insights challenges for captives Facing the strategic

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1 insights captives ISSUE 2010 Facing the strategic challenges for captives Also in this issue: The economic and regulatory challenges for captives, 2010 and beyond Questions captive owners should be asking about Solvency II Quantitative Risk Analysis a fresh look at the strategy for captives Here to help your world.

2 In this issue 3 Welcome 4 The economic and regulatory challenges for captives, 2010 and beyond 6 Solvency II: Questions captive owners should be asking about Solvency II 8 Quantitative Risk Analysis: Taking a fresh look at your captive strategy 12 Loss Portfolio Transfers: Exit strategy for captives 16 Collateral Toolkit: Securing collateral in today s economy 20 International regulation: Is your direct captive insurance program aligned with local licensing and premium tax requirements? 2

3 insights 10 Welcome to this edition of insights which focuses on the economic and regulatory changes affecting captives in the European insurance market. Within this issue, we are aiming to provide European risk managers and treasurers with some valuable information on the pressures they may face over the next few years, which may affect the way they structure their captive insurance programs in the future. We also aim to provide some thoughts and ideas that risk managers could discuss with their treasurer, insurer, broker and captive manager, to ensure they are prepared for future challenges and to make well informed decisions on the way they retain their own risk and implement their risk management strategy in a changing world. We hope you find this issue informative and helpful. Kind Regards, Dr. Paul Wöhrmann Head of Captive Services Zurich Global Corporate Dr. Paul Wöhrmann Paul is responsible for overseeing Captive related business within Zurich for Global Corporate. 3

4 The economic and regulatory challenges for captives, 2010 and beyond It is well known that the economic downturn has affected virtually all companies globally, and although several European economies have shown some signs of a recovery, there still remains real uncertainty and in particular in the way that companies raise capital. The captive industry is naturally worried as it tends to write comparatively less diversified portfolios and does not maintain the same level of governance, infrastructure and expertise as mainstream insurers. Naturally, captives have not escaped the impact of the economic downturn. Whilst many of their parent companies may not have their first requirement for refinancing until 2011 or later, parent companies and captives are witnessing reduced amounts of available credit as well as a significant rise in borrowing margins, making it a much more challenging environment to raise money in the markets. These pressures are leading to a greater focus by parent companies on their captives investment activities as well as the need to explore the option to withdraw much needed capital from the captive that may be better deployed elsewhere within their overall business. Additionally, these pressures are also impacting some captives ease in providing collateral, particularly in the form of letters of credit to their fronting insurers and are at the minimum leading to rising costs. Simultaneously, the effects of Solvency II are reaching captives domiciles and have the potential of adding additional pressure and cost for parent companies in the running of their captives and the structuring of their programs. Solvency II is set to become the new regulatory framework for the European insurance industry in and many of the leading insurers are busy creating their own internal models in preparation for implementation. The captive industry is naturally worried as it tends to underwrite comparatively less diversified portfolios and does not maintain the same level of governance infrastructure and expertise as mainstream insurers. The consequences may be the need for more economic capital, changes in investment strategy as well as increased reporting, disclosure and modelling requirements. 4

5 insights 10 However, such consequences are largely dependent upon the way Solvency II is adopted across captive domiciles for which there is still a great deal of uncertainty. Meanwhile, on a global level there continues to be evolving and increasingly complex legal, regulatory and licencing requirements as well as foreign premium tax payment rules that apply to insurers when they are procuring global insurance coverage. Companies and their captives continually need to ensure that their global insurance coverage is not in breach of a particular country s insurance licensing and premium tax regime. This combination of the impact of the economic downturn on the prioritisation of credit, the uncertainty of the outcome of Solvency II on the captive industry and changing regulatory and licencing landscape associated with global insurance programs add more complexity to the decisions of the risk manager and treasurer. 5

6 Solvency II Questions captive owners should be asking about Solvency II Solvency II is likely to be implemented throughout the European Union (EU) towards the end of 2012, or in early 2013, unless there is further delay to the roll-out. 6

7 Significant questions remain about the final shape of the legislation, including the extent to which it will be adopted beyond the EU and its ultimate impact on captives. In considering the likely impact of Solvency II on their insurance arrangements, captive owners should think about asking a number of questions: insights 10 Top Tips Domicile Will my captive s domicile country adopt Solvency II as an EU member? As a non EU member will it seek equivalence or should I consider moving domicile to avoid the need to comply? Cost and capital What is the cost impact of adopting (or not adopting) Solvency II? Consideration should be given to operating costs and internal rates of return on any additional capital you may require. Your captive manager may also be able to advise you on the likely cost impact. Does my captive match the Solvency II definition of a captive and if not what impact will this have? The current drafting of the Directive includes a captive definition that is very limited. The existing definition would exclude any insurance undertaking with third party beneficiaries. This could be interpreted as precluding a captive from writing any liability business where the claimant was not part of the parent group, the consequence could be that a captive would not be able to rely on light touch implementation and would have to comply as though it were a commercial insurer. Does my approach to running my captive need to change? Are there aspects of the captive operations and approach that may need to be revisited such as inter company loans of assets and retention of historic liabilities with associated reserving risk. Which of the assumptions in the original business case for the captive will need to be revisited in light of the answers to the questions listed above? Whilst the legislation is still far from finalised, captive owners should be mindful of the need to understand the impact on their arrangements to allow sufficient time to revisit the business case for the captive and implement any necessary changes. Some captive owners are engaging with their professional bodies to lobby the EU to ensure that the final legislation does not unduly impact captives; this means taking the time to understand the proposal in enough detail to be able to quantify its impact. 7

8 Quantitative Risk Analysis Taking a fresh look at your captive strategy 8

9 insights 10 With Solvency II on the horizon, reduced investment returns and a shortage of corporate capital, it may be time to take a fresh look at the strategy for your captive. A Quantitative Risk Analysis (QRA) can help determine a more efficient insurance structure based on your risk appetite and use of corporate capital. A QRA is an essential tool for any risk manager wishing to better understand and quantify the risks within their captive. What is a QRA? A QRA is a tailor-made actuarial study of the insurance risks within a company. It provides risk insight regarding expected losses and related volatilities. In other words a QRA helps to quantify and predict a company s insurance risk and is an essential tool for any risk manager wishing to better understand and quantify the risks within their captive. Ultimately a company can better understand and mitigate their risk and improve decisions on how to finance that risk. 9

10 A Quantitative Risk Analysis (QRA) can help determine a more efficient insurance structure based on your risk appetite and use of corporate capital. What are the goals and benefits of a QRA? Assists with determining the optimised retention level for your company. Provides a quantitative understanding of the insurance risks in your company. Gives a forecast of expected losses and quantifies the volatility at various confidence levels. Helps to deal with the uncertainty of potential loss scenarios. Allows scenario testing by simulating alternative captive structures such as different per occurrence limit and aggregates. Improves insurance structure in relation to your specific risk appetite and capital restrictions. Helps to decide the feasibility of a captive as a risk financing vehicle for your company. 10

11 Optimum retention level A QRA helps determine the optimal retention level to minimise total cost of risk insights 10 Costs Total cost of risk Risk retention cost Optimal retention Risk transfer cost (insurance premiums, interest, etc.) Retention level Aim of a QRA Top Tips Some key questions to ask your insurer, broker and/or captive manager. How can I minimise the cost of risk financing of my company? For example, could I release capital and letter of credit pressure by means of a loss portfolio transfer? How could I create greater diversification in my captive? For example, could a cross class aggregate approach provide diversification benefit? Do I fully understand the insurance risks my company or captive is exposed to? How much capital do I need in my captive? 11

12 Loss Portfolio Transfers Exit strategy for captives Large corporations and their risk management strategies evolve over time and at some stage in the lifecycle of a captive, the owners of a captive company might look upon an exit strategy. Regardless of the route to exit (see diagrams on page 14), one of the attributes of an insurance or reinsurance company is that from the moment a risk has been assumed, the company is active until all financial and regulatory obligations are totally extinguished. Funding will be required for the life of the company unless a way to transfer the financial obligations has been agreed. Loss portfolio transfers (LPTs) are one way of achieving this. Each LPT is tailor-made and the proposed solution that provides the best fit will largely depend on the captive owners motivations. 12

13 insights 10 Main benefits of LPTs usually include: collateral restructuring: possible release of security through an insurance arrangement representing substantial cost reductions to the captive/ parent company improvement of solvency particularly in the case of long-tail classes reduction in potential unpredictable volatility: transfer of significant remaining aggregates instead of uncertain IBNR (incurred but not reported) / IBNER (incurred but not enough reported) for a guaranteed cost possible cash flow benefits for the captive/parent, depending on the level of reserves established for the liabilities shareholder value enhancement: removing a company s old liabilities from the books at gross level, achieves more than just reducing the net risk. It can improve the company s image, enhance its shareholders value and increase its ability to issue debt. It can also maximise the use of capital administrative savings. Prime candidates who can benefit from LPTs would include: large manufacturing, or headcount intensive businesses long-tail risk exposures: typically Public/Products Liability, Motor and Employer s Liability but other classes of business can be considered preferably established captives with a minimum of three to five years operations. LPTs often require extended due diligence. Talk with your insurer as early as possible and they will be able to offer expertise and guidance through the available options and relevant process. Engage with all other relevant parties as early as possible. Relevant fields to consider may include Tax, Accounting, Legal, and Regulatory. When looking at the economics of all available options, take into consideration all associated indirect costs relating to the running of the captive. Typical examples may include annual management costs, cost of historical collateral in place with fronting insurers and the need for cash injection to satisfy regulatory requirements or tax implications. Top Tips 13

14 Typical types of LPTs Before After Commutation Insurance policies Insurance policies Fronting Insurer Fronting Insurer Collateral Collateral Captive Captive Transfer Liabilities Before After Novation Insurance policies Insurance policies Fronting Insurer Fronting Insurer Collateral Collateral Captive Captive Reinsurer Transfer Liabilities Before After Insurance policies Insurance policies Fronting Insurer Fronting Insurer Collateral Collateral Captive Reinsurer Captive Transfer Liabilities 14

15 A Commutation is where the fronting insurers agrees to assume the captive s remaining historical liabilities relating to the exposures and underwriting years which they fronted for historically. The Commutation may release the historical collateral retained by the fronting insurer. A Novation is where a reinsurer agrees to assume the captive s remaining historical liabilities relating to the exposures and underwriting years which another insurance company fronted for and therefore become their reinsurer instead of the captive. A new reinsurer can also agree to assume the captive s remaining historical liabilities relating to the exposures and underwriting years, which either a third party insurance company fronted for or when the captive issued direct policies. Commutation Novation insights 10 15

16 Collateral Toolkit Securing collateral in today s economy Securing collateral in today s economy can not only tie up valuable lines of credit, but has proven more difficult to obtain and costly. As banks continue to raise requirements, it becomes harder for corporates (parent companies) to acquire letters of credit (LOCs) and when LOCs are approved, the associated fees have also escalated. Parental Guarantees, Performance Bonds, Insurance Trusts/ Security Interest Agreements and Cash Options, represent in today s market a cost-effective way to keep corporates and/or captives from having to rely solely on LOCs to provide collateral. Parental Guarantees Corporates can provide Parental Guarantees in order to guarantee the performance of their captive reinsurance obligations to their insurer. The parent company s liability only arises if its captive cannot meet the obligations as defined under the reinsurance contract. The benefits of Parental Guarantees are: they do not carry direct costs they are easy to use and quick to execute. Parental Guarantees Insurance policies obligations Fronting Insurer Captive The captive s parent company issues a Deed of Indemnity to the fronting insurer Beneficiary Parent Company Under the Deed, the parent company guarantees the performance of the captive s obligations under the reinsurance contract 16

17 Performance Bonds A Performance Bond is a guarantee provided by a surety provider and guarantees the captive s obligations due to the fronting insurer under the reinsurance contract. The Performance Bond is a tri-partite agreement whereby one party (the surety) guarantees to another party (the owner) that a third party (the principal) will perform the contract. The general obligations of the surety are set out in a bond, which is an accessory instrument to the contract, creating a secondary obligation. The underlying contract guarantees the terms and conditions of the principal s performance. The benefits of Performance Bonds are: not usually cash backed and lower direct costs compared with cash backed letter of credit Performance Bonds Surety provider obtains deed of indemnity from parent company Insurance policies pays surety premium Fronting Insurer Performance Bond Provider obligations Surety provider issues captive Performance Bond Captive insights 10 reduce burden on banking credit lines Performance Bonds are short tail (typically one to three years). Pledged Assets With Pledged Assets, the pledgor deposits assets into a collateral account which is pledged to a beneficiary for a set duration. The pledgee acts according to fiduciary or contractual obligations over the collateral, and pays away claims in the event of default or trigger events. The pledgee holds and administers assets, which can be comprised of cash, fixed deposits and/or eligible securities. The benefits of a Deed of Pledge are: lower direct set-up costs compared with cash backed letter of credit assets in the pledged account usually remain on the books of the pledgor; as restricted assets and therefore part of current assets the pledgor may earn investment income on the pledged funds no renewals or yearly negotiations (deed of pledge is evergreen). Pledged Assets Deed of Charge between beneficiary and pledgor* Pledgor Insurance policies obligations Fronting Insurer Beneficiary Tripartite Collateral Agreement Deed of Pledge Pledgor deposit assets in pledged account *Only for the Tripartite Deed of Pledge Arrangement Captive Pledgee holds and administers deposited assets Pledgee 17

18 Insurance Trust (where applicable in some jurisdictions) With the Insurance Trust, the grantor deposits assets into a collateral account which is pledged to a beneficiary for a set duration. The trustee or collateral agent (depending on jurisdiction) acts according to fiduciary or contractual obligations over the collateral, and pays away claims in the event of default or trigger events. The custodian holds and administers assets, which can be comprised of either cash, fixed deposits and/or eligible securities. Security Interest Agreement (where applicable in some jurisdictions) A Security Interest Agreement is a tripartite agreement between the insurer, the captive and the investment manager and gives the insurer a charge over a proportion of the captive s existing investment portfolio entitling the insurer to seize and sell assets to discharge a bad debt falling under the reinsurance contract. The benefits of Insurance Trust and Security Interest Agreement are: lower direct set-up costs compared with cash backed letter of credit The Insurance Trust (where applicable in some jurisdictions) Deed of Charge between beneficiary and grantor* Grantor Insurance policies obligations Fronting Insurer Beneficiary The Security Interest Agreement (where applicable in some jurisdictions) Custodian/trustee holds and administers deposited assets Tripartite Collateral Agreement Trust Agreement Custodian / Trustee Grantor deposit assets in collateral account /trust *Only for the Tripartite Custodian Agreement Arrangement Captive the trust frees up available credit for the corporation and/or captive assets in the trust usually remain on the books of the grantor, Insurance policies Fronting Insurer obligations Captive as restricted assets and therefore part of current assets the depositor may earn investment income on the funds Asset investment to (subject to insurer s approval) held on trust no renewals or yearly negotiations (trust is evergreen) trust can be adjusted and can be depleting, i.e. funds can be used to pay reinsurance recoveries. Asset management (subject to insurer approval) Investment Portfolio Investment Manager 18

19 The Cash on Deposit Insurance policies Fronting Insurer obligations Captive insights 10 Grantor deposit Cash in Current Deposit Account Beneficiary Beneficiary deposit Cash in segregated Deposit Account Cash Options With the Cash on Deposit option the money is deposited in the form of currency, such as banknotes. The grantor deposits the cash into a current deposit account with the beneficiary and the beneficiary holds onto the cash as collateral. In some instances, the beneficiary might be able to invest the cash in interest bearing instruments and able to give the accrued interest back to the grantor. The benefits of Cash Options are: no fees and no early withdrawal penalties no minimum duration requirements easy to use and quick to execute Cash Deposit allows mid-term adjustments and can be used to pay reinsurance recoveries accrued interest transferable to the depositor. Talk with your insurer as early as possible to find out what alternatives are available as part of their collateral toolkit as this may differ by fronting insurer. Engage early with the relevant internal stakeholder within your company as some alternatives can take longer to set up and need to be authorised and signed off by the Finance Director and Board Members. When looking at the cost benefits of the various alternatives, consider also other aspects such as the effects on the company balance sheet, cash flow and investment strategy. Consider the nature and tail of the exposure to be secured and how this may affect the collateral options available. Consider the term duration and life time cycle of the alternative and its flexibility versus the length of the policy period and exposure to be secured (adjustment mid term and withdrawal). Top Tips Weight the certainty of the purchasing cost of these alternatives versus the impact on Cash Flow and Current Assets. 19

20 20 International regulation Is your direct captive insurance program aligned with local licensing and premium tax requirements?

21 insights 10 Whilst the majority of captives worldwide are reinsurance captives, a significant proportion of the captive market place is also occupied by direct insurance captives. This has been particularly evident with multinational companies with strong presence in Europe who have taken advantage of the Freedom of Services (FOS) legislation. Whereas a reinsurance captive assumes a defined share of its group s risk from the fronting insurer in return for a reinsurance premium, a direct insurance captive fulfils the same role as a direct insurer. This means that a direct insurance captive will be subject to many of the same complex legal, regulatory and licensing requirements as a fronting insurer. Fundamentally, foreign premium taxes must be paid according to the relevant laws of each country. Consequently, captive owners should be aware of the additional jurisdictional insurance licensing requirements and possible obligations they may have relating to a direct captive insurance company in each concerned territory. For instance, whilst direct insurance captives may have a licence to write insurance business under the FOS legislation, there are other considerations to take into account as demonstrated in the following examples:...a direct insurance captive will be subject to many of the same complex legal, regulatory and licensing requirements as a fronting insurer. 21

22 Spain Consorcio de Compensación de Seguros (Insurance compensation consortium) A UK parented direct writing captive may decide to use a fronting insurer to issue a separate policy in Spain instead of using their FOS licence due to the implications of not paying tax on time. In Spain the Consorcio de Compensación de Seguros provides insurance coverage for natural perils and terrorism by paying the calculated amount of tax. Naturally this generates a tax, the Consorcio tax, which is compulsory for all property and bodily injury risks located in Spain. This tax must be paid within 30 days of policy inception or the Consorcio will not cover the extraordinary risk and deny the payment of loss. France GAREAT (French terrorism reinsurance pool) A newly formed direct writing captive may have intended to use its new FOS licence to cover its property risk in France, but instead decided to use a fronting insurer to issue a separate property policy. This may be necessary if the parent company needs terrorism included within their coverage. In such a case their FOS solution (for France) will need to be discontinued as their captive will not belong to GAREAT. This means that they will require an appropriate fronting insurer that is a member of GAREAT to enable them to access the pool. 22

23 There are other examples of accessing government funds (e.g. the Norwegian National Natural Perils Fund) as well as different considerations such as the provision of specialised cover (e.g. Environmental Impairment Liability coverage), which may need a local insurer with the appropriate licenses to issue a local insurance policy. insights 10 Consequently, as local legislation and regulation continues to change, it may be worth re-visiting the goals of your direct writing captive. To obtain clarity, engage with your insurer to understand the increasing complexity of regulatory licensing and foreign premium tax requirements (such as the US FET Tax) and the impact it may have on your overall insurance program. Top Tips Key questions to ask your insurer: Is my insurance coverage compliant with applicable insurance regulation? Are my premiums allocated fairly and reasonably to every exposure? Are my foreign premium taxes recorded and paid correctly? Is my coverage valid and will my claims be paid? What would it cost for a fronting insurer to issue my local insurance policies? How does this compare to running a direct insurance captive? Have I considered the operational and reputational risk of a non compliant insurance program? 23

24 How to contact us: If you would like to find out more about captives, speak with your usual Zurich contact or your broker. Here to help your world A02 (09/10) ZCA The information in this publication was compiled from sources believed to be reliable for informational purposes only. All sample policies and procedures herein should serve as a guideline, which you can use to create your own policies and procedures. We trust that you will customize these samples to reflect your own operations and believe that these samples may serve as a helpful platform for this endeavour. Any and all information contained herein is not intended to constitute legal advice and accordingly, you should consult with your own attorneys when developing programs and policies. Moreover, Zurich reminds you that this cannot be assumed to contain every acceptable safety and compliance procedure or that additional procedure might not be appropriate under the circumstances. This is also intended as a general description of certain types of services available to qualified customers. Zurich does not guarantee any particular outcome and there may be conditions on your premises or within your organization, which may not be apparent to us. You are in the best position to understand your business and your organization and to take steps to minimize risk, and we wish to assist you by providing the information and tools to help you assess your changing risk environment. Risk engineering services are provided by Zurich Services Corporation. Zurich is a trading name for companies within the Zurich Financial Services Group. Zurich is a provider of insurance and related services through subsidiaries within the Zurich Financial Services Group including: In the United States: Zurich American Insurance Company, 1400 American Lane, Schaumburg, Illinois In Canada: Zurich Insurance Company Ltd, 400 University Avenue, Toronto, Ontario M5G 1S9 Outside the US and Canada: (i) Zurich Insurance Plc, Zurich House, Ballsbridge Park, Dublin 4, Ireland; (ii) Zurich Insurance Company, Mythenquai 2, 8002 Zürich, Switzerland; (iii) Zurich Australian Insurance Limited, 5 Blue Street, North Sydney, NSW 2060, Australia; and (iv) further legal entities, as may be required by local jurisdiction. The insurance policy is the contract that specifically and fully describes the insurance coverage provided.