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Captives wake up to tough new rules

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Solvency II, the looming capital adequacy requirements for European insurers that some fear could be burdensome to captive insurers—particularly small ones—are stirring regulators and managers to build their cases for special treatment.

A somewhat clearer picture is expected later this year of how the risk-based framework aimed at establishing the capital adequacy of E.U. insurers and reinsurers will impact captives. The E.U. is planning to complete a preliminary draft of the directive in 2007 and implement Solvency II in 2010.

A concern for captives, sources say, is that Solvency II is expected to require all insurers and reinsurers to use a standard model or develop their own to calculate risk-based solvency requirements, an expensive task, especially for small companies. And, monoline captives could find themselves at an expensive disadvantage under the proposals, some say.

While the rules for Solvency II have yet to be outlined, there's no indication that captives will be able to escape the regulation.

Onerous

"The theory is that Solvency II will apply to all insurers and reinsurers that are regulated," said Philip Whittingham, risk competence team leader at KPMG in London.

"Direct and reinsurance captives—there is no difference in Solvency II," said Victor Rod, president of the management board of the insurance commission of Luxembourg. "Each and every member state will have to apply Solvency II to all captives."

Some worry that because implementation seems far away, captives are not yet considering Solvency II's potential impact.

"It is a big, onerous requirement," said Mr. Whittingham. Captives and their managers should be "lobbying to have reduced requirements," he said.

"At the moment, if you look at it completely in isolation, I think that Solvency II could have a dramatic impact on captives," said David Stafford, European regional director with AIG Insurance Management Services in Dublin.

Most captives and captive managers "don't have the actuarial resources to actively participate" in the shaping of complex Solvency II requirements, said Mr. Stafford. "That really hasn't happened."

Dublin's managers and regulators, however, are being stirred to action by Solvency II's potential impact. Mr. Stafford pointed out that, through the Dublin Insurance Managers Association, managers are seeking actuarial help to determine what impact the requirements could have on themselves and their clients.

Mike Frazer, deputy head of the Irish Financial Services Regulatory Authority's insurance supervision department in Dublin, said that regulators in that domicile are "very significantly involved" in making captives' concerns known to the drafters of Solvency II.

"What we're finding is that something like captives isn't high on the agenda" in some of the E.U. countries where the directive will be required, he said. "They don't register at all for some countries. We are looking at it from a different perspective, given their importance here. "And that's one of the things that we are trying to bring to the table," Mr. Frazer said.

Sources say there is a danger that small insurers could be burdened with the same requirements under Solvency II as large insurers that can more easily implement them. Small captives and other insurers could, for example, be forced to develop complex and costly in-house models or have a standard model imposed upon them, they say.

Regulators in Malta, the youngest E.U. captive domicile, hope to create a flexible "national model" that would be bounded by parameters set forth in Solvency II yet allow the regulators to "tune it to each and every particular company," said Joseph Bannister, chairman and president of the Malta Financial Services Authority. Such a model would save companies from bearing the expense of developing their own models or gearing up to apply a one-size-fits-all standard model, he explained.

Diversification

Mr. Whittingham noted that another potential problem looms under Solvency II for captives that do not have a diversified book of business. "You can claim a diversification benefit if you are a property/casualty company," which is likely to allow less onerous capital requirements for those insurers, he said. "But you lose that benefit within a book of monoline business."

In the end, Solvency II may not have as great an impact on captive formations as more traditional issues, according to some experts.

"I don't think regulation affects setting up a captive," said Marisa Attard, director of insurance at the Malta Financial Services Authority. "I think it's the market conditions; it's how costly it is to obtain reinsurance, how risk-aware the shareholders are, whether they wish to share that risk or assume it. I don't think regulations scare captives, from our limited experience."

In fact, she noted, captives generally are happy when they are well-regulated. "That is the feeling that we get."