Captives
and Solvency ii - CEIOPS Level 2
CEIOPS’’ Advice for Level 2 Implementing Measures on Solvency II:
SCR standard formula - Article 111 (j) Simplifications /
Specifications for captives
(former Consultation Paper 79)
This Paper aims at providing advice with regard to
simplified calculations for the
calculation of the solvency capital
requirement for captives as requested in Article 111 (l) of the
Solvency II Level 1 text.
The objective of this paper is to elaborate
on possible simplifications for the calculation of the
solvency capital requirement for captives, due to their specific
business model.
However, the provisions included in this advice are
not to be understood to prevent captives
from applying other simplifications developed for
non-captive undertakings, which might be stated in other Level 2
or Level 3 measures.
2. Extract from Level 1 Text
Legal basis for implementing measure
Article 111 - Implementing measures (SCR)
1. In order to ensure that the same
treatment is applied to all insurance and reinsurance
undertakings calculating the Solvency Capital Requirement
on the basis of the standard formula,
or to take account of market developments, the Commission shall
adopt implementing measures laying down the following:
[…]
(l) the
simplified calculations provided for specific sub-modules and risk
modules,
as well as the criteria that insurance and reinsurance
undertakings, including captive and
reinsurance undertakings, shall be required to meet in
order to be entitled to use each of these simplifications, as set
out in Article 109;
Other relevant articles for providing the background to the advice
Recital 10
References in this Directive to insurance or reinsurance
undertakings, should include captive
insurance and captive reinsurance undertakings, except
where specific provision is made for those undertakings.
Recital 18
The supervisory authorities of the Member States should therefore
have at their disposal all means necessary
to ensure the orderly pursuit of business by insurance and
reinsurance undertakings throughout the Community whether carried
on under the right of establishment or the freedom to provide
services.
In order to ensure the effectiveness of the supervision all
actions taken by the supervisory authorities should be
proportionate to the nature and the
complexity of the risks inherent to the business of an insurance
or reinsurance undertaking,
regardless of the importance of the undertaking concerned
for the over-all financial stability for the market.
Recital 19
This Directive should
not be too burdensome for small and medium-sized insurance
undertakings.
One of the tools to achieve that objective is the proper
application of the proportionality principle.
That principle should apply both to the requirements on the
insurance and reinsurance undertakings and on the exercise
of supervisory powers.
Recital 21
This Directive should also take account of
the specific nature of captive insurance and reinsurance
undertakings.
As those undertakings only cover risks associated with the
industrial or commercial group to which they belong, appropriate
approaches should thus be provided in line with the principle of
proportionality to reflect the nature, scale and complexity of
their business.
Article 13 (2) Definitions
Captive insurance undertaking means
an insurance undertaking owned either by a financial undertaking
other than an insurance or a reinsurance undertaking or a group of
insurance or reinsurance undertakings within the meaning of
Article
212(1)(c), or by a non-financial undertaking, the purpose of which
is to provide insurance cover exclusively for the risks of the
undertaking or undertakings to which it belongs or of an
undertaking or undertakings of the group of which the captive
insurance undertaking is a member;
Article 13(5) Definitions
Captive reinsurance undertaking means
a reinsurance undertaking owned either by a financial undertaking
other than an insurance or a reinsurance undertaking or a group of
insurance or reinsurance undertakings within the meaning of
Article
212(1)(c) or by a non-financial undertaking, the purpose of which
is to provide reinsurance cover exclusively for the risks of the
undertaking or undertakings to which it belongs or of an
undertaking or undertakings of the group of which the
captive reinsurance undertaking is a member;
Article 29 – General principles of supervision
[…]
3. Member States shall ensure that the requirements laid down in
this Directive are applied in a manner which is
proportionate to the nature,
complexity and scale of the risks inherent to the business of each
insurance or reinsurance undertaking.
4. The Commission shall ensure implementing measures
include the principle of proportionality,
thus ensuring the proportionate application of the
Directive, in particular to very small insurance undertakings.
Article 109 – Simplifications in the standard formula
Insurance and reinsurance undertakings may
use a simplified calculation for a specific sub-module or risk
module where the nature, scale and
complexity of the risks they face justifies it and where it would
be disproportionate to require all
insurance and reinsurance undertakings to apply the standardised
calculation.
Simplified calculations shall be calibrated in accordance with
Article 101(3).
3. Advice
3.1 Explanatory text
3.1.1 Reasons for providing simplifications for captives
3.1. Due to the nature of the business model
of captive (re)insurers, the proportionality principle as laid
down in Article 29 of the Level 1 text applies to captives.
Articles 109 dealing with simplifications is also of relevance for
the treatment of captives.
3.2. Captives are specialised entities
limiting their underwriting exclusively to risks faced by one or
several undertakings of the group to which they belong.
As captives cover a limited number of risks
the law of large numbers does not play for them, and the
behaviour of their portfolio may thus not be
compared to a traditional (re)insurer’s portfolio.
Business accepted and ceded can change quickly which makes it
impossible for captives to rely on historical data in a mechanical
way.
3.3. Simplifications similar to the ones suggested have been
tested on captives during the QIS4 exercise, along with the
standard formula as it was presented in QIS4.
Where the simplification led to a higher capital charge in QIS4
than the standard formula in QIS4 for a particular (sub)module,
the simplification was considered to be acceptable as the
advantage provided by using the simplification is supposed to be
counterbalanced by a higher capital charge and is thus an
incentive for captives to put in place the necessary resources
(like human resources or IT resources) and procedures to
possibly ‘converge’ over time to the
standard formula, or a full or partial internal model.
3.4. The simplifications proposed are split in
two different categories.
Section 3.1.3 is about simplifications only applicable to captives
based on their specific business model.
Section 3.1.4 deals with simplifications applicable to the ceding
undertakings of captive reinsurance
undertakings.
3.5. Simplifications for the calculation of the SCR standard
formula by captives have been extensively tested in the QIS4
exercise.
The supervisory authorities of Luxembourg,
Ireland and Malta suggested these simplifications in a
national guidance paper.
The outcome of each simplification has been compared to the
standard formula in the QIS4 Technical Specifications, in order to
check the suitability of the suggested simplification.
The outcome of the comparison simplifications vs. standard model
for each (sub-)module for the Luxembourg market can be found in
Annex A.
3.1.2 Criteria required in order to be entitled to use the
simplifications.
3.6. Simplifications suggested in this advice may be applied by
entities meeting the definition of captives
as stated in Article 13(2) and 13(5) of the Level 1 text.
The definitions in Articles 13(2) and 13(5) are to be understood
in the sense that the group of the captive undertaking does
not include another insurance or reinsurance undertaking, other
than another captive undertaking which meets the requirements (a)
and (b) below, besides other provisions stated in those
definitions.
3.7. If the undertaking does not meet the
legal definition of a captive as stated above, it will be
considered as an insurance or reinsurance undertaking for the
purpose of this advice.
This terminology (specific to the present advice) does not put
into question the definition of captives as stated in 13(2) and
13(5) of the Level 1 text. In this circumstance, the undertaking
could nevertheless benefit from general simplifications under
Solvency II.
3.8.
The application of the simplifications will be limited to captives
meeting the following requirements (Requirements a (i-ii) and b
which are supported by a majority of CEIOPS Members:
(a) (i) The insurance obligations of an insurance captive
undertaking only relate to contracts where
all insured persons and beneficiaries in respect of unexpired
risks are legal entities of the group of the captive undertaking
and where all insured persons and beneficiaries were legal
entities of the group at the time the contract was entered into.
(a) (ii) The reinsurance obligations of a captive undertaking
only relate to contracts where all insured
persons and beneficiaries of the underlying direct insurance
contracts in respect of unexpired risks are legal entities of the
group of the captive undertaking and where all insured persons and
beneficiaries of the underlying direct insurance contracts were
legal entities of the group at the time the contract was entered
into.
(b) The insurance obligations of the direct insurance captive
undertaking do not relate to any third party
liability insurance.
Explanation of requirement (a)
3.9. According to Article 13(2) of the Level 1 text,
“captive insurance undertaking means an
insurance undertaking owned
either by a financial undertaking other than an insurance or a
reinsurance undertaking or a group of insurance or reinsurance
undertakings, or by a non-financial undertaking, the purpose of
which is to provide insurance cover exclusively for the risks of
the undertaking or undertakings to which it belongs or of an
undertaking or undertakings of the group of which the
captive insurance undertaking is a member;”
There is an analogue definition of captive reinsurance undertaking
in Article 13(5).
3.10. According to these definitions, a necessary requirement for
a captive is the purpose to provide insurance cover
exclusively for the risks of its owners.
This requirement needs to be defined more
precisely for the following reasons.
Firstly, one could hold the view that the purpose mentioned before
does not prevent that at least a small part of the captive
undertaking’s business relates to risks other than the risks of
its owner.
However, such an interpretation would weaken the protection of the
policyholders outside of the owner’s group and should therefore be
ruled out.
Secondly, it is unclear what “risks of the undertaking” means.
For example, some captive undertakings insure the employees and
the customers of the owning group.
These cases are not covered by the definition.
3.11. The term ‘beneficiary’
indicated in 3.8 (ai) and 3.8 (aii) is to be understood as defined
in recital 16 of the Level 1 text:
“…The term beneficiary is intended to cover any natural or legal
person who is entitled to a right under an insurance contract”.
From this recital it is clear that only insurance contracts are
targeted since the Level 1 text specifically uses the term
‘reinsurance contracts’ when referring to reinsurance contracts.
The term ‘beneficiary’ in 3.8 (ai) and 3.8 (aii) would thus relate
to a situation in which a natural or legal person would have a
direct right against a captive insurance undertaking or a captive
reinsurance undertaking resulting from an insurance contract.
3.12. The term ‘insured person’ is commonly
defined as being ‘a person whose interests are protected by an
insurance contract or ‘a person who contracts for an insurance
contract that indemnifies him against loss of property, life or
health’.
The terms ‘insured person’ and ‘beneficiary’
are thus always linked to the existence of an insurance contract
linking the insured person, the beneficiary and an entity of the
group.
Explanation of requirement (b)
3.13. The rationale of Recital 21 is that in case of default of a
captive insurance contract, the harm to the policyholder or
insured person is limited because they economically coincide with
the provider of the insurance cover.
However, the reason why some kinds of insurance are compulsory is
not to protect policyholders or insured persons but third party
beneficiaries.
For example, pharmaceutical third party liability insurance is
compulsory in some markets in order to ensure that victims of
pharmaceutical failures (i.e. third party beneficiaries) will be
compensated for any damage caused.
Third party liability insurance is compulsory in this case because
without insurance cover the pharmaceutical undertaking may not be
able to compensate the victims.
If captive undertakings provide compulsory third party liability
insurance and the solvency requirements on captives are less
accurate as a direct consequence of the use of simplifications,
the objective of the compulsory insurance and the protection of
the beneficiaries would be undermined.
3.14. In addition to these requirements, the particular
simplification should be proportionate to
the nature, scale and complexity of the risks inherent in
business of the captive undertaking.
The assessment of proportionality should take into account the
defining characteristic of a captive undertaking as stated in
Recital 21.
3.15. Irrespective of whether the captive
undertaking meets the requirements (ai), (aii) and (b) or makes
use of particular captive simplifications, it can make use of the
general simplifications provided for insurance and reinsurance
undertakings, if the criteria of these simplifications can be
fulfilled.
3.16.
Captives which exclusively write for instance one or more of the
following risks could benefit from the simplifications in this
advice (non exhaustive list):
•
Property damage
to property belonging to the captive owner’s group;
•
Machinery breakdown
of equipment belong to the inventory of the captive owner’s group;
• Risks which would fall under the category
‘financial loss to the captive owner’,
like Business Interruption, Product and
Environmental liability, Keyman insurance, Counterparty default
insurance, Computer Crime and Fraud, Hull / Cargo insurance,
Bankers’ Blanked Bond, Transport insurance, Theft and Robbery
insurance.
• Non compulsory liability in general.
In this context, the notion of
related/unrelated risk has been extensively addressed in appendix
1, paragraph 6 of the document ‘IAIS issues paper on regulation
and supervision of captive insurance companies’
“The definition of unrelated parties needs to be carefully
considered.
[…] It is also important to define what is meant by ‘third party
business’.
Many of the definitions of a ‘pure’ captive’ may exclude the
insurance of third party risks and the issue arises as to whether
this is a reasonable restriction on a captive of a major
industrial or commercial company […].
Liability insurance is purchased to benefit
the insured, not the injured party which is why it is a
related and not unrelated risk.
There is therefore a strong argument that
those companies referred to above are regulated as ‘pure’ captives
as they are only insuring a responsibility that would ultimately
fall on the parent company if no insurance were in place.”
This example however only relates to reinsurance captive
undertakings.
• Compulsory third party risks for those
amounts that exceed the minimum level foreseen by legislation (if
such a minimum exists).
For instance, in some jurisdictions, MTPL is limited by the law to
some fixed amount say 200 million EUR for instance.
If an industrial or commercial group decides to insure itself for
the layer 100 million EUR in excess of 200 million EUR in a
captive, it is doing so on a voluntary basis and this type of
insurance would then also be classified as ‘financial loss’
insurance.
The industrial or commercial group would legally only be liable up
to the amount foreseen by the law i.e. 200 million EUR in the
example referred to above and this amount is insured by the
industrial or commercial group via external insurance to a
non-captive undertaking applying no simplifications foreseen in
this advice.
This example however only relates to reinsurance captive
undertakings.
3.17. In the examples referred to above, the insured person would
always be an entity of the captive owner’s group and the
beneficiary would also be some entity of that group since these
examples all represent ‘financial loss’ insurance to the captive
owner.
3.1.3 Simplifications for captives due to their specific business
model
Non-life premium and reserve risk
3.18. The national QIS4 guidance of Luxembourg, Ireland and Malta
included a simplified calculation of the non-life premium and
reserve risk submodule.
Compared to the QIS4 default calculation, the simplified approach
included changes as follows:
(a) The formula was simplified by choosing
uniform parameters.
For example the same correlation factor for all lines of business.
(b) The risk-mitigating effect of aggregate
limits was taken into account.
(c) The expected profit/loss stemming from new business written
during the next year was taken into account.
3.19. Groups often use their captive to retain their profits
within the group by keeping the risks with a good loss ratio
within their captive.
The QIS4 standard formula assumes a 100% combined ratio and does
therefore not allow for this captive particularity.
As also many non-captive insurance and reinsurance undertakings
have stable combined ratios below 100%, an allowance for the
expected profit/loss only for captive undertakings would not
create a level playing field.
Hence, CEIOPS believes that if such an element is introduced in
the standard formula, it should apply to all undertakings.
3.20. However, there are doubts whether the expected profit/loss
can reliably be modelled under the standard formula approach.
CEIOPS has received guidance from the European Commission saying
that the expected profit/loss from new business is not expected to
be modelled in the SCR standard formula.
3.21. The simplification mentioned in letter (a) of paragraph 3.16
is based on the following assumptions:
(a) The risk function ρ of the sub-module calculation can be
replaced by a linear approximation:
ρ(σ) = 3xσ
(b) The standard deviations σ(prem,lob) and σ(res,lob) for premium
and reserve risk for all lines of business are 30%, which is the
highest volatility factor calibrated in CP 71 for premium and
reserve risk.
CEIOPS is aware that this is a conservative
choice, but would like to highlight to stakeholders that
some model error is included in the simplification and the high
factor compensates to some extend for this model error.[Pending
final calibration on non-life underwriting risk).
(c) The correlation factors for all pairs of lines of business are
35%.
This is the average of the factors in the correlation matrix
(excluding the diagonal entries).
3.24. The
assumptions and formulas in 3.21, 3.22 and 3.23 will be updated
once the calibration exercice in the non life underwriting risk
module (former CP71) has been finalised.
3.25. The aggregate limit shall represent the net retention per
line of business, after reinsurance, taken into account the limits
stated in acceptance as well as in reinsurance treaties, increased
by a possible reinstatement premium.
There may be limits
in treaties accepted and in treaties reinsured, or in only
acceptance or reinsurance.
If for one line of
business, several treaties are written but for one of them no
limit can be defined, the aggregate limit shall not be taken into
account.
If
an aggregate limit covers several lines of business (so called
‘umbrella treaties’, or ‘multi-line treaties’), it should be
assured that this overall limit is not taken into account for each
line of business.
Further work is
necessary on the treatment of the aggregate limit at the level of
a particular line of business in case of umbrella or multi-line
treaties.
The choice of the
aggregate limit should ensure that the probability of a loss
exceeding the aggregate limit has a zero probability.
Non-life catastrophe risk
3.26. QIS4 provided evidence that Method 1 (factor based method)
for the calculation on the non-life catastrophe sub-module
produced inaccurate capital charges for captives.
On the other hand,
due to a lack of precise guidelines for Method 3 (scenarios
designed by the undertaking itself), many captives simply used the
maximum possible liability stated in the respective reinsurance
contracts.
These two different
approaches produced extremely divergent results and capital
charges.
One regulator
highlighted an average ratio Method 3 / Method 1 of 1518% for
captives during the QIS4 exercise.
3.27. However, due to time constraints and lack of industry input,
CEIOPS is not in a position today to adequately address this issue
for captives and give specific treatment of CAT risk for captives.
Concentration risk
3.28. CEIOPS would like to highlight that a minority of its
members supports the removal of the following beneficial treatment
of concentration risk for captives.
3.29. Captives are often part of so called cash-pooling
arrangements, where a multinational group manages the in– and
outflows of the overall cash in the group.
Thus
a substantial share of a captive’s assets is pooled at a single
counterparty.
But it has to be
borne in mind that the captive owner is also the insured so it has
a strong interest to support the captive's cash
position in case of difficulties, or in order to limit effects of
financial difficulties he encounters.
In addition captive
reinsurance treaties often include provisions where the
reinsurer’s liabilities may be offset by intragroup
exposures the reinsurer may hold on other entities of the group.
Thus the credit risk in relation to cash-pooling arrangements with
the mother undertaking is of reduced importance.
3.30. QIS4 showed that the capital charge for captives in the
concentration risk sub-module represented on average 78% of the
total market risk module (ratio SCR_conc/SCR_mkt, before
diversification,) and on average 34% of the overall SCR (SCR_conc/SCR).
This is due to the
fact that the concentration threshold of 5% and 3% in QIS4 was
often exceeded by the asset concentration of captives.
Following lessons to
be learnt from the crisis, CEIOPS has lowered these thresholds to
2% and 1%, leading to an even higher concentration risk charge for
captives than it was in QIS4.
Captives have on average only 3 or 4 bank deposits at different
banks.
In order to account
for the specific business model of captives, CEIOPS suggests
allowing for higher concentration thresholds for captives than the
thresholds foreseen in paragraph 4.162 of CEIOPS-DOC-40/09 (Advice
on the design of the market risk module, former CP47) under the
following cumulative conditions:
• the credit institution or cash-pooling
entity of the group has a rating of AA;
• the credit institutions do not belong to the same group;
3.31. As stated in paragraph 4.140 of CP 47, cash held at bank is
submitted to capital charge in the counterparty default risk
module, and not in the concentration risk module.
Furthermore,
paragraph 4.149 of CEIOPSDOC-40/09 (Advice on the design of the
market risk module, former CP47) states that bank deposits
considered in the concentration risk submodule can be exempted to
the extend their value is covered by a
government guarantee scheme in the EEA area, the guarantee is
applicable unconditionally to the undertaking and provided there
is no double-counting of such guarantee with any other element of
the SCR calculation.
As the above simplifications are granted to captives with regard
to their particular business features as described in paragraph
3.26, CEIOPS would like to stress that it does not intend to
extend these simplifications to other categories of (re)insurers.
Interest rate risk
3.32. As cash-flow projections for assets are not always readily
available, the standard calculation of the interest rate
sub-module can be too burdensome for captive undertakings from a
practical point of view.
In line with the
proportionality principle an appropriate simplification would be
to apply the shocks by grouping the assets by intervals of
maturities and by translating the shocks on interest rates into a
simple percentage to be deducted from the market value of the
assets.
This simplification
would require that the main part of the asset is to be repaid at
maturity.
Using the maturity approach in other situations would lead to
divergent results.
3.33. Accordingly the shocks on liabilities have been translated
into a percentage to be deducted from the undiscounted best
estimate of the technical provisions.
The discounting
proxy provided in TS.IV.I.6 of the QIS4 technical specifications
has been extended to translate the shocks
on interest rates into a percentage to be deducted from the
undiscounted best estimate.
Since the
information on duration of liabilities in TS.IV.I.6 have been
calibrated on direct insurers active in the German market, they
cannot be translated without further adjustment to captive
business in all cases.
Stakeholders are
asked to comment on the suitability of the durations per line of
business as in TS.IV.I.6.
3.34. As an illustration the shocks on the undiscounted best
estimate of technical provisions for the market interest rate
shock simplification used for QIS4, considering the durations in
TS.IV.I.6 and shocks in TS.IX.B.5 of the QIS4 technical
specifications, were as follows :
3.36. In
QIS4, captives argued that it would be too burdensome to
investigate on the rating of each single bond.
Thus, it was
suggested as a simplification to assume that all bonds are rated
BBB.
The
simplification suggested in this advice broadly reflects this
concern, but excludes structured bonds and bonds with a rating
lower than BBB from its’ scope.
In practice, this can achieved for instance by indicating
respective provisions in asset management mandates set up by the
captive.
3.1.4 Simplifications applicable on ceding undertakings to captive
reinsurers
3.37. SCR counterparty risk / recoverables towards a captive:
If an
explicit and legally effective guarantee by the captive owner for
the liabilities of the captive exists, then the credit rating of
the guarantor instead of the captive may be used
• in the calculation of the SCR counterparty
default risk module for the ceding undertaking, and
• in the calculation of the adjustment for expected losses due to
counterparty default for the recoverables towards the captive.
3.38. Cut-through liability clauses: Captives’ ceding undertakings
may consider the probability of default of the retroceding
undertakings of a captive if a
‘cut-through-liability’ cause exists or a similar binding
agreement, for the amounts involved in the transactions with the
captive.
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