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Like the rest of the world, Europe has been badly affected by the ongoing COVID-19 pandemic with millions people losing their jobs, businesses closing, and countries like the UK crashing into the deepest recession of any major economy. Within the insurance industry, captive insurance companies have been highlighted as an option for coverage for future events similar to the current global pandemic.
Andy Hulme, executive vice president, director of underwriting at Strategic Risk Solutions (SRS), explains that the captive market is seeing increased interest at this time and there are compelling reasons to consider captives.
Hulme says: “The capability to design coverage which will ensure losses are settled is compelling.”
“We will see interest in non-insurable risks, such as non-physical damage business interruption (NDBI)/contingent business interruption coverages post-COVID-19 and captives are a great vehicle to incubate such a policy.”
Although the obvious answer should be yes, in terms of setting up a captive, Shruti Vyas, captive manager, insurance at SES Satellites, suggests there is a catch.
Vyas says: “A difficult market is not the time to think about setting up a captive. To make the most of the captives they need to be set up in a soft market so the benefits can be seen in a difficult market like now.”
However, Guenter Droese, executive director of European Captive Insurance and Reinsurance Owners’ Association (ECIROA), notes: “Captives may reduce the impact of huge financial losses especially by building up technical reserves and buffers which the parent company may not be allowed due to tax reasons but these solutions are also limited to pay out to the limit insured and for a self-determined time frame, not for whatever will happen in the worst case.”
Even before the pandemic, the European captive market was gaining significant interest. A report by the Federation of European Risk Management Associations (FERMA) confirmed that levels of interest had almost tripled from 2018.
Some of the reasons behind the increase included the current market conditions with the industry looking at a hard market after a very soft market for several years. A continued trend from last year is the increase in rates and inclusions and the reduction of capacity is on the rise.
Hulme explains that interest in alternative risk financing remains high in Europe as it is fueled by the capacity contraction and the premium increases in the traditional (re)insurance space.
He says: “We are seeing increasing consideration of captives by European organisations as they continue to encounter severe challenges in their upcoming renewals.”
Another trend in the European captive market, according to Droese, is captive owners and captive managers checking their business model, the business rationale and the targets and mapping how to improve the captive performance.
Droese says he expects to see a lot more employee benefits programmes underwritten by captives during the coming years.
Hulme also notes that they are seeing interest from existing captive owners looking to leverage their captives further, whether it be to better utilise capital within the captive or to facilitate new lines of business where the insurance market is pushing rate and retention increases.
“There are also numerous considerations how to optimise the use of the capital invested and whether alternative risk transfer (ART) in combination with rather so-called NDBI/supply chain risk and cyber, will add value for the parent company,” Droese adds.
Captive competition
As the level of interest around captives picks up, so does the competition around domicile selection. Vyas suggests the “eternal challenge” is to remain competitive.
She states: “I see many jurisdictions across the ocean realising the attraction in the business and trying to promote the captives.”
Europe is home to some of the larger captive domiciles, with Luxembourg having the biggest reinsurance market in Europe and Guernsey, the Isle of Man, Ireland and Malta being popular domiciles of choice.
Even countries that have had little activity in well over a decade saw movement this year as the French Prudential Supervision and Resolution Authority approved a reinsurance captive for the first time in 20 years.
In order to attract captives, Vyas explains that the biggest role is played by the local regulator. She explains that all the European captives are governed by a single regulatory framework, but how they are implemented in individual countries very much depends on the interest of local regulators.
Droese suggests that captive owners “primarily decide to establish a captive in countries where the experience of the local supervisor with these special purpose vehicles has been developed over the years”.
Hulme notes that countries like Ireland, Malta and Luxembourg have the perception of being a captive friendly domicile. Which is further supported by the growth of the captive service industries including banking, legal, secretarial, audit, insurance management and insurance specialists, who are willing to provide INED services.
Droese said: “It’s rather a surprise that companies in some so-called industrialised/high-developed countries are not using this instrument of a captive to optimise their risk management structure and tools as companies in other countries.”
He said they recognise a difference in understanding, education and experience of entrepreneurs and on the C-level of big corporations regarding the business rationale and the use of captives. There may also be a gap in consulting and advisory experience and skills.
Vyas also suggests that she would not discount the need for greater education and openness for captives in general.
“My observation has been, more often than not, it is the fear of the unknown that prevents entrepreneurial setups like captives from flourishing,” she adds.
Hulme suggests: “I think it is fair to suggest that some European domiciles have focused more directly on captives (perhaps to the detriment of the traditional insurance or reinsurance market) and it is those markets that are trending as the most popular domiciles.”
Solvency II Review
With competition strong within Europe, Vyas also emphasises the importance of Europe as a whole remaining competitive with global captive domiciles.
Vyas comments: “Hopefully the upcoming Solvency II Review will be a step in the direction of maintaining the position of European captives in the market. It is a long shot but maybe this review will help captive owners to respond to the evergreen question of the substance of captives much more easily,” she adds.
After coming into effect in January 2016, the European Commission called on the European Insurance and Occupational Pensions Authority (EIOPA) to provide technical advice for a comprehensive review of the Solvency II Directive in 2019 as the European captive industry had some issues with the regulations.
The review was due to be published this year, however in order to take into account the importance of assessing the impact of the current COVID-19 situation on the Solvency II Review, EIOPA will deliver its advice to the European Commission at end December.
It will focus on long-term guarantees measures and measures on equity risk; methods, assumptions and standard parameters used when calculating the solvency capital requirement standard formula; member states’ rules and supervisory authorities practices regarding the calculation of the minimum capital requirement; and group supervision and capital management within a group of insurance or reinsurance undertakings. Beyond the minimum scope, other parts of the Solvency II framework were also identified by the EC services or by stakeholders as deserving a reassessment, such as the supervision of cross-border activities or the enhancement of proportionality principles, including as regards reporting, and among others.
Commenting on the review, Droese says based on the recommendations provided by various stakeholders, including ECIROA, he expects “some simplifications for the captive market”.
He notes that this should help to reduce workload and cost and that it should be “at least a further step in the development and understanding of their captive activities”.
“Based on the principle of proportionality there is more room and there are a lot of single issues which may allow the exemption from some requirements for captives in the future.”
“We understand the Solvency II evolution as permanent development progress,” he adds.
Vyas states that the captive industry would welcome from the review of Solvency II a simplification in reporting and one way to do that could be to pay more attention to the use of the principle of proportionality.
According to Hulme, Solvency II has had an “interesting impact” on captives.
He says: “The go-to thought when assessing Solvency II impact would be capital adequacy, though the industry will often report that captives remain some most prudently capitalised structures around, therefore, I suspect that the impact has been on strategic planning and impact assessment for the positive, and cost and time impacts for the negative.”
However, Hulme says that the minimum capital requirement within the Solvency II framework is too significant and acts as a barrier to entry for many companies thinking of a captive – especially when there are high-quality domiciles that have lower minimum capital requirements.
Going forward, he suggests that there needs to be a recognition that captive vehicles and commercial vehicles may share regulation but are wholly different structures operating for wholly different purposes, most importantly regarding the relationship with the recipient of the insurance protection.
Hulme says: The proportionality application is an important tool in applying regulations and discerning those structures working to the benefit of a related party, a sophisticated risk financier, and those offering insurance products to consumers.”
“I’d like to see a carve-out remain for the captive class recognising their limited purpose and ensuring that they continue to focus on the aspects of the regulation, such as substance, value creation, governance and of course, adequate risk- based capitalisation.“
“This will allow Europe to continue to grow to ensure that Europe’s corporations recognise and retain their risk financing structures within the continent,” he concludes.
