Will Regulatory Reform Trigger Doomsday for Captives?

If you’re startled by this headline, you’re not alone. Until recently, the words “reform” and “captive” were rarely used in the same sentence. That’s because captive insurance companies have long been immune to traditional insurance company regulation because of their special characteristics.

Should captives be more heavily regulated?

Many argue that captive insurance companies deserve a special place in regulatory regimes because they:

• Are specialist underwriters primarily limited to writing the risks of their owners.
• Have limited investment assets compared to traditional insurers.
• Are often operated and managed by outsourced experts, with fewer resources to devote to compliance.
• Use policy language related to owner concerns.
• Perform uniquely, not following typical insurance cycles.
• Are not subject to the law of large numbers like traditional insurers.

These are compelling arguments — especially for those who understand that regulatory flexibility has been one of the primary advantages to domiciling a captive insurance company offshore.

However, the formerly benign regulation of the captive segment is about to change. For the first time, captive owners and managers must contemplate the likelihood that regulatory flexibility may be sharply curtailed by regulations put into place in the wake of the most recent financial crisis. For the first time, traditional insurance and captive regulation are converging.

While it can be argued that regulations spawned by Sarbanes-Oxley and FINRA have had little effect on the captive market, that reasoning ignores three unintended consequences of these legislative efforts:

• The cost of compliance has caused financial officers to critically evaluate captive effectiveness in detail.
• The general desire to achieve greater capital efficiency has caused senior management to drill down into areas of operations previously ignored. Many existing captives will not fare well when exposed to intense management scrutiny.
• In anticipation of possible captive exits, there is already a substantial amount of insurance company surplus earmarked for potential captive runoff.

The United States legislative acts pale in significance when compared to Solvency II, the European Union effort to regulate insurers. Solvency II is intended to reform insurance regulation, provide a safety net for policyholders and support market stability. It is scheduled to take effect June 2013, with full implementation by January 2014. Solvency II will place increased demands for compliance on the entire insurance industry, including captives. It is a risk-based regulatory effort with a high-level focus on the scale and complexity of risks. As such, it is driven more by risk management than by modeling.

While Solvency II pertains to European Union members only, several major offshore captive domiciles have made significant progress toward obtaining equivalence under the proposed Solvency II regulations, Bermuda being the most notable. Such certification means that the EU regulators agree to accept the non-EU applicants’ regulations as acceptable under Solvency II, or “equivalent.”

Just as important, several competing (offshore) domiciles, presumably seeking competitive advantage, have announced that they will neither comply with the requirements nor seek equivalence. The United States, with separate state jurisdictions and limited federal regulation of insurance, will have significant political and practical problems complying with Solvency II — essentially seen as a “continental regulatory issue.”

In Every Challenge Lies Opportunity

There’s no question that Solvency II will present both a challenge and an opportunity for U.S. captive regulators. Naturally, the opportunity will come in the form of offshore captives fleeing domiciles that choose to meet Solvency II equivalence tests for captive insurers. This quasi-forced re-domestication will present a new and fresh pool of applicants for licensing by new and mature U.S. domiciles. As with any significant change in a regulated environment, challenges will accompany opportunities. For example:

• If re-domestication occurs from a Solvency II-affected domicile, what will be the attitude of the regulator toward the captive, the fronting carrier and the reinsurer(s)?
• Is there a likelihood that only captives with compliance issues will re-domicile, and if so, what safeguards need to be in place to ensure that the state’s captive insurance department is not simply licensing companies that are likely to incur future impairment?
• Should the captive licensing and regulatory capital requirements of companies seeking re-domestication be considered in a different light than new applications?

Although captive formations have slowed in recent years due to the soft insurance market, that trend is likely to reverse as the economy recovers and the market hardens. When alternative risk management becomes popular again, new captive formations and re- domiciliation requests could swamp the existing captive insurance divisions of state regulatory departments. If this occurs, which class of new applicants will take precedence — those with a performance history returning to the U.S. to avoid Solvency II or new captive formations? These are questions that each regulator and state insurance department must consider.

Whatever regulatory methodology is eventually adopted, the challenges ahead for all captives will hinge on whether regulations are geared for captive complexity, the cost of compliance, minimum solvency requirements and the methodology used to meet regulatory approval. These are different and more sophisticated issues than many captive leaders have dealt with in the past.

Back to the Future

While the future is difficult to predict, the results of new regulations will likely be:

• The cost of compliance will increase for domestic captives, as well as those subject to Solvency II.
• Some captive insurance companies will be unable or unwilling to access resources to pay for compliance.
• Formerly inattentive financial officers will apply a new, high-level focus to captive operations to meet capital efficiency requirements and to contain reputational risk.

Some offshore captives, especially those in Bermuda, may look to re-domicile to the United States to avoid Solvency II requirements. Others, especially high-performing captives, may be delighted to remain in a domicile with high-compliance requirements.

There will be a significant runoff and/or sale of captive liabilities as companies cease funding for marginal operations.

New Day, Not Doomsday

The current regulatory changes are so remarkable and profound that the entire face of the captive risk transfer market may be altered by the results of their implementation. For captives around the globe, the next two years will represent a new day, but not necessarily doomsday.

Smart captive leaders will proactively prepare now to position their organizations for a brighter, albeit more regulated, future.