Originally published in Captive Review, October 2010

This is an era of unprecedented international pressure towards a global order and towards the domination of the regulation of financial services by major economies and trading blocks. This may fly in the face of common sense given their previous poor record in the area as witnessed by the credit crunch and subsequent economic depression but it is nevertheless a political reality. Modern professional politicians appear to be often motivated by a desire to control rather than to serve, despite multiple examples of the futility or damage often caused by their well-meaning but misguided intervention and the evidence of their very public failure to prevent the recent financial crisis and other calamitous events.

At least in the past they have focused their interest on their own jurisdiction and visited the inevitable poor outcomes on those who have elected them: there is, you might say, some poetic justice in this.

However, increasingly they find that globalisation is undermining their ability to intervene effectively. Increases in the burden of regulation serve merely to undermine the competitiveness of their own finance industry and the most likely result is not the desired one (to be seen to be doing something about perceived risks) nor even the likely one (the addition of cost without any significant improvement in the risks supposedly being reduced), but the exodus of business and capital to other more pragmatic regulatory jurisdictions that allow legitimate business to be conducted more efficiently.

The global financial crisis has led to public pressure to do something, anything, to prevent a similar disaster happening again. In their increasingly desperate attempts to be seen to be effective in controlling the finance industry, politicians and regulators are seeking to act collectively to create a global consensus around a regulatory regime on which everyone might agree: not the lowest common denominator (i.e. lightest touch) but rather the highest, showing the public that they 'mean business'.

This is predicated on the assumption that prescriptive regulation is the most effective means of controlling risk in financial services; coupled with a realisation that regulation can be an effective means of influencing cross border trade

A good example of this is the attempt by the EU to impose equivalence on the international captive insurance industry under their proposed Solvency II regime. It is of course entirely reasonable for the EU to seek to restrict the admissibility of reinsurance assets purchased by the companies it regulates from entities outside its control. On the face of it there may seem to be a number of reasons why an independent jurisdiction might wish to consider pursuing EU regulatory equivalence and thereby ensure the admissibility of its reinsurers' assets by the EU. However, in reality the cost benefit analysis of doing this is unproven and involves uncertainty - hardly the basis for making a key strategic policy decision.

How high will you need to jump?

The short answer here is that no-one needs to jump. However, there are some requirements hard-wired into the Solvency II regulations that will establish a bar significantly above current (and arguably adequate) requirements, for example in relation to regulatory capital and disclosure standards. That said there are a number of other areas in which it can reasonably be expected that regulatory standards will need to be increased substantially above existing (and again arguably adequate) international standards, including those recommended by the International Association of Insurance Supervisors (IAIS).

The precise criteria on which each jurisdiction might be granted equivalence is subject to negotiation and shrouded in mystery as to date only vague guidance has been forthcoming. Some optimists in small jurisdictions are hoping for a two tier system in which international insurers will be able to elect for the existing regulatory regime or a more restrictive equivalent one at their own discretion. Certainly this would be an acceptable compromise though it is difficult to imagine why anyone would elect for the equivalent regime rather than simply relocate to the EU where they would have the benefit of EU wide market access under freedom of services rules.

And how high will the bar get?

Of course the EU is keen to get other jurisdictions to sign up for equivalence as they are seeking to establish their regime as the basis of global regulatory standards. This agenda will be pursued not only through the active selling of the concept by the drivers of Solvency II, but also through the membership of EU national regulators of the IAIS where many will be promoting the incorporation of EU standards within the IAIS's core principles. We can only hope that other members of the IAIS have the good sense and courage to resist such attempts.

There is also the risk that current standards may not remain the same for very long. Once signed up to equivalence, jurisdictions will have to constantly enhance their regulatory requirements in order to preserve their equivalent status. By this means the EU will hope to exercise its influence far beyond its own membership and curtail the efficiency of more appropriately regulated jurisdictions.

How green is the grass on the other side of the fence?

Advantages claimed for equivalence range from the inaccurate, to the irrelevant, occasionally via the fanciful.

Many small, independent jurisdictions have insurance industries comprising a small domestic insurance sector and a significantly larger international sector. This latter is made up mainly of insurance subsidiaries of international companies and groups providing risk financing services within their corporate insurance programmes( that is to say what is often referred to colloquially as 'captive' insurance companies) with smaller numbers of international life companies and, in a few circumstances, a discreet number of commercial insurers and/or reinsurers.

Generally their regulatory regimes reflect the unusual risk profile inherent in the business they oversee and providing a flexible, pragmatic business environment in which captive insurance has flourished and delivered great value to captive owners. Insurance failures are rare (and certainly far rarer than in major jurisdictions) due to the high level of cooperation and communication between regulator and industry.

For many small independent jurisdictions the overwhelming majority of their business is captives of one sort or another. Many of these act as reinsurers to commercial carriers who provide and service the direct policies issued to the owner of the captive and to its sister companies. These carriers are commonly referred to as 'fronters' in this context.

It is held in some quarters that regulatory equivalence will better facilitate fronting arrangements of insurance into the EU by ensuring that the reinsurance asset provided to the fronting insurer by the captive is recognised as such within the calculation of regulatory capital by the fronting insurer. This is, as far as can be determined at this point, inaccurate since commercial fronting insurers have never themselves recognised the validity of captive reinsurance assets and have always ensured that such assets are fully secured, typically by Letters of Credit issued by rated banks. The asset relevant to their assessment of risk is therefore not the unrated and non-equivalent captive but the rated bank.

It is believed by some that the achievement of equivalence will facilitate the attraction of commercial reinsurance companies to the jurisdictions that achieve it. This is irrelevant as there is no reason to believe that the formation of reinsurance companies in the future will be more prevalent than in the past. Since 2005, and ignoring domestic reinsurers and Lloyds syndicates, very few commercial reinsurance companies have been formed, and fewer still have been established in traditional independent jurisdictions. From my research I cannot find a single example of any commercial reinsurer or insurer ever migrating to an independent jurisdiction from a mainstream one.

There are those who assert that equivalence is part of the inevitable march of history as the world moves into a new era of ever closer global cooperation on regulation. This is unrealistic. Solvency II implementation is still not cut and dried. Global cooperation in a wider global context is an even more fanciful concept involving the ceding by proud nations of their right to determine the regulation appropriate to their very diverse local needs.

Some have alluded to the need to adopt the highest regulatory standards in order to maintain the international reputation of the jurisdiction. However, this is a red herring: whoever would judge their own reputation on the opinion of and against standards set by their competitors? There are objective assessments made of the quality of a jurisdiction and the only reputation that ultimately matters is that of ones customers.

In short there are no really hard reasons why any jurisdiction would at this stage be interested in immediately adopting equivalence.

So, do we look it in the eye or burn it?

This topic is getting much airtime at the moment. However, it is difficult to see what attractions equivalence might have for small independent jurisdictions where captive insurance is their main international insurance business. Clearly the mix of business in any particular domicile will dictate its exact determination of where its interests lie.

Solvency II per se is not under criticism here. It is a legitimate response to concerns about large commercial insurance and reinsurance security whose failure has potentially damaging implications for the host economy. It is beholden upon the EU to address these concerns as they see fit.

However, Solvency II is not a suitable basis on which to regulate captive insurance; this much is heavily witnessed by the efforts of insurance industry associations and other representatives of EU based captives seeking accommodation under so-called 'proportionality' rules that allow a more appropriate regulatory approach to be taken to accommodate the needs of the EU captive industry. I am sure we all wish them well in this work.

It is not easy to conclude other than the above for small, independent domiciles, in the absence of the larger scale business for which Solvency II is designed. It is difficult to see any sense in seeking to introduce a standard where you then have to introduce proportionality caveats to accommodate the needs of the overwhelming bulk of your existing insurance industry.

Two concluding remarks if I may. Solvency II used to be referred to the insurance equivalence of Basel II. Since the global financial crisis, supporters of Solvency II have sought to delink these two regulatory initiatives. Is there a fear that closer scrutiny may reveal that Solvency II contains similar flaws?

For an offshore observer, it is somewhat ironic to see the EU fall over itself to embrace risk based regulation and solvency when for decades it has attacked the regulation of the offshore insurance industry which has successfully operated under similar, though less proscriptive, risk-based regulatory regimes. There is no more fervent advocate than a convert!

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

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