Finally, practical guidelines for the supervision of captives
Although the EU’s Solvency II Directive covers captive insurance and reinsurance, it fails to make evident the unique nature of captives and captive reinsurers beyond providing the general requirement that captives should be regulated.
Although the EU’s Solvency II Directive covers captive insurance and reinsurance, it fails to make evident the unique nature of captives and captive reinsurers beyond providing the general requirement that captives should be regulated. Supervisors are told to take into account the captive’s business model and risk and then apply the principles of proportionality in relation to the nature, scale and complexity.
On the other hand, the International Association of Insurance Supervisors’s (IAIS) Application Paper on the Regulation and Supervision of Captive Insurers, which was released in November 2015, takes a very different approach. The paper updates guidance for insurance supervisors on the application of all aspects of regulation and supervision that are specifically relevant to captive insurers or reinsurers. It recognises and describes the unique nature and risks of various types of captives. The paper provides detailed supervisory guidance tied to the IAIS Insurance Core Principles (ICPs) on how supervisors should regulate these entities and highlights those matters specifically applicable to captive supervision.
Solvency II required the European Insurance and Occupational Pensions Authority (EIOPA) to draft regulatory technical standards including captive insurance and reinsurance undertakings. EIOPA also recognised the unique business model associated with captives and provided numerous simplifications in its guidelines. However, the IAIS application paper is more comprehensive and provides a practical approach allowing supervisors more latitude as they address the varying degrees of risk presented by the different business models of captive insurance and reinsurance.
The IAIS paper presents the following classifications that supervisors tend to use for captives:
The paper emphasises that regulatory risk inherent in a captive insurer varies substantially and the level of supervision should match the risk. A pure captive represents the lowest regulatory risk because there are no unrelated party policyholders or potential third-party beneficiaries. Captives representing the highest regulatory risk are those that underwrite risks for unrelated party policyholders or underwrite compulsory third-party liability risks where the third party has direct recourse to the insurer. The highest risk captives are similar to commercial insurers. Therefore, supervisors should consider applying regulatory requirements for high risk captives comparable to those for commercial insurers.
Captives typically pose reduced risk to external stakeholders or to the financial stability of the insurance market. Supervisors, nevertheless, need to receive sufficient and timely reporting to monitor solvency, assess compliance with legislation and identify potential problems. In defining the scope, content and frequency of the information to be provided, supervisors may take into account the captive’s particular risks, size and the amount of third party and/or unrelated party insurance exposures, if any.
Captives often rely on one reinsurer, and therefore, the captive’s board and the supervisor must insure that there are adequate procedures to monitor this significant counterparty exposure. Supervisors should require that cedants are transparent in their reinsurance arrangements and the associated risks.
Many captives are owned by industrial or commercial organisations, and therefore, the captive will be the only legal entity within a group that is subject to financial regulation. In this case, the supervisor may not have the authority to undertake group supervision. However, the supervisory focus needs to remain on the legal entity while, at the same time, the supervisor must take into account the potential for the activities of the group to impact on the captive. Controls must be in place to prevent the group from removing assets from the captive without the approval of the captive’s board and the supervisor.
Good corporate governance for captives differs from commercial insurers and reinsurers because of the presence of insurance managers, which often separate the oversight function from the management responsibilities. ICPs do not apply to insurance managers or other outsourcers but to the insurers for which they act, necessitating a requirement to formalise the outsourced arrangements among captive owners, directors and insurance managers. Because of the traditional use of insurance managers for captives, the board must clearly define the responsibilities of the insurance manager with adequate controls in place.
When the insurance managers are licensed, the supervisor should assess whether the insurance manager is fit and proper to carry out functions on behalf of the captive. An insurance manager should have sufficient financial and skilled human resources in relation to the number and complexity of the captives it manages and the necessary insurance protection in cases of negligence and fraud. The captive manager must be very familiar with local regulations and supervisory practices. When assessing a captive’s corporate governance framework, supervisors should recognise that an insurance manager is an outsourced service provider.
At the same time, it will form part of the captive’s corporate governance framework. Supervisors should be satisfied that there are agreements in place reflecting the division of responsibilities between the insurance manager and the captive’s board and management, and that these agreements clearly reflect the relative obligations of both parties.
Effective systems of risk management and internal controls, including effective functions for risk management, compliance, actuarial matters and internal audit, are an essential part of the overall corporate governance framework and the supervisor should require a captive to have such functions. Despite the presence of an insurance manager, the board of a captive must recognise that it cannot delegate its responsibilities for corporate governance to the insurance manager. The board must satisfy itself of the adequacy of its governance arrangements as well as the governance arrangements within the insurance manager.
Supervisors should be satisfied that the boards of insurance managers have a clear understanding of their obligations with respect to the captives they manage. Supervisors may require the appointment of a compliance officer function by insurance managers to oversee their outsourced compliance function to the captives.
Poor management, whether or not the management is outsourced, where there is a lack of technical knowledge, is particularly significant as it can pose a threat to the solvency of the captive through inadequate premium levels or insufficient technical provisions or solvency. Most importantly, the board must collectively have the skills and experience necessary to manage effectively any outsourced operations including outsourced insurance management functions.
The captive’s board needs transparent, effective ways to identify owner conflicts of interest and to ensure that they are managed and satisfactorily dealt with so that transactions, payments or charges on assets initiated by the owner (dividends, reinsurance agreements with related entities, loans, expenses or guarantees) do not financially impair the captive’s ability to meet its obligations.
Supervisors set capital adequacy requirements for solvency purposes to ensure that insurers can absorb significant unforeseen losses while also providing for varying degrees of supervisory intervention. Regulatory capital requirements have both a prescribed capital requirement (PCR) and a minimum capital requirement (MCR). The PCR may be lower for captives than for other types of insurer.
Some captives may be structured as protected cell companies (PCCs), which maintain a legal separation between the assets and liabilities relating to each policyholder, but in other captives, such as rental captives, these may not be kept legally separate. Supervisors should consider the adequacy of the capital within a PCC in both the core and the individual cells. Supervisors should also be satisfied that the board has put in place suitable corporate governance procedures to ensure that potential conflicts of interest that may exist between the owners or management of the PCC and that of its cells can be identified and managed.
Captives often depend on the financial strength of the parent or rely significantly on reinsurance. This requires the supervisor to be aware of the risk of parent insolvency, and to ensure the good credit standings of reinsurers. When the risks to which captives are exposed are similar to those of commercial insurers but the degree and diversity of exposure is different, the supervisor can look to the resources of the parent. In these troubled times, even captives run the potential risk of money laundering, terrorist financing and fraudulent activities, and these all must be monitored by the supervisor.
Supervisors should exercise their power to require the captive to hold sufficient funds to meet the maximum potential claim level in a given period. Also, they should monitor high claims volatility, high liquidity risk and exposure to related parties. Asset concentration risk and credit risk should be monitored, managed and mitigated by a captive, especially if it holds relatively low levels of assets and has low solvency capital requirements.
It is clear that the Application Paper on the Regulation and Supervision of Captive Insurer has heard the industry when it comes to practical regulation of captives. The paper presents a strong case for proportionate supervision when regulating these unique entities so their supervision appropriately matches the existing risks.
