BEST S SPECIAL REPORT

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.

B

S

R

Market Review October 11, 2010

Sector

Related Reports

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 +44 20 7397 0322

[email protected]

Europe’s Captives Navigate

Recession, Regulatory Changes

The captive insurance market is accustomed to changing circum-stances, 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 Sol-vency 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. Special-ist insurers are consequently developing exit models to run off cap-tives, 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 alterna-tive 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.

BestWeek subscribers have full access to all statistical studies and special reports at www.ambest.com/research. Some special reports are offered to the general public at no cost.

* 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) Dublin 125 Dublin 125 Malta 8 Malta 8 Luxembourg 198 Luxembourg 198 Isle of Man 151 Isle of Man 151 Sweden 49 Sweden 49 Gibraltar 17 Gibraltar 17 Guernsey 347* Guernsey 347*

European Captives by Domicile

As at 30 September 2010. Dublin 125 Dublin 125 Malta 8 Malta 8 Luxembourg 198 Luxembourg 198 Isle of Man 151 Isle of Man 151 Sweden 49 Sweden 49 Gibraltar 17 Gibraltar 17 Guernsey 347* Guernsey 347*

While captive owners and managers are generally receptive to the prospect of new insurance legislation replacing Europe’s current 14 capital adequacy and risk man-agement directives, the industry is still awaiting clarity on the precise require-ments 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 2012. There are fears that smaller and more recently established captives may not have built sufficient surplus to comply with financial requirements under the pend-ing regulation. Furthermore, companies are bracing themselves for increased demands on management time to meet the risk man-agement requirements of Pillar 2.

The European Captive Insurance and Rein-surance Owners’ Association (ECIROA), an industry body, has been calling for cap-tives 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 Com-mittee of European Insurance and Occupa-tional Pensions Supervisors’ (CEIOPS’) fifth Quantitative Impact Study (QIS5) would fur-ther demonstrate to regulators the “different and special nature” of captives.

QIS5 results are scheduled for publication in early 2011, and it is hoped that participa-tion in the study will be higher than in QIS4

in 2008, when 99 of an estimated 550 eligi-ble 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 cap-tive 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 dis-play 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 cap-tives 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 intro-duce an equivalent level of regulation to Solvency II.

A.M. Best, which rates more than 200 cap-tives, 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 cor-porate governance involved in running cap-tives, and Solvency II is expected to increase capital requirements. Some companies are reportedly considering their captives in rela-tion 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 com-panies may consider these demands to be too onerous.

Regulation Remains the Primary Focus

Special Report

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

Captives have ceased to underwrite new business for wide-ranging reasons. For instance, companies can find themselves with more than one captive as a conse-quence of merger and acquisition (M&A) activity. Some businesses have also incorpo-rated a number of captives in different domi-ciles over the years when some domidomi-ciles offered more favourable tax advantages. In the wake of the global economic crisis, companies are constantly examining the best way to deploy their capital. Further-more, the cost of collateral has become a major issue for some captives. Fronting insurers have a greater focus on coun-terparty 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 opportu-nity 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 sup-porting 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 sin-gle PCC entity.

However, although innovative solutions are increasingly being offered to close captives or pass on liabilities, most companies cur-rently tend to favour running off the busi-ness 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 man-agers 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 sig-nificant 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 recog-nised as a long-term strategy, not a

Exhibit 1

European Captives – Number of

Insurers by Domicile

As at 30 September 2010.

EU Domicile Number of Captives Number of Cells

Dublin 125 0 Gibraltar 17 35 Guernsey 347* 339 Isle of Man 151 1 Luxembourg 198 0 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

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, Guern-sey, Luxembourg, Malta and Bermuda.

A slowdown in captive formations could in part be attributed to many larger compa-nies already owning captives. It is estimat-ed 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 cur-rently 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 encourag-ing captive formation. Dubai, Qatar and Bahrain, for instance, have introduced cap-tive legislation, and insurance market par-ticipants are encouraging a greater under-standing of enterprise risk management (ERM). It is hoped that a number of compa-nies could utilise captives for energy risks. Kane Group, which has a presence in Bah-rain and Dubai, anticipates growth in this region and became the first captive manag-er awarded a licence by the Qatar Financial Centre Regulatory Authority in September 2010. 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 cap-tive market is considered mature, although there are thought to be opportunities for the SME market, in particular with rela-tion 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 pre-dominantly for P/C lines and other conven-tional risks and are reportedly considering utilising PCCs for one-off risks, including for environmental lines of business. Some companies are also considering uti-lising captives for particular lines of busi-ness where rates and deductibles have increased in the wake of the financial crisis, in particular for credit insurance or profes-sional 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 cover-age. 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 cap-tives for employee benefits have returned to the fore in recent months, with long-term health and long-long-term disability being proposed as lines of business that more captives could offer. The Isle of Man, for example, is increasingly focused on cap-tive 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 cap-tives in innovative ways, although capcap-tives 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 Sol-vency II’s impact on capital requirements emerge from QIS5.

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 cap-tives, A.M. Best expects the sector to expe-rience some stability, with ratings affirma-tions 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.

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. 08858

Phone: +1 (908) 439-2200 NEWS BUREAU 830 national Press Building 529 14th Street n.W., Washington, D.C. 20045

Phone: +1 (202) 347-3090 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)20 7626-6264 A.M. BEST ASIA-PACIfIC LTD.

unit 4004 Central Plaza, 18 harbour road, Wanchai, hong Kong Phone: +852 2827-3400

Copyright © 2010 by A.M. Best Company, Inc., Ambest Road, Oldwick, New Jersey 08858. 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. For additional details, see Terms of Use available at the A.M. Best Company Web site www.ambest.com.

Any and all ratings, opinions and information contained herein are provided “as is,” without any expressed or implied warranty. A rating may be changed, suspended or withdrawn at any time for any reason at the sole discretion of A.M. Best.

A Best’s Financial Strength Rating – Insurer is an independent opinion of an insurer’s financial strength and ability to meet its ongoing insurance policy and contract obligations. It is based on a comprehensive quantitative and qualitative evaluation of a company’s balance

tracts and does not address any other risk, including, but not limited to, an insurer’s claims-payment policies or procedures; the ability of the insurer to dispute or deny claims claims-payment on grounds of misrepresentation or fraud; or any specific liability contractually borne by the policy or contract holder. A Financial Strength Rating is not a recommendation to purchase, hold or terminate any insurance policy, contract or any other financial obligation issued by an insurer, nor does it address the suitability of any particular policy or contract for a specific purpose or purchaser.

A Best’s Debt/Issuer Credit Rating is an opinion regarding the relative future credit risk of an entity, a credit commitment or a debt or debt-like security. It is based on a comprehensive quantita-tive and qualitaquantita-tive evaluation of a company’s balance sheet strength, operating performance and business profile and, where appropriate, the specific nature and details of a rated debt security.Credit risk is the risk that an entity may not meet its contractual, financial obligations as they come due. These credit ratings do not address any other risk, including but not limited to liquidity risk, market value risk or price volatility of rated securities. The rating is not a recommendation to buy, sell or hold any securities, insurance policies, contracts or any other financial obligations, nor does it address the suitability of any particular financial obligation for a specific purpose or purchaser.

A Best’s Financial Strength Rating – Bank is an opinion of the relative ability of a bank to meet its ongoing financial obligations to depositors. It is based on a comprehensive quantitative and qualita-tive evaluation of a company’s capitalization, asset quality, management, earnings, liquidity and sen-sitivity to market risk. The ratings are not assigned to specific deposit accounts or contracts and do not address the ability of the bank to repay any other financial obligation issued by the bank. A Finan-cial Strength Rating is not a recommendation to buy, sell or hold finanFinan-cial obligations of a bank, nor does it address the suitability of any particular financial obligation for a specific purpose or purchaser. In arriving at a rating decision, A.M. Best relies on third-party audited financial data and/or other information provided to it. While this information is believed to be reliable, A.M. Best does not independently verify the accuracy or reliability of the information.

A.M. Best does not offer consulting or advisory services. A.M. Best is not an Investment Adviser and does not offer investment advice of any kind, nor does the company or its Rating Analysts offer any form of structuring or financial advice. A.M. Best does not sell securities. A.M. Best is compensated for its interactive rating services. These rating fees can vary from US$ 5,000 to US$ 500,000. In addition, A.M. Best may receive compensation from rated entities for non-rat-ing related services or products offered.

A.M. Best’s special reports and any associated spreadsheet data are available, free of charge, to all BestWeek subscribers. On those reports, nonsubscribers can access an excerpt and pur-chase the full report and spreadsheet data. Special reports are available through our Web site at

www.ambest.com/research or by calling Customer Service at (908) 439-2200, ext. 5742. Some special reports are offered to the general public at no cost.

For press inquiries or to contact the authors, please contact James Peavy at (908) 439-2200, ext. 5644.