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Solvency II complicates captive strategies

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The implementation of Solvency II in Europe has provided an additional risk management tool to owners of European captives, but at a cost, forcing risk managers to re-examine whether they are getting the best use out of their captives.

Solvency II, the European Union-wide risk-based capital rules for insurers and reinsurers, came into force in January 2016, and with it came new elements that have affected captives, for better or for worse.

“What we’re seeing as managers is an increased interest in strategic reviews and companies re-examining the captives to explore optimization opportunities and thus potentially expanding the captive by including additional risks not considered prior to Solvency II,” said Derek Bridgeman, vice president and Solvency II leader EU for the Marsh Captive Solutions group based in Dublin. “Solvency II does demand that the owners and risk managers have a better understanding of the risks and drivers which will benefit overall risk management.”

The positive aspects of Solvency II include increased transparency in terms of capital adequacy, an easier ability for regulators to compare captives with peers because of more consistent reporting, added certainty for parent owners with regard to financial strengths because of the requirement to maintain a capital ratio of at least 100%, and increased risk awareness and management, said Paul Wöhrmann, head of captive services commercial insurance in Europe, Middle East, Asia-Pacific and Latin America for Zurich Insurance Group Ltd. based in Zurich.

A 100% ratio under Solvency II means an insurer’s capital is sufficient to withstand an event expected to occur once every 200 years.

The Own Risk and Assessment provisions, considered a key element of Solvency II, provides a process for captive owners and insurance companies to think through their risk profiles, tolerance and underwriting strategies.

“In a nutshell, it’s a useful risk management tool so that the captive or the insurance company gets deep insight into its risk,” he said. “We see it as a positive on the impact of Solvency II if the company didn’t have it in place already, but, of course, it is some work to put this together, so it is one of the additional burdens as well.” 

Some captive owners are using the diversification benefits that Solvency II offers to bring in new lines, such as employee benefits, and restructuring to take advantage of the fact that well-diversified captives are subject to lower capital requirements.

“The previous regime was quite simplistic in its capital calculation and did not reward prudent risk management such as diversification of risk within the captive program,” Mr. Bridgeman said. “Solvency II does, however, reward such prudent decision-making. Another benefit of Solvency II for owners is that it provides an increased flexibility, particularly around investments, that was not available to owners under the previous regime.”

However, there have been additional management, actuarial and other costs associated with Solvency II compliance.

“The cost burden has been a strain for the smaller captives, not so much the larger ones,” Mr. Wöhrmann said. “They require some mathematical expertise to calculate the Pillar 1 requirements.”

Pillar 1 refers to the insurer demonstrating the adequacy of its financial resources to meet all liabilities and features a solvency capital requirement and a minimum capital requirement.

“Now everything is risk-based, so everything has to be calculated more carefully in terms of the assets and the liability side,” he said. “There’s also the cost of writing these documents. Generally, the costs have been borne well by the industry. People have taken this in a positive way because they’re getting a lot of risk insight and knowledge about the insurance business.” 

Several captive owners responded to the increased costs and regulatory requirements associated with Solvency II by shutting down their captives prior to the regime taking effect, although some of these moves may have also been partly driven by a desire to domicile a captive in the same jurisdiction as the corporate headquarters or take advantage of a favorable insurance market for buyers, experts say.

“There were a number of captives that closed down in the lead-up to Solvency II because they didn’t want to have to meet the capital requirements, and/or from a pricing perspective they thought, ‘We could do just as well in the market, we don’t really need a captive,’” said Elizabeth Bothwell, partner with law firm Arthur Cox based in Dublin. “For certain businesses, it wasn’t making economic sense anymore.”

Other owners with multiple captives have consolidated the exposures into one captive, while at least one major company, The Coca-Cola Co., relocated the risk in its Solvency II-domiciled captive to a domicile outside of the regime.

Solvency II is applied to captives using the “principle of proportionality” to consider the relative size and complexity of captives, which could mean that national regulators could impose lighter reporting requirements on captives than on commercial insurers, but some guidance from regulators would be welcome, experts say.

“How (the national regulators) implement that and the level of proportionality they apply to the captives is going to be important, because the overall aim of Solvency II is to create this harmonized approach,” Mr. Bridgeman said. “There is going to be clarification required from the regulators in terms of how they are applying proportionality so we can achieve that harmonization. That will be the main thing to come from the early years of implementation.”