in both jurisdictions relative to Solvency II-based locations,” he says.

Barrett sees cells as a cost-effective alternative to a single parent captive that offers access to the reinsurance market, while reducing the demands on management time. Cells do not require a parent company to form a board for the captive, which can be quite onerous, and are very flexible and increasingly tried and tested, says Barrett.

“There has been no major legal challenge to a cell structure as yet but there are so many cells in existence now it is clear they are a robust structure,” he adds.

The power of EEA captives

Perhaps the biggest decision a company has to make regarding a new captive in Europe is whether to domicile it within the European Economic Area (EEA) and, by extension, within the scope of Solvency II regulations. Some consider Solvency II somewhat draconian in its application to captives, specifically with regards to capital reserves. There are certainly benefits too, however.

“An EEA captive is a unique thing,” says Barrett. “In US terms it would be the equivalent of a captive that was, for example, licensed in all 50 states. That is a powerful risk management tool.”

The decision about whether to set up within the EEA depends on how many countries the captive wants to write business in, he explains: if it is a lot of countries, it probably needs a fronting partner. Another consideration is how many captives a company wants to have.

“You look at all these factors and sketch out what you need, what you would like and what would be nice to have, and then you find the domicile that offers an attractive fit,” says Barrett.

“A domicile analysis is typically included as a standard component of a captive feasibility study, which is an important step in determining an appropriate location for the captive.”

There has been some pressure coming from within the captives industry to have elements of Solvency II relaxed for captives, on the basis that they usually do not sell insurance to third parties and therefore do not constitute a systemic risk. Barrett has little sympathy for this argument, however, dismissing them as just another example of lobbying groups doing what they are paid to do.

“I don’t think there is any huge appetite in the industry to relax provisions for captives, or much expectation that there would be,” he says.

“Some provisions have been looked at for relevance, but ultimately an important thing is for captives to be acknowledged as real insurance companies, and a two-tier approach to regulation exposes captives to challenges to their status as real insurance companies.”

Barrett stresses that the Solvency II regime is a risk-based capital model that is very well established and understood.

“It is close to the International Association of Insurance Supervisors’ idea for a global regulatory regime, and the National Association of Insurance Commissioners in the US has adopted some of its provisions,” he notes. “Solvency II wanted to set a standard and it has done that.”