Originally published in Insurance Insight,25 May 2012

Fiona Le Poidevin, Deputy Chief Executive of Guernsey Finance – the promotional agency for the Island's finance industry, looks at the factors which a third country has to assess when considering whether or not to seek equivalence with Solvency II.

Across the insurance industry there has been one issue in particular which has received more attention than any other in the last couple of years, Solvency II. The EU's proposed regulatory regime for insurance and reinsurance business has been heavily debated and its introduction much anticipated. Jurisdictions which are not part of the EU, such as Guernsey, are not required to adopt the regime and these so-called 'third countries' can choose whether or not to seek equivalence under Solvency II.

The uncertainty surrounding Solvency II's final form, the practical implications and the timing of its introduction has been causing some angst around Europe and it has also hampered the decision making process for third countries. Guernsey opted for certainty when, in January 2011, the Island's government and the financial services regulator, the Guernsey Financial Services Commission (GFSC), issued a joint statement announcing that there were no plans to seek equivalence under Solvency II.

Guernsey's announcement provided current and potential clients with certainty and it was primarily based on the understanding that, unless there were significant amendments to the Solvency II terms and conditions, then seeking equivalence was not in the best interests of Guernsey's insurance industry.

Solvency II has been designed to address systemic and group risks within commercial insurance markets, yet, these are risks not generally faced within Guernsey's insurance industry, which is predominantly comprised of captive insurance companies. A captive is usually formed for a specific purpose, primarily self-insurance and it is called a 'captive' because, in its purest form, it is set up by its owners only to insure the risks of its parent and/or fellow subsidiaries. The concept is reliant on the ability to be flexible and adaptable in order to ensure that risks are managed in the most cost-efficient and capital-efficient way for the parental group.

In recognition of the diverse nature of insurance vehicles, including captives, the International Association of Insurance Supervisors (IAIS) is not prescriptive in its regulatory demands. Indeed, most captive supervisors apply regulatory levels which appear low by commercial insurer standards but which allow the captive's parent to achieve its optimal risk management arrangements without unnecessarily hindering the efficient use of scarce capital resources.

Under the current proposals, Solvency II is set to impose a number of inflexible requirements. It is for this reason and not because captives are inherently risky, that 30% of European captives are failing to meet the Solvency Capital Requirements of Solvency II, according to the European Captive Insurance and Reinsurance Owners Association (ECIROA) report published in May 2011.

Karel van Hulle, Head of Unit, Insurance and Pensions, DG Internal Market and Services, and the architect of Solvency II, has been quoted as stating that the special nature of captives will be accounted for in the final rules and that the commission will make sure they receive proportional treatment when the Directive is finally introduced in January 2014. However, it is unclear what this means or if any action will be taken at all. The European Insurance and Occupational Pensions Authority (EIOPA) which advises the EU on the detailed implementation plans for Solvency II has been rather reluctant to bring any meaningful proportionality to the table for captives.

Guernsey believes applying Solvency II as it is currently constructed would burden insurers in the Island with additional costs and render currently effective captive business plans uneconomic. Only by remaining outside of the regime can it ensure that it is able to continue to offer a viable set of captive products and services. Guernsey will continue to meet the standards of the IAIS – in January 2011, the IMF commended the Island for having high levels of compliance with the 28 insurance core principles of the IAIS – however, its proportionality principles mean that we will provide a more attractive environment for captive owners and other niche insurers.

Other non-EU jurisdictions such as Bermuda and Switzerland are adopting a different stance. These countries were in the first wave of equivalence applications. They were not seeking equivalence for their captives but to protect their international commercial reinsurance industries and Bermuda in particular is seeking to mitigate the impact on its captive insurance business.

If Bermuda is able to achieve an equivalence assessment which excludes application to captives then it will have a competitive advantage over the EU domiciles regarding captive solvency requirements, albeit that the Bermuda captive won't have passporting rights under the EU freedom of services legislation. However, if Bermuda does not achieve equivalence without including its captives into the equation then this will place an unnecessary burden on its US owned captives, for whom Solvency II is not relevant. It will also mean that European owners of captives will suffer the additional capital requirements but without the passporting rights which EU captives enjoy.

Third countries do have to consider that not seeking equivalence will mean that 'fronting' insurers will continue to be required to access EU markets. Yet, this will simply be a continuation of the status quo for those jurisdictions and in addition, the previously mooted increases in fronting costs are now being considered unlikely by industry experts.

At the time of writing, there is still a degree of uncertainty surrounding equivalence and what this means for third countries. Officials in Guernsey understand that the finalisation of the transitional provisions may depend on the actions of the European Parliament and the European Council. Until their position is understood, there will remain a degree of uncertainty about the equivalence process and how it will progress. On this basis, Guernsey remains committed to the policy outlined in January 2011 that it is not currently seeking equivalence under Solvency II.

There has been positive feedback to this decision from captive owners already using Guernsey, as well as potential clients. Indeed, figures show that the Guernsey Financial Services Commission (GFSC) licensed 72 international insurers during 2011 – a 53% increase from the 47 approved during 2010. These were across the range of entities from conventional captive insurance companies, PCCs (Protected Cell Companies), ICCs (Incorporated Cell Companies) and in particular, PCC and ICC cells.

We believe that this growth in new business is the result, at least in part, of our decision not to seek equivalence with Solvency II. Indeed, Guernsey's proposition may be attractive for captive owners and their insurance vehicles currently based within EU domiciles, especially where they are writing business outside the EU. This may become increasingly so if the uncertainty regarding Solvency II continues and/or if the implications for captives appear particularly onerous.

For more information about Guernsey's finance industry please visit www.guernseyfinance.com.

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