European captives and Solvency II

13 April 2015

Written by Dominic Wheatley

Stephen Durham, Reporter at Captive Insurance Times, asks Dominic Wheatley, Chief Executive of Guernsey Finance, for his thoughts about where European captives are with Solvency II, and how they are adapting to today’s financial environment.

Stephen Durham: What challenges do European captives currently face in the run-up to Solvency II’s implementation next year?

Dominic Wheatley: Captives domiciled within the EU will have to comply with Solvency II’s blanket approach to the regulation of (re)insurance business. It is designed to deal with problems within the commercial market and therefore some of the requirements are simply disproportionately onerous for captives.

Guernsey is not in the EU (although it is in Europe geographically) and as such, is not required to implement Solvency II. Instead, the Island is updating its own risk-based, proportionate solvency regime in line with the Insurance Core Principles (ICPs) of the International Association of Insurance Supervisors (IAIS).

SD: How will the directive’s capital requirements affect captive funding—will the cost be too high for captive owners, or do they already have this in the bag?

DW: All captives based in the EU will have to comply with Solvency II’s requirement for (re)insurance companies to hold sufficient capital to meet their obligations over the next twelve months with a 99.5% confidence level. This is unnecessarily burdensome for captives and may even render some captive business plans uneconomic and unviable.

Unlike Solvency II, Guernsey’s new regime distinguishes between commercial (re)insurance and captive insurance. As such, captives in Guernsey will have a minimum capital requirement of £100,000 and confidence levels of 90%. This proportionate approach should be very attractive to current and potential captive owners and especially those who still want a domicile within the European region.

SD: How are European captive owners managing their capital in a continuing difficult economic environment?

DW: As I have mentioned previously, the new solvency regimes are pushing up the capital requirements for captives. However, this is restricted to secured assets and yet they are low yielding. As such, this is squeezing the margins for captives and therefore this undermines their economic viability especially in the context of soft conventional insurance units. In Guernsey, captives are addressing this by upstreaming to parents as a way to decrease the counterparty risk and enhance returns.

SD: Which captive structures are proving the most popular in Europe, and why?

DW: There were 85 new international insurance entities established in Guernsey during 2014. Some of these were established using limited companies but the vast majority were Protected Cell Companies (PCCs) and Incorporated Cell Companies (ICCs) and related cells.

Guernsey pioneered the concept when it introduced the PCC in 1997 and therefore has built up significant experience and expertise in using cell companies within the captive insurance sector. In the last year we have seen a number of captive insurers established as ICCs to transfer pension longevity risk.

For example, BT’s pension scheme has established a new insurance company, BTPS Insurance ICC Ltd and effected the transfer of a quarter of the scheme’s exposure to increased longevity and so hedged around US$16 billion of liabilities. Similar structures have since been established by Towers Watson and PwC to facilitate transactions for their pension fund clients.

The ability to quickly and cheaply establish new cells is a major reason for the popularity of PCCs and ICCs and is behind their use within Guernsey’s fast-growing Insurance Linked Securities (ILS) market and in particular the collateralised reinsurance segment.

This has been enhanced by the fact that protected cells conducting collateralised reinsurance business are able to secure regulatory pre-authorisation. Guernsey’s regime has now been enhanced further by the publication of guidance notes on the use of transformer vehicles for insurance and reinsurance business.

SD: What are European companies considering before they launch a captive? How has the reasoning behind captive formation changed in the years following the financial crisis?

DW: Captives might be established for a number of reasons, including the insurance of unusual risks not catered for by the commercial market or where market capacity is limited, direct access to reinsurance markets, paying premiums related to the insured’s own track record and the retention of net premiums over claims.

However, the financial crisis highlighted major failures of corporate governance and has brought about increased focus within the boardroom on de-risking companies. Establishing a captive improves the understanding of risk and the cost of risk management within a company and as such has been a major driver in the continued use of captives within Europe. Yet, the use of captives in Europe has not reached such deep penetration as in the US and this suggests that there is scope for further growth.

I would expect the number of formations to continue to build across Europe as a result of current trends in corporate governance and risk financing technology. The trend being seen across many major companies is for the retention of larger and more complex risks, which need to be effectively managed from both a governance and financing perspective. This results partly from the limitations of the conventional insurance markets and partly from the increasing willingness of companies to retain risk as a result of the deeper understanding of their own risk that arises out of the enhanced analytics and improved financial modelling available today.

An original version of this article was published in Captive Insurance Times, Issue 69, April 2015.

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