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Hugh's Views for Captive.com Issue 16
[Editor's Note: This is the first of three articles on new developments in captive regulation. Hot on the heels of Hugh's article below, captive.com will publish an interview with Len Crouse, formerly the Deputy Commissioner charged with captive regulation in the State of Vermont, currently working with Towner Management Group as a Partner for US Operations. The third article in the series will be a brief Mancini's Musings reflecting on Hugh's and Len's perspectives on the current state of regulation. We hope you will find this series helpful.]
In the “Basics of Captives” courses I used to run, I would inevitably come to the subject of insurance regulation in general and captive regulation in particular. I would summarize the main points of regulation as I saw them: to protect policyholders, claimants, and shareholders from conscious or unconscious actions or positions of insurance companies. That was followed by the observation that this kind of insurance regulation has been around for a long time, and is aimed at commercial insurance activities, which often mistakenly includes captives. Why mistakenly? Because of that close link between policyholders, claimants and shareholders in captive insurance companies. Still generalizing, I would go on about over- and under- regulation of captives, concluding with the obvious platitude that no regulation is a bad thing for the reputation of captives, but too much is bad for them, too. One of the reasons for the formation of some entities as “captives” is to escape from too much insurance regulation. When pressed for what that means, the answer usually comes back that it is freedom from rate and form filing, which is not to be confused with the obligation for captives to file and explain changes in their business plans. That, by the way, can become as annoying and time-consuming as the dreaded rate and form filing requirement. Most of that was solidly relevant in the “old days” when a captive was a single-owner captive, and wrote no unrelated business. The argument was that captives didn’t really need any insurance regulation because the basic protection of policyholders, claimants and shareholders wasn’t needed. But the protection of the domicile turned out to be more important that the owners realized, and so some basic regulations under some principles-based insurance legislation developed. Then, things changed as some of those single-owner captives wrote unrelated business for tax-defense purposes and began to get into financial difficulty because of it. Group-owned captives, at first owned by a small group of sophisticated buyers, but then owned by a larger groups of not-so-sophisticated buyers emerged. Some of these got into difficulties caused by high expenses and claims outrunning premiums and retained earnings. Early on, it became clear to practitioners and even owners’ groups that total freedom for anything licensed as a “captive” needed some constraints.
As one might expect, new laws and regulations in Bermuda
and onshore developed, defining different kinds of “captives.”
IAIS cites 21 captive types in the Appendix section of their 2008 report
entitled Guidance Paper on the Regulation and Supervision
of Captive Insurance Companies. (see
sidebar
What it means to regulators In my inquiry into what is “good” regulation, I was reminded of the IAIS’ enumeration of 28 principles of good regulation spelled out in the paper entitled Insurance core principles and methodology . Aimed at all regulators everywhere, it was piloted by some of the offshore captive domiciles, notably Guernsey. I am always surprised at the number of people in “the industry” who haven’t read them through. One should, if only to get a feel for what good regulation means to regulators. These principles clearly highlight the purpose of “good regulation” from these supervisors’ point of view. The aim is to protect the good name of the domicile and policyholders: “They [the principles] serve as the basis for assessing the existing supervisory framework and in so doing may identify weaknesses, some of which could affect policyholder protection and market stability.” For “market stability” I read “domicile reputation.” Some more on what good regulation means is to be found in CICA’s “Best Practices for Captives” from last year, a good third of which was devoted to that subject, and the thrust of which was to validate some external financial measures against which regulators should assess captives, and to reveal the regulators’ constant seeking to know (and control) a lot more stuff about captives than they really need to know. And what about the "Global Regulator" that was all the buzz at the recent G20 meeting? Just as the world financial community is seeking a worldwide regulator concept, and maybe even a person or staff to try to handle it, what about having one of them for worldwide insurance regulation, too? Already, the Europeans are seeing if they can come up with the concept to regulate their upcoming Solvency 2 rules, which they have been working on for the last three years, and which won't take effect until 2012. I don't see any progress or even a framework for the pan-European regulator idea. But they recently rejected the notion of allowing big insurance groups like AIG to combine all their assets and capital in favor of country-by-country oversight of their solvency 2 calculations, which actually goes the opposite direction from international regulation. It seems to me that if the forward-thinking Europeans aren't making any progress on cross-border insurance supervision, then there won't be any international insurance regulator emerging any time soon. While waiting for the concept to work its way into a state of disappearance, though, we could do well to take the IAIS' 28 principles of good insurance supervision as a starting point. I say starting point, because even their salutary efforts would not have encouraged one or more of their superviosry bodies to have noticed or called a halt to the excesses on the part of the company that brought AIG to the state it is in today. A few notes on “good regulation” In my experience, captive owners and managers have a lot to say about what makes good regulation at the time of application and formation. Right now, for instance, the attentiveness and eagerness for new business of some of the emerging domiciles makes them attractive to those who are in a hurry. The lamentable state of Arizona’s department makes it slow and difficult to get an application processed there. Of course there are differing capital requirements and premium tax levels and annual fees, but these are more objective comparative features of captive regulation, and are neither good nor bad. One thing that strikes me about these anecdotal reports is the importance of the regulators’ availability and understanding of a captive application. For ongoing captives, the subjects that come up the most are technical and subjective ones. The technical points concerning “good regulation” have to do with how much or how little “risk-based” regulation is applied, since the regulators’ attitude toward that subject, grounded in commercial insurance lore, are invariably more conservative than those of the owners and managers. Another technical issue that comes up a lot is the attitude towards loanbacks to the shareholders – whether to allow any, and how much. And of course the unending discussion of “solvency,” whether this be looking back, the way regulators always do, or looking forward, which is what captive owners and managers would rather do. The subjective issues that seem to come up have to do with the regulators’ perceived understanding of captive insurance to begin with, their understanding of the basics of the owners’ business (not all the details and tax angles, just the basics about workers comp in building risks, or automobile risks, or product liability risks, for instance). Then, there is their attitude towards protection of the captive – whether they should “regulate” how much and with what reinsurers, for instance. Finally, there is the subject of notification of change in business plan. Some regulators are so strict that a big loss that takes down 20% of a captive’s surplus is considered a reason for notification, others want to know about raising retentions or changing fronting companies. Good regulation -- it all comes down to this Even in these technical and subjective anecdotes, what emerges clearly to me, again, is the comprehension and availability of the regulators – and their flexibility to understand the “captive difference” if it comes to having to seek a variance from an accepted practice or rule. You won’t see the league tables of domiciles published in these terms – indeed, as the regulators come and go, and the department budgets wax and wane, they change regularly. But those in the business can tell you. And being good marketers, salesmen, and promoters is definitely not part of good regulation, no matter what those regulators who engage in it will tell you. Hugh’s views In the current financial turmoil and seizing-up of credit and confidence, it is insurance that has emerged in much better shape than the rest of the financial system. Could one argue that this is because of “good regulation” -- the very regulation captive owners and managers grumble about? Could it be possible that the existence of an active, multi-national group of supervisors has produced the unofficial equivalent of the super-regulator that is being called for elsewhere? I don’t think so, alas. The regulatory efforts to codify and supply guidelines have only a little to do with the behaviour and activities of the insurance business, taken as a whole. Good regulation will always be looked upon as a necessary annoyance to captive insurance, as a first line of defense against those entities mis-using captive legislation for commercial business, and as the main argument of legitimacy against the incursions of tax authorities’ continued attempts to disallow captives altogether. It is my view that captives nowadays have indeed improved from the point of view of their own objectives and missions, but that this had much more to do with enlightened management and service providers than it has to do with regulation. 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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