The European captive industry has survived the global economic downturn well but the forthcoming implementation of Solvency II could pose a new problem for the sector, according to a new report from A.M. Best.
The report describes the impact of the financial downturn on captives, the state of the captive market and the potential effects of Solvency II.
Looking at the affect that the three pillars of Solvency II will have on captives, the ratings firm's report said that many captives may find Own Risk and Solvency Assesment (ORSA) compliance particularly difficult under Pillar II as there is no specific ORSA model to follow. Though Pillar III’s further disclosures, increased transparency and improved benchmarking is generally welcome, despite being difficult for captives.
The report states that while some captives will struggle with the new directive, others will find opportunities. Captives that focus on risk and capital management and maintain well diversified or defensible niche strategies are well prepared for Solvency II. By maintaining sufficient capital levels, they will be able to take advantage of opportunities to expand their roles, should they arise.
In terms of exposure to sovereign debt, a captive’s exposure is generally lower compared to a conventional insurer.
“Although the economic uncertainty in Europe appears to have somewhat eased compared with 2011 and early-to-mid 2012, underlying issues remain and have resulted in heightened investment risk. Meanwhile, returns in general have remained minimal, as it has become more difficult to diversify into very highly rated bonds because of the various sovereign and corporate downgrades over the past year or so,” states the report.
Yvette Essen, the report's author and A.M. Best's director of industry research in Europe and emerging markets, added: "Parent companies continue to have a wide choice of jurisdictions for their captives. Cells are being formed, although the soft market and uncertainties regarding Solvency II's final specifications and implementation date could result in delayed decisions to form captives in onshore jurisdictions."
Anandi Nangy-Kotecha, associate director of analytics at A.M. Best, said: "Direct captives are likely to be more heavily impacted by the current form of Solvency II than reinsurance captives. Small captives, which lack risk diversification and have high counterparty exposures, are expected to need capital increases to meet regulatory requirements. Given the more onerous regulatory environment and the costs involved, some parents may close dormant captives and run off existing vehicles."
