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Derek Bridgeman
Marsh Captive Management
Solvency II has seen captive owners explore alternative forms of capital, as the threat of the UK’s EU exit looms. Derek Bridgeman of Marsh explains

Almost a year on from the implementation of Solvency II, what impact has the directive had on the captive insurance industry?

Despite the lack of success in securing a separate carve-out for captives, the EU captive industry has, for the most part, embraced Solvency II with positivity and optimism. With regards to the impact on the global captive market, fears that there would be a fall-off in onshore EU captives post-Solvency II have been unfounded. Although new captive formations in Europe have been slow through 2016, we have recently seen an increase in demand for capital and structure optimisation analysis offerings. With successful implementation complete, owners view capital and balance sheet optimisation as being the next natural steps to facilitate effective governance within the new regime.

Overall, captives are not treating the regulations, in particular the corporate governance requirements, as merely a tick-the-box exercise. We are seeing a broader integration of captives into the risk management and enterprise risk techniques of their parent groups. With the pursuit of capital efficiency we are seeing an increase in diversification of captive risks beyond the traditional areas of property and casualty, into non-traditional areas such as employee benefits, supply chain, and cyber risk.

Many captive owners are also now exploring alternative forms of capital (tier two/three capital) in order to strengthen their capital base. To date, options including the use of letters of credit, parental guarantees, subordinated debt and unpaid share capital have received regulatory approval.

In our own business, we are seeing a greater call for the services of captive managers and advisers as captives address evolving aspects of the solvency capital requirement (SCR) optimisation and focus further on a fully integrated service solution across all three Solvency II pillars. The owners and managers that have fared best through implementation are those that have invested in integrated IT platforms to ensure maximum automation with respect to SCR calculation and reporting. This again will be crucial as we move through the first annual reporting cycle.

What challenges are captives facing with Solvency II?

Generally, the implementation of Solvency II has been successful to date. However, what was an efficient captive structure under the previous regime may not be so under Solvency II. As such, there were examples where some structural changes, particularly in property programmes, were required in order to meet the new solvency capital requirements. Structures that incorporated reinsurance/investment with counterparties in non-Solvency II equivalent domiciles resulted in counterparty issues for captive owners, which needed to be worked through ahead of implementation. Going forward, the challenge surrounding Pillar I will be to achieve a high level of capital efficiency while still meeting the captive’s overall objective.

The day one and quarterly reporting to date has resulted in high compliance rates across the main domiciles. Caution should be exercised, however, the level of resources required in order to meet the annual quantitative and qualitative reporting requirements will be significantly higher than that of the quarterly requirements. The sourcing of granular investment data, particularly with respect to the assets subject to the full ‘look-through’ requirements is an area that will require additional resources for annual reporting. Regulators are encouraging boards to begin planning for the annual reporting processes as soon as possible and many regulators have/plan to provide dry-run test platforms in advance, together with technical assistance.

The external audit of annual quantitative and qualitative reports, such as the solvency and financial condition report (SFCR), will present challenges for companies located in countries where applicable. The fact that not all countries are implementing the requirement creates issues and is an example of how different interpretations and applications of proportionality are threatening the harmonisation objective of the European Insurance and Occupational Pensions Authority (EIOPA). Within the legislation there is provision for the non-disclosure of information within the SFCR, which, subject to regulatory approval, may provide a competitive advantage to a competitor if disclosed. However, what constitutes a ‘competitive advantage’ by regulators within different domiciles may vary, leading to the potential for less harmonisation across domiciles.

Have there been any negative impacts on captives since implementation?

Some key changes for captives under the new regime have been the call for higher capital requirements, enhanced governance and internal control procedures, together with additional supervisory and public disclosure. All of these have inevitably led to additional expense to captive owners.

In addition, the prospect of zero return-typical captive investment strategies has resulted in pressures on risk managers from parent owners to re-evaluate the use of capital in captives. In contrast to the previous regime, however, Solvency II presents an opportunity to deploy strategies that can create a more efficient capital base. Requests to captive managers to quantify the effect of alternative mix/spread of investments to maximise return and the diversification benefit, and explore the use of alternative reinsurance arrangements to limit catastrophe exposure and counterparty risk charges, are becoming more common.

Do you think captives should be given a tailor-made regime for Solvency II, rather than the one-size-fits-all approach?

The continued interest in captives taking on new and emerging risks post-Solvency II suggests that captives fit within the Solvency II regime, so a separate regime is not needed in my opinion. However, the application of proportionality is crucial to ensure the parent groups’ captive objective is still achievable in the future. It is important to note that while the legislation does define ‘captives,’ they are not mentioned again with the exception that the concept of proportionality is meant to be applied ‘somewhere’ within the supervisory regimes across the EU. Some within the industry believe EIOPA should have been more prescriptive in the directive to set defined levels for ‘appropriate’ given an entity’s size, complexity, and so on. The industry now needs to come to an agreement as to the best way to apply the concept of proportionality with individual supervisors across the EU.

How regulators enforce the Pillar III requirements, including external audit, will be closely watched by all in the industry. Although there are numerous provisions on proportionality in the Solvency II delegated acts, the feeling in the captive industry is that further work could be done to ensure that all requirements are proportionate to risk. Proportionality could be compromised in domiciles where regulators effectively ‘gold plate’ key functions and insist on additional reconciliations and disclosures.

In the pursuit of a more harmonised regime, there have been calls by the industry for national regulators to publish guidance on how proportionality is being implemented within their jurisdictions so as to enable EIOPA to perform a detailed comparison and propose changes to increase harmonisation in the future.

What is the likely impact of an EU exit on the applicability on Solvency II in the UK?

The impact on Solvency II depends on the type of post-Brexit EU/UK deal reached. Should the UK take up the option to look to obtain third-country status, then it will essentially be deemed to have a Solvency II equivalent regime in place. In terms of Solvency II, this would mean that the directive and regulations would continue to apply to UK insurers and the UK would have to apply for equivalence. A downside for the UK is that it would have less influence on Solvency II going forward. However, UK regulators would be able to relax some of the requirements of Solvency II, particularly around asset look-through, which are viewed by many as providing less value for captives.

The indication at the moment is that insurers are calling on regulators to refine Solvency II to better suit the UK market, rather than replace it entirely when the UK leaves the EU.

In a recent webinar, it revealed that 25 percent of attendees were yet to start a contingency plan for Brexit. Is this a concern and why?

The absence of a contingency plan would not be a major concern at present, however, companies should be monitoring the situation closely and at least considering potential impacts. Article 50 has yet to be triggered and many of the effects of Brexit on captive owners will become more apparent in the coming months. We are working with companies to assist them to review their captive risk profiles and insurance programmes so as to be aware of, and plan for, any potential impact.

When boards and captive owners are contingency planning for Brexit, what should be top of the agenda? And why?

Brexit could have a direct impact on captives’ passporting rights. This should be top of the agenda when captive owners are contingency planning.

If the captive is an EU onshore captive, then it may need to obtain a licence to continue to write UK risks, in the absence of a trade deal. Whether the UK can finalise its exit from the EU with these trade deals in place will be closely monitored and only then will the true impact on such captives will be known.

EU captives who access the UK commercial reinsurance market will need to follow developments closely. It is likely that the UK will look to achieve equivalence similar to Bermuda, Australia, Japan, and Switzerland. This equivalence status would be necessary to ensure appetite for EU companies to access the UK reinsurance markets. In addition, credit ratings for reinsurers and insurers should also be closely monitored for potential downgrades and knock-on effects of the captive’s SCR under Solvency II.

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