Solvency II burden for captive insurers

Captive insurers insuring employee benefit risks will be required to demonstrate more robust governance and risk management as well hold higher capital reserves as a result of Solvency II’s second pillar, warns Towers Watson.

The consultancy says around a quarter of single-owner captives are domiciled in either the European Union or in Bermuda, which has recently opted for a modified version of Solvency II. These captives will be affected by the implications of Solvency II, which is due to take effect from January 1, 2014.

Towers Watson says Solvency II governance requirements will create additional work for captive management, although additional employee benefit programme governance and risk management should not add appreciably to the existing costs of Solvency II and compliance for existing property and casualty captives.

Under Solvency II, captive board members have to understand the business they are writing, as well as the associated operating and investments risks. Towers Watson suggests that risk management of employee benefit risks is different from P&C risks.

Towers Watson director Mark Cook says: “Until now the greatest concern for captive managers about Solvency II has been the solvency capital requirement and the implications of the solvency margin standard formula for the balance between risk retention, capital and reinsurance. Now, captive owners realise that improved governance and control also matter, especially when those captives are writing employee benefit risks. To date, employee benefit risks are not commonplace risks to be found financed via captives but this is changing fast. They have different risk profiles to most of captives’ ‘normal’ property & casualty business so captive boards are starting to recognise that they need specialist benefits expertise and advice. We are seeing captive owners starting to focus on the governance and risk management aspects of Solvency II, to be in a good position for when Solvency II comes into effect. One note of caution that has not been clarified as of yet is that the long-term reserving requirements for benefits paid out as annuities are still an area under debate.

“Governance and risk management requirements can have a serious effect on captives’ operations. However, one thing it doesn’t imply is to relocate an EU-based captive to a low-regulation alternative domicile. The fact that regulators are now more focused on avoiding regulatory shopping means that there will be more uniformity. Although there are additional requirements coming into play that weren’t around a few years back, the improved framework should enhance the long-term success of captive programmes if well thought through.”

“We see many captives that write employee benefits risks having governance frameworks in place already. For example, many will have a captive board sub-committee that has specialist employee benefits knowledge. This committee will focus on the employee benefit risks and advise on a variety of topics such as underwriting, pricing, reporting and provider service levels. So this area under Solvency II will be an extension or formalisation of current best practice.” 

“In the case of a captive’s typical P&C risk exposure, the risks are often highly unpredictable and potentially very volatile, whereas employee benefit risks are somewhat more predictable, higher frequency and lower volatility in comparison. Captives writing employee benefit risks should therefore seek to understand the risks of their employee benefit business, determine how they may adversely affect the captive and then take the appropriate risk management steps.

“Governance and the risk management of employee benefit programmes in captives will require specialised knowledge and experience. On a positive note; introducing employee benefit risks can reduce the risk of the captive becoming insolvent by the addition of an essentially uncorrelated line of business.”