The looming implementation of Solvency II is bound to change the market environment dramatically for captive insurers, as parent organizations take a fresh look at captives’ role in light of increased regulatory requirements under the new regime. Regulatory capital requirements appear certain to increase dramatically—as much as three—to fourfold for European Union (EU) domiciled captives.
Most captives operate with multiples of the current regulatory capital requirements, but A.M. Best Co. believes many owners will have to commit more capital to their captives under Solvency II.
Pillars II and III of the new regime will tighten standards for enterprise risk management (ERM), processes and reporting, leading to higher operating costs.
Captives writing business inside the EU but domiciled elsewhere will find their fates tied to the achievement and application of regulatory equivalence with the new EU system.
Since many captives operate as reinsurers, equivalence could be a key consideration, as some reinsurance business is already supported by collateral or deposits of reserves with a fronting company.
Captive centres clearly have a difficult balance to strike between obtaining equivalence and remaining attractive to captives; decisive factors are likely to be how proportionality is implemented within the EU and the impact of collateral posting on captives.
It is unclear whether proportionality—simplification provisions designed for smaller insurers—will apply to the captive sector, and each captive likely will be viewed on its own merits, given that proportionality under Solvency II is more about risk profile than size.
Captives, to minimise the impact of Solvency II, should prepare for a worst case scenario—no grant of proportionality—and try to mitigate the new regime’s effects.
Key steps would be participation in the European Insurance and Occupational Pensions Authority’s (EIOPA) quantitative impact studies (QIS) and the parallel development of partial capital models that best reflect each captive’s risks.
A.M. Best believes that captives able to obtain a secure financial strength rating should not have major difficulties adapting to Solvency II; strong risk-based capital, robust risk management and governance, close integration with a securely rated parent and effective reporting systems will leave captives well positioned to satisfy the demands of the new regime.
