Domiciles can achieve competitive advantage by applying ICP 17 and reducing capital requirements for lowest risk captives, says Martin Le Pelley, Chairman of the Guernsey International Insurance Association.

With so much attention being placed on the impact of Solvency II on EU captive domiciles and those jurisdictions seeking equivalence with Solvency II, some may have overlooked the fact that the International Association of Insurance Supervisors updated its Insurance Core Principles in October 2011.

It is the adherence to the IAIS core principles which the IMF use to assess the preparedness of jurisdictions in compliance with international regulations and maintenance of financial stability. As such, not only are the ICPs more important for comparability of jurisdictions than Solvency II, but furthermore, they will be difficult for jurisdictions to "opt out" of without risking being perceived as behind the curve in terms of risk-based regulatory best practice.

Solvency II, as a regulatory regime, is almost certainly fully compliant with the IAIS Core Principles, as the EU regulatory regime was developed with the changing ICPs in mind, and the architects of Solvency II will also have been key players in the development of the ICPs.

This means that captives which are located within the EU and which are capable of meeting the requirements of the new regulations in a cost-efficient way will have nothing to worry about in relation to compliance with insurance regulatory best practice. Of course, many may struggle to comply, and the fine tuning of Solvency II is taking much longer than anticipated due to the ongoing Eurozone credit crisis. However, if we put aside the significant economic pitfalls which continue to blight Europe, it could be argued that the EU is well progressed in meeting the ICPs.

In the rest of the world, the regulatory community is waking up to the need to amend their regulations to continue to comply with the ICPs. In particular the revised ICP 17 on Capital Adequacy is a significant step forward from the previous prudential regulatory principles. This risk-based solvency principle does allow more flexibility than is built into Solvency II – for instance there is no prescriptive confidence level requirement for capital adequacy, unlike Solvency II which requires a 99.5% VaR confidence.

However, there is a requirement to set a confidence level, and to assess licensees against the stated confidence level. This means, therefore that the supervisor must have the capability to develop risk-based solvency requirements based around a stated solvency, and licensees must have the capability to assess themselves against the requirements.

Captive domiciles, in particular, are aware that 99.5% VaR is likely to be overly prudent in relation to the simple risk profile of a captive, where the parent company's risk appetite is the driver (but is unlikely to have been defined with clarity), however the determination of a different confidence level is, itself, a challenge, as the supervisor will need to justify their choice of confidence level, and explain why they are, potentially, out of line with other insurance domiciles.

The "prescribed capital requirement (PCR)" is the capital level which is determined by applying the confidence level to the various risks associated with the insurer, such that the PCR should represent a "solvency control level above which the supervisor does not intervene on capital adequacy grounds" per ICP 17.4. In Solvency II the Solvency Capital Requirement (SCR) is this regulatory regime's PCR.

The choice of confidence level is not the only challenge faced by captive supervisors, as the ICP also requires supervisors to put in place a "range of different intervention actions" depending on the point at which the insurer's capital falls below the PCR but remains above the minimum capital requirement (MCR). If a supervisor sets the PCR too high, then it risks requiring insurers to hold too much capital and may need to intervene regularly when capital levels fall short. On the other hand, if the PCR is set too low, then the jurisdiction may be seen as "light touch" or "high risk" in relation to the capital requirements for insurers, especially when the supervisor should not intervene if the insurer is capitalised in excess of its PCR.

Furthermore, what does "range of different intervention actions" actually mean? Do supervisors need to stipulate when they will take action, and what action that will be? If they are not prescriptive then there is a risk that captive boards will be paranoid about breaching the PCR, even if they regard the capital requirement as excessive, such that their concerns about compliance may outweigh their concerns about effective use of capital. On the other hand, if the supervisor is too explicit in terms of intervention actions, this may inadvertently lead to captive boards routinely breaching their PCR on the basis that the regulatory intervention is more tolerable than holding more capital. If the PCR is routinely breached, then its effectiveness as a capital adequacy measure becomes significantly weakened.

In Guernsey, which is the largest European captive domicile (and outside of the EU) the supervisor is actively considering ways to engineer compliance with the new ICP 17 in such a way as to continue to make Guernsey attractive as a captive domicile (and more attractive than the EU) whilst ensuring that the island is fully compliant with the material requirements of ICP 17.

Conversely, Bermuda, which is seeking Solvency II equivalence for its commercial insurers, is looking to exempt its captives from the requirements of equivalence. Does this indicate that Bermuda may be looking to avoid compliance with ICP 17? There does not appear to have been any attempt to bring the captive regulations in Bermuda up to the requirements of ICP 17 yet?

The USA is a significant captive domicile in its own right, with a number of States enacting captive legislation, and Vermont continuing to occupy the position of one of the largest captive domiciles in the world. However, will any of these States change their capital requirements to enable compliance with ICP 17? If not, does this mean that the USA will be regarded as non-compliant with international regulatory best practice by the IMF?

The IAIS has not yet published any guidance as to how to apply ICP 17 to captive supervision. Under the previous core principles, the IAIS published a Captive Guidance Paper to help supervisors in their application of the requirements of the core principles. This paper has not yet been updated for the new core principles, such that, when it is, it may be the case that the Bermuda approach (and the EU supervisory approach for insurers writing less than €5m gross premiums) which is to disregard ICP17 may be appropriate.

However, jurisdictions which seek to avoid implementing the requirements of ICP 17 may be missing an opportunity. The IAIS is much more aware of the differences in the variety of insurance vehicles around the world than the European Commission is. They understand that for regulations to be effective they must be appropriate for the types of risk inherent in the large variety of insurance vehicles. It is for this reason that the Core Principles allow flexibility to ensure supervisors can adhere to the intention of the Core Principle by adopting regulations which are tailored specifically to the market under supervision. For captive insurance, this means ensuring that the regulatory regime is risk-based, firstly, and secondly is proportionate to the risks being run by the insurers, which in the case of captive insurers are limited and easily defined.

As a consequence, there is competitive advantage to be had by supervisors who can apply ICP 17 in such a way as to reduce capital requirements for the lowest risk captives, and increase capital requirements for those captives involved in more complex risk, including third party liability risks. The key will be for the supervisor to properly understand the risks in the market, and develop regulations which not only respond adequately to those risks, whilst minimising unnecessary regulatory capital requirements, but also comply with ICP 17 to enable the international community to better appreciate that not all insurers are the same, and that a proper risk-based capital adequacy regime is actually in the interests of all insurers, including captives.

The problem for EU captive domiciles is that the European Commission failed in its drafting of Solvency II to appreciate the breadth of different types of insurers, and draft sufficiently flexible risk-based regulations to cater for them all.

I am still hopeful that, one day, this will happen, but in the meantime, there are opportunities for those domiciles that do have this appreciation and can act on it.

Originally published in Captive Review, September 2012

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