A.M. Best-rated European captives have generally been resilient to the effects of the COVID-19 pandemic and have maintained stable ratings fundamentals throughout 2021, according to the credit rating agency in a new market segment report. A.M. Best’s new report, ‘Europe’s Captive Sector Thrives Amidst Hardening Market’, investigates the increasing use and importance of captives as a result of commercial insurance rate increases and the continued hard market. These market conditions have demonstrated the role of captives as a risk management tool that provides bespoke risk solutions to parent organisations in lines of business where commercial capacity has declined and rates have increased. In these current conditions, it is now important for companies to have the flexibility throughout the insurance cycle and the access to reinsurance market capacity that is afforded by captives. A.M. Best identifies that price increases in the reinsurance market began as early as 2018 in some segments, and has continued to harden since — particularly in casualty lines as insurers respond to the impact on loss experience of social inflation. The top three captive domiciles in Europe by the number of licensed captives are Guernsey, Luxembourg and the Isle of Man. The rating agency also notes in its report that tougher renewal discussions in Europe have led to an uptick in the use of existing captives in order to optimise risk transfer solutions. For example, increasing retentions or limits on existing cover, or else expanding into new lines of business. A.M. Best-rated European captives generally have strong capital buffers that provide resilience against significant market shocks, such as the market volatility, global economic slowdown and increased claims activity caused by the COVID-19 pandemic. The report notes that, in the future, a captive could offer business interruption capacity to its parent company only to control the limit provided for pandemic-related coverage, but this is recognised to have pricing challenges. Solvency II From a regulatory perspective, A.M. Best says the ongoing review of Solvency II continues to occupy the minds of EU-domiciled captive owners and managers. On 22 September, the European Commission (EC) adopted its review package for Solvency II rules for insurers and reinsurers domiciled in the EU. Moving forward with the review, the European Parliament and member states of the council must negotiate the final legislative texts based on the EC’s proposals. The review is particularly relevant to captives concerning the application of proportionality, which is designed to “ensure that the practices and powers of supervisory authorities are proportionate to the nature, scale and complexity of risk inherent in the business of the insurer or reinsurer”. A.M. Best highlights that this is important for captives in ensuring that regulatory requirements do not become too onerous. ESG and innovation The report recognises that innovation is increasingly important to the long-term success of all insurers, as it provides sustainable competitive advantages and allows insurers to be responsive to external challenges, such as low investment yields, stagnant growth and declining expense ratios. A.M. Best notes that, while captives themselves are an example of innovation in the insurance industry, captive innovation initiatives are often driven by the needs of the parent company. This is also true of a captive’s ESG approach, which tends to be very closely linked to that of the parent organisation as a growing number of captive owners begin to integrate ESG factors into their operations, particularly concerning corporate governance and investments. The rating agency notes that this change in a captive owner’s operations to give greater emphasis to ESG considerations is usually part of an organisation’s wider risk management strategy to manage transition risk, especially in the oil and gas sector. In addition to more commercial reinsurers formally integrating ESG factors into their strategy, new emerging risks will require captives to adapt to ensure they still fully meet the requirements of the parent company. Such emerging risks include environmental liability and cyber risk, with the latter requiring social engineering and data security to ensure the captive still provides adequate coverage while considering ESG factors in its operations.
