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Issue 13 -- November 2006
I have been following the activities of the International Association of Insurance Supervisors (IAIS) since its beginning, and have sympathized with those among them who represented captive domiciles and who tried to uphold “the captive difference” as the IAIS developed and published their Insurance Core Principals. There are 28 of them, and they are principles for the regulation of insurance by regulators. There are such big differences between commercial insurers and captives, that something was needed to alert regulators to the different requirements for regulating captives. Their paper “Issues Paper on the Regulation and Supervision of Captive Insurance Companies” that they released last October at their Beijing meeting goes a long way towards explaining these differences, and towards heading off the application of general insurance supervision standards to all regulated captives. The Issues paper is not a set of standards, nor even a guidance paper, but it is easy to understand that there will be one or more coming out of the IAIS soon. The 53-page paper covers a wide range of topics, and is meant to serve as a reference for jurisdictions thinking of licensing captives for the first time, and for those in established domiciles who need to be reminded of the “basics of captives” as they are understood by the regulators. Hugh’s overview: I usually have a lot to disagree with when I read through a new “basics of captives” paper, but I had surprisingly little to criticize in this one. It is very thorough, if devoid of any examples. It is also heavily oriented towards single-owner captives, with only passing mention of group-owned captives. And it mostly misses the point that many of the advantages of a captive for single owners are enjoyed more by the business units than by the captive-owning group.
It reveals a great deal of unease about captives writing long-tail liability lines, and reveals the importance the drafters put in good solid reinsurance behind captives (although good risk management just might reduce that importance, they point out!) . It has a great number of insights from a group of captive domicile supervisors that will be of great interest to captive owners and service providers. Here are some of them: Another captive definition: Here’s theirs: “an insurance or reinsurance entity created and owned, directly or indirectly, by one or more industrial, commercial, or financial entities, the purpose of which is to provide insurance or reinsurance cover for risks of the entity or entities to which it belongs, or for entities connected to those entities and only a small part If any of its exposure is related to providing insurance or reinsurance to other parties.” Principal rationale for captives: This is theirs: “The principal rationale for captive insurance companies arises from the greater level of physical risk control exercised by the parent company and the consequently reduced physical risk which permits the insurance program to be placed at a lower level than the insurance market can offer.” Physical risk? Reveals the property orientation of many of the drafters, I think. On reinsurance: The paper extols the virtues of reinsurance in several places. Here are some revealing points I picked up: “Excess of loss (nonproportional) reinsurance lends itself to high value/low frequency exposures and quota share (proportional) reinsurance to low value/high frequency business.” “Captives with a high percentage of reinsured risk will probably have reinsurance recoverables as their largest asset.” Surprising to me, especially since their point of view is mainly for property-writing captives. ..and this gem: “Reinsurance of captives is regarded as one of the more profitable sectors of reinsurance because captive risks tend to be good risks.” On PORCS (Producer-owned reinsurance companies): “There are additional risks associated with these companies since the producer could be in a position to influence he placing the business with its own captive and could control the level of premiums or commissions that apply….There may be a need for additional corporate governance and transparency requirements to apply to PORCS to mitigate the risk of abuse.” The IAIS reasons for captives: All such documents have a list of them, and here is theirs. The first one mentioned is tax reasons, of course, and then, in this order:
On misuses of captives: We don’t often hear about fraud and money laundering when talking to regulators, but insurance regulators, particularly those offshore, are constantly on the lookout for them. PORCS are singled out in this section of the paper, incidentally, using the example of the abuse of title insurance in the US On captive management: “It is not unusual for the client of a major broking group to a different group as captive manager and this action may be considered from a prudent governance angle.” Well, well. If the regulators are repeating what the independent management companies have been saying all along, there must be something in it! On capitalization: I was struck with the repetition in several places of the importance of demonstrating to the regulator that additional capital would be available if needed. Reading between the lines, it appeared to me that this would relieve some of the requirements for covering the “risk gap” in full, and, in its absence, would be a reason for regulators requiring more capital up front. See below for more on the risk gap. On fit and proper persons: While the paper goes into some detail about the importance of the right people, they recognize that captive owners have good managers and consultants, and “supervisors usually do not assess the fitness and propriety of captive owners on the basis of whether the owner or its board has sufficient experience in insurance. Supervisors find it more important to examine the suitability of those assigned to manage the risk placed within the captive.” Which presumably includes the risk manager. On inspections by supervisors: They should undertake office reviews and visits to the managers, but It all boils down to : solvency, asset quality and the adequacy of technical provisions. On corporate governance: The issue paper is a bit thin on this topic, but makes up for it by stating plainly in the section on risk management that “Altogether the risk management system in place in a captive may be significantly different from that of a commercial insurer. Supervisors, when setting requirements or providing guidance on risk management systems, may incorporate these differences into their guidance.” I would like to believe that “different” means “better.” On setting reserves: “Captive jurisdictions usually provide some kind oif flexibility, often on a case-by-case basis, to allow a captive to set its technical provisions using methods that may differ from those applied by commercial insurers.” On collateral: I was amazed to read what things have come to in this revealing statement about captive assets: “If there is a fronting insurer, most of the captive’s assets will either be held by the fronting insurer as security against losses, or the captive’s assets will be used as collateral for other financial guarantees to the fronting insurer, such as a letter of credit.” One small advantage to collateral: “Where there is a contractual requirement by a fronting insurer for the captive to deposit collateral and because this is usually in the form of cash or an irrevocable letter of credit, this arrangement reduces the financial risk to the captive and therefore the level of solvency required.” On investment counterparty risks: The issues paper warns against concentrating assets in the hands of the same bank: “Ignorance of the markets and desired conservatism can occasionally lead to inappropriate practices such as excessive exposure to counterparty risk, especially the captive’s bank.” And, they say: “Captive owners and their insurance managers may simply not wish to devote management time to outsourcing investment management to sophisticated investment houses but will rely on their own bankers to place funds. The majority of captives around the world probably fall into this category..” I don’t know where their “majority” figure comes from, probably from numerous smaller captives, but I estimate, from what I hear, that the majority of captive assets aren’t left with the banks, but are under management.. On Solvency: This section makes the most interesting reading. Short of quoting the whole thing, here are some salient points: “The difference in risk between captives and commercial underwriters will be acknowledged when reviewing captive jurisdictions .” For instance, “In the light of a higher probability of accurate ultimate loss reserves in a captive it is unreasonable for solvency levels that would be applied to a commercial insurer to be applied to a captive.” I bet the European Reinsurance Directive drafters didn’t think of that difference! On the Risk Gap: Defined as “the total of a captive’s net retained liability less year one premiums (italics mine) net of expenses, capital, profit balance, and any other free reserves.” “Captive owners and managers are required to demonstrate how the captive manages the risk gap. Protection strategies may include guarantees of additional capital or premiums, LOCs, or other alternatives in a form acceptable to the supervisor.” It is encouraging to see how risk-based assessment of captives is becoming more reasonable. Or at least the IAIS says it ought to be more reasonable than a simple formula. On Disclosure: For a long time Alan Fleming strove to exempt captives from this requirement, and language to that effect is included in this paper. Bravo! At the end: The whole document is downloadable from www.iaisweb.org. Read it if you have the time. Can't get enough of Hugh's oft-irreverent views? You're in luck! Follow this link to all of Hugh's pearls of wisdom:
Hugh Rosenbaum, one of captive.com's friends and valued contributors, is a freelance consultant. Hugh can be reached by telephone at +4420 8883 6729 or by e-mail at hughro2@yahoo.com. Learn how you can spend a day with Hugh! Visit Hugh's Captive Consulting and Music Websites
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