BEST S SPECIAL REPORT

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1 BEST S SPECIAL REPORT European Captive Insurance Our Insight, Your Advantage. Market Review October 11, 2010 Sector Property/Casualty Related Reports 2009 Special Report: European Captive Insurance Market Review Methodology: A.M. Best s Rating Methodology for Captive Insurance Companies Rating Protected Cell Companies Market Analysis Yvette Essen, Head of Market Analysis Yvette.Essen@ambest.com Europe s Captives Navigate Recession, Regulatory Changes The captive insurance market is accustomed to changing circumstances, and significant new developments could be afoot as the industry copes with the economic climate and pending regulatory requirements. In the past few decades, the industry has embraced substantive change, including the emergence of new domiciles and the development of protected cell companies. A.M. Best believes the captive market is again evolving in a variety of ways: What was once considered to be a lightly regulated industry has become exposed to significantly higher standards, and the Solvency II Directive may tighten captive regulation further not just in Europe but in domiciles outside of the European Union. The cost of complying with increased regulation, combined with the general desire to achieve greater capital efficiency in the wake of constrained capital markets, has resulted in parent companies increasingly evaluating the effectiveness of using captives. Specialist insurers are consequently developing exit models to run off captives, or to purchase some of the liabilities associated with them. Captive formation has been sluggish in recent years, largely reflecting soft property/casualty rates and less need for alternative risk transfer. However, some companies are seeking ways to utilise their captives more fully, possibly to cover risks that may include credit insurance and employee benefits. European Captives by Domicile As at 30 September Sweden 49 Sweden 49 Isle of Man 151 Dublin Isle of Man Dublin Luxembourg Guernsey Luxembourg 347* 198 Guernsey 347* Gibraltar 17 Gibraltar 17 BestWeek subscribers have full access to all statistical studies and special reports at Some special reports are offered to the general public at no cost. Malta 8 Malta * International insurers. 8 Sources: Dublin International Insurance & Management Association; Financial Services Commission (Gibraltar); Guernsey Financial Services Commission; Insurance and Pensions Authority (Isle of Man); Commissariat aux Assurances (Luxembourg); Malta Financial Services Authority; Finansinspektionen (Sweden) Copyright 2010 by A.M. Best Company, Inc. All rights reserved. No part of this report may be reproduced, stored in a retrieval system or transmitted in any form or by any means; electronic, mechanical, photocopying, recording or otherwise.

2 Regulation Remains the Primary Focus While captive owners and managers are generally receptive to the prospect of new insurance legislation replacing Europe s current 14 capital adequacy and risk management directives, the industry is still awaiting clarity on the precise requirements of Solvency II. Solvency II remains among the biggest hurdles for the captive community ahead of the directive s scheduled introduction at the end of There are fears that smaller and more recently established captives may not have built sufficient surplus to comply with financial requirements under the pending regulation. Furthermore, companies are bracing themselves for increased demands on management time to meet the risk management requirements of Pillar 2. The European Captive Insurance and Reinsurance Owners Association (ECIROA), an industry body, has been calling for captives to be judged under a Proportionality Principle, reflecting their less risky nature than conventional insurance companies. In August 2010, ECIROA urged its 73 captive owner members to partake in the latest study into Solvency II. The association has argued that data from captives involved in the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS ) fifth Quantitative Impact Study (QIS5) would further demonstrate to regulators the different and special nature of captives. QIS5 results are scheduled for publication in early 2011, and it is hoped that participation in the study will be higher than in QIS4 Special Report ANALYTICAL COMMUNICATIONS Carole Ann King, Managing Senior Business Analyst Brendan Noonan, Managing Senior Business Analyst Carol Demyanovich, Senior Business Analyst Joe Niedzielski, Senior Business Analyst Laura McArdle, Business Analyst Christopher Sharkey, Business Analyst Thomas Dawson IV, Associate Editor PRODUCTION SERVICES Andrew Crespo, Senior Designer in 2008, when 99 of an estimated 550 eligible European captives took part. Of these, 65 were in Luxembourg, which attracts mainly reinsurance captives and is seen as atypical of the captive community. In addition to awaiting details of the exact regulatory demands of Solvency II, the captive community is still uncertain as to how domiciles outside of the EU will respond to the new rules. As Solvency II raises the bar in Europe, domiciles outside of this jurisdiction are balancing the need to display high levels of regulation alongside the desire to attract captives in pursuit of relief from onerous new rules. As Exhibit 1 demonstrates, companies have a considerable choice of where to domicile their captives or protected cell companies (PCCs). Domiciles want to exhibit strong standards, but also to appeal to new captives, considering that as captives generally tend to outsource and do not employ staff, it is relatively easy to redomicile a captive. It is not yet clear whether domiciles such as Guernsey, the Isle of Man and Gibraltar will seek to introduce an equivalent level of regulation to Solvency II. A.M. Best, which rates more than 200 captives, expects as a result of Solvency II that captives outside of the European regulatory environment (particularly those offshore ) may move to demonstrate similar levels of security and corporate governance through ratings. More EU captives are also expected to consider obtaining ratings in light of the increased focus on financial strength under the new regulatory regime. Added Value of Captives Is Questioned In the past decade, there has been more corporate governance involved in running captives, and Solvency II is expected to increase capital requirements. Some companies are reportedly considering their captives in relation to capital efficiency, in part given the capital and time costs that could result from the pending new regulation. As an estimated one-fifth of captives are dormant, some companies may consider these demands to be too onerous.

3 Exhibit 1 European Captives Number of Insurers by Domicile As at 30 September EU Domicile Number of Captives Number of Cells Dublin Gibraltar Guernsey 347* 339 Isle of Man Luxembourg Malta 8 3 Sweden 49 0 * International insurers. Sources: Dublin International Insurance & Management Association Financial Services Commission (Gibraltar) Guernsey Financial Services Commission Insurance and Pensions Authority (Isle of Man) Commissariat aux Assurances (Luxembourg) Malta Financial Services Authority Finansinspektionen (Sweden) Captives have ceased to underwrite new business for wide-ranging reasons. For instance, companies can find themselves with more than one captive as a consequence of merger and acquisition (M&A) activity. Some businesses have also incorporated a number of captives in different domiciles over the years when some domiciles offered more favourable tax advantages. In the wake of the global economic crisis, companies are constantly examining the best way to deploy their capital. Furthermore, the cost of collateral has become a major issue for some captives. Fronting insurers have a greater focus on counterparty credit risk and are asking for increased collateral, for instance through higher letters of credit (LOCs). In some instances, banks have been demanding increased rates for the provision of LOCs, although a secure captive rating can help to reduce the need for a LOC. A range of other factors is resulting in a heightened focus on capital. For example, a parent company may have a strategic change of direction or may have appointed a new finance director. Some businesses may be looking to release trapped capital for use elsewhere, perhaps to expand their core business, while others may be seeking certainty on historical liabilities. As companies increasingly question the cost effectiveness of self-insurance, certain specialist insurers are attempting to attract companies considering exit strategies. For example, Grafton (Europe) Insurance Co., which was assigned a Best s Financial Strength Rating (FSR) of A- (Excellent) and an Issuer Credit Rating (ICR) of a- in December 2009, has identified an unexploited opportunity in the captive market to run off liability risks. The Malta-domiciled vehicle provides captives and their parent companies with the potential to use a captive s capital more efficiently and to release LOCs and the supporting collateral, by the novation of existing contracts through which fronting insurers and captives transfer selected portfolios of policies to Grafton. The desire for enhanced efficiency has also resulted in consolidation of particular captives or, more recently, PCCs. Heritage Insurance Management has also claimed a new first in March 2010, it performed the first amalgamation of two PCCs into a single PCC entity. However, although innovative solutions are increasingly being offered to close captives or pass on liabilities, most companies currently tend to favour running off the business themselves. Captive Formations Slow; Long-Term Value Remains The pace at which new captives are being formed has slowed in recent years. This is in part owing to parent companies focusing on their core business during the recent financially challenging years, as opposed to turning to self-insurance. Captive formation is additionally associated with a hard insurance market and risk managers struggling to find affordable capacity. There are certain lines of business where insurance premiums have increased, but the property/casualty (P/C) market is generally soft, and reinsurance pricing has broadly fallen. Given the soft market, there is not significant pressure for alternative risk transfer (ART), including the use of captives. However, there is an understanding that the inherent value of captives extends far beyond merely obtaining lower premiums by acting as a catalyst for enhanced risk management. The use of a captive is recognised as a long-term strategy, not a short-

4 term solution. There does not appear to be a major rush of captive closures in this soft market, perhaps as companies understand that while obtaining reduced premiums can be the primary function of a captive, awareness of risk management can increase through self-insurance. There is still some captive and PCC activity. For example, in April 2010, White Rock, a company owned by insurance broker Aon, launched a PCC facility on the Isle of Man, building on its presence in Gibraltar, Guernsey, Luxembourg, Malta and Bermuda. A slowdown in captive formations could in part be attributed to many larger companies already owning captives. It is estimated that four-fifths of FTSE 100 companies currently have their own self-insurance vehicles, and it is the small to medium enterprises (SMEs) that tend to be currently creating captives or considering the use of PCCs. On the other hand, the captive market continues to expand geographically, with a number of insurance regulators encouraging captive formation. Dubai, Qatar and Bahrain, for instance, have introduced captive legislation, and insurance market participants are encouraging a greater understanding of enterprise risk management (ERM). It is hoped that a number of companies could utilise captives for energy risks. Kane Group, which has a presence in Bahrain and Dubai, anticipates growth in this region and became the first captive manager awarded a licence by the Qatar Financial Centre Regulatory Authority in September However, to date, captive formation in the Middle East has been muted and is considered a long-term undertaking. Meanwhile, Randall & Quilter has recently signed a captive management joint venture in Denmark and Sweden. The Nordic captive market is considered mature, although there are thought to be opportunities for the SME market, in particular with relation to PCCs. Generally, the advantages of establishing a PCC instead of a captive remain including the lower costs involved and less demand on management time. Nevertheless, Dublin, Ireland continues to offer the owned captive option only. Potential New Lines Of Business for Captives Larger companies tend to use captives predominantly for P/C lines and other conventional risks and are reportedly considering utilising PCCs for one-off risks, including for environmental lines of business. Some companies are also considering utilising captives for particular lines of business where rates and deductibles have increased in the wake of the financial crisis, in particular for credit insurance or professional indemnity cover. For a number of years, the industry has debated the use of captives to provide employee benefits, although one of the challenges for covering this risk is related to the need to provide continuous coverage. However, there has been a shift over the years from employee benefits being considered a human resources matter, to treasurers and board members recognising employee benefits as major costs that need to be stabilised. Discussions surrounding the use of captives for employee benefits have returned to the fore in recent months, with longterm health and long-term disability being proposed as lines of business that more captives could offer. The Isle of Man, for example, is increasingly focused on captive development with regard to employee benefits, given the domicile s particular strength in the life insurance sector. The Department of Economic Development, the government s marketing and development arm, has recently produced a discussion document for Isle of Man captive employee benefits business. Companies are considering using their captives in innovative ways, although captives need to find a balance between writing profitable business and serving their parent companies. Uncertain Future, Promising Prospects The captive industry is undergoing a new period of change, although uncertainty is set to remain until further details of Solvency II s impact on capital requirements emerge from QIS5.

5 The challenging economic climate is also impacting the captive and PCC markets, and there are reduced opportunities for self-insurance if parent companies are under pressure. Companies with captives and PCCs are looking at utilising these vehicles for different lines of business, although captives and PCCs must continue to focus on appropriate pricing of risks. Despite the range of challenges facing captives, A.M. Best expects the sector to experience some stability, with ratings affirmations vastly outnumbering downgrades. Captives have changed tremendously over the past decades. That evolution will continue in the next few years as the industry braces itself for further significant development.

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8 Published by A.M. Best Company Special Report Chairman & President Arthur Snyder III Executive Vice President Larry G. Mayewski Executive Vice President Paul C. Tinnirello Senior Vice Presidents Manfred Nowacki, Matthew Mosher, Rita L. Tedesco A.M. Best Company World Headquarters Ambest Road, Oldwick, N.J Phone: +1 (908) news Bureau 830 National Press Building th Street N.W., Washington, D.C Phone: +1 (202) A.M. Best Europe Rating Services Ltd. A.M. Best Europe Information Services Ltd. 12 Arthur Street, 6th Floor, London, UK EC4R9AB Phone: +44 (0) A.M. Best asia-pacific LTD. Unit 4004 Central Plaza, 18 Harbour Road, Wanchai, Hong Kong Phone: Copyright 2010 by A.M. Best Company, Inc., Ambest Road, Oldwick, New Jersey ALL RIGHTS RESERVED. No part of this report or document may be distributed in any electronic form or by any means, or stored in a database or retrieval system, without the prior written permission of the A.M. Best Company. 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