EIOPA consults on expectations for supervision of captives

October 2023

EIOPA has released for consultation a draft Opinion on the supervision of captive (re)insurance undertakings, with a focus on the capital treatment of cash pooling arrangements, Prudent Person Principle (PPP) and governance.

The Opinion is directed towards National Competent Authorities (NCAs) and aims to facilitate supervisory convergence across the Single Market, although EIOPA recognises there may be national specificities to the captive (re)insurance sector that need to be considered during implementation. While aimed at NCAs, captives and their groups will be affected because of changes to supervisory practices as a result.

Who is this of interest to?

The consultation will be of interest to EU captives, their parent companies, and related entities, particularly if they participate in cash pooling arrangements. There are over 300 captive (re)insurers in the EU with a significant portion domiciled in Luxembourg and Ireland, followed by Sweden, Malta and the Netherlands. Interest in captive vehicles is expected to grow given the hardening market, making in-house solutions more attractive (although supervisory expectations around arm's length terms may create challenges in this regard).

Why are captives a focus for EIOPA?

Captive (re)insurers cover risks associated with the industrial or commercial group to which they belong. They present specific issues around proportionality, given that a sub-set of regulatory requirements for commercial insurers do not translate well to a captive scenario. 

EIOPA is concerned that differences in supervisory expectations have the potential to lead to concerns regarding level playing field and supervisory and regulatory arbitrage. The intention is to ensure consistent treatment of cash pooling arrangements e.g. that an arrangement that would be treated as a loan in Ireland would also be treated as a loan in Luxembourg. Interestingly, EIOPA's consultation focuses on 'traditional' captives that provide first party cover, and does not explicitly assess the impact of those taking on third-party risk e.g. covering commercial motor fleet or public liability.

How does this fit into broader insurance regulation?

Captives are defined, authorised and supervised under the Solvency II framework. Solvency II already contains simplifications for the calculation of the Solvency Capital Requirement (SCR) for captive (re)insurers.  

Separate from this EIOPA consultation there are proposals, as part of the EU review of Solvency II currently under negotiation, to include captives as part of the 'low-risk profile undertakings' definition. This would further reduce their reporting and regulatory requirements. These proposals from the European Parliament are a recognition that 'pure' captives — those only serving the (re)insurance needs of the parent company — are tools to manage risk and are unlikely to put external parties at risk. These proposals also fit into the growing competitiveness focus within EU (and UK) regulatory discussions.

A key area of focus for EIOPA regarding captives is cash pooling, an arrangement that allows entities within a group to share liquidity. Broadly speaking, entities with positive balances offset those with negative ones.

EIOPA recognises the benefits such centralised arrangements bring, notably the efficiency of cash management. However, there are certain risks including:

• Non-commercial terms: similar to other intra-group transactions, a risk that entities within the group receive remuneration inconsistent with arm's length interest rates;
• Concentration risk: any material reliance needs to be reflected in the Own Risk and Solvency Assessment (ORSA);
  
• Default and liquidity risks: the risk of the parent company or other entities within the group becoming insolvent or experiencing deteriorating financial position. EIOPA considers that cash pooling arrangements can introduce a heightened risk of contagion.
  

In addition to the SCR considerations described below, risk exposure relating to the availability of the funds needs to be assessed under stress scenarios. The group should also set tolerance limits on assets held to cover liabilities towards policyholders.

EIOPA is proposing to direct NCAs towards correctly assessing the classification of captives' cash pooling transactions and ensure their SCR treatment corresponds to economic substance:

• If the contract is a loan or there is a time restriction on withdrawal: the asset is to be considered under the Market Risk submodule for the SCR, including spread and concentration risks. EIOPA notes this is the more typical classification.
• If the contract is not a loan and there are no time restrictions on withdrawals: the asset is classified as cash at bank and the Counterparty Default risk module should be used to account for the possibility that the counterparties' financial position can deteriorate.
  • Furthermore, EIOPA is proposing to clarify that if a cash pooling arrangement is with an unrated intragroup entity, the probability of default of that counterparty is to be calculated as an 'unrated' credit exposure. The rating of the parent cannot be relied on unless there is a letter of credit, guarantees or a similar arrangement.

EIOPA's proposed approach is in line with Standard Formula for firms in the EU (and in the UK) but EIOPA is spelling out that it is also applicable in the context of cash pooling arrangements involving captives. Additionally, EIOPA is proposing to clarify that this extends to both physical and notional cash pooling — in case of the latter, the captive needs to look through to the underlying assets' default and risk drivers.

NCAs should ensure firms consider how their portfolio — assessed as a whole — complies with the PPP:

• Security and quality: for cash pooling arrangements that are loans, consider the number and credit-worthiness of counterparties within the cash pooling arrangement, and if this ensures adequate level of security and quality of the portfolio.
• Liquidity and availability: assess duration of the arrangements, including the time to convert to cash, taking into account any restrictions on conversions.
  
• Profitability: centralisation of resources is expected to lead to higher interest rates.
  

In addition, captives should consider the degree of asset-liability duration matching, conflicts of interest that may impact policyholders (external assurance may be necessary to assess that the price of transactions is at arm's length) and appropriateness of diversification across a range of metrics.

Finally, captive undertakings should be able to provide sufficient detail to NCAs, including evidence behind arm's length pricing, and notify their supervisor in case of any material changes.

Governance

EIOPA outlines its proposed expectations regarding governance, pointing out there is no exception for captives from the requirement to ensure the necessary seniority, qualifications, competency, skills and professional experience for its Board.

Key functions can be outsourced, however the captive needs to allocate responsibility for the oversight of the outsourced functions to a key function holder with capacity to provide the required degree of challenge. EIOPA also emphasises the need to manage conflicts of interest and have clear and documented segregation of duties.  

The practical implementation of these expectations will be of interest to captives, who generally outsource their key functions (CRO, Head of Compliance, etc.) to a professional captive manager or the parents undertaking. Some EU Member States have already set out their expectations that captives should designate an individual — generally the captive manager or CEO — to have oversight over the outsourced key functions or activities. This is another example of an area where EIOPA's draft Opinion is aimed at converging supervisory practices. 

Implications for firms

While this is a consultation, with final policy to be finalised, the draft Opinion provides a clear sense of direction on EIOPA's expectations regarding the supervision of captives.

Captives, their parents and related entities may want to consider if their capital, risk management and governance arrangements are in line with supervisory expectations. While the expectations are in line with insurance supervisory approaches more broadly, they may nevertheless present an implementation challenge for some captives whose compliance teams may not be as large as those of commercial insurers.

KPMG professionals have a wealth of experience in supporting captives including on regulatory change, capital optimisation, risk management and governance. If you want to discuss how these supervisory expectations can impact your firm, please reach out to your KPMG contact.