Solvency II and Captive Insurance: Evolving Regulations and Benefits

Solvency II is a European Union directive that sets comprehensive regulatory standards for insurance and reinsurance companies operating within the EU, including captive insurers. Implemented in January 2016, it replaced the Solvency I regime, which was widely regarded as outdated and structurally deficient. 

The directive aims to achieve several key objectives.

• Safeguard the interests of policyholders and beneficiaries
• Enhance transparency, comparability, and competitiveness in the insurance market
• Minimize the risk of insurer insolvency

Solvency II outlines requirements across critical domains such as financial resources, governance and accountability, risk management, supervisory oversight, and reporting and public disclosure. Its risk-based framework evaluates insurers' solvency in a way that promotes efficient capital allocation, balancing risk and shareholder returns. 

Solvency II Timeline 

Following its introduction on January 1, 2016, the European Commission (EC) initiated a review of Solvency II 3 years later to evaluate its practical effectiveness and efficiency. The review aimed to identify and address any shortcomings or areas in need of improvement. 

In September 2021, the EC proposed amendments to the Solvency II framework, referred to as Solvency II 2.2. The proposal was provisionally approved by the European Parliament in April 2024 and is set to take effect in early 2026. These amendments aim to address specific concerns and enhance key aspects of the regulation. 

In this context, AM Best highlighted the potential impact of the Solvency II amendments on captive insurers, noting, "Solvency II amendments, expected to come into force in January 2026, should lead to a more streamlined, proportionate, and risk-based prudential process for EU-domiciled captive entities. As captives are often small and have lightly staffed operations, this principle of proportionality is of particular importance in ensuring that the regulatory requirements do not become overly burdensome." 

The revisions, developed in collaboration with the European Insurance and Occupational Pensions Authority, aim to enhance the regulatory framework. These updates focus on improving market stability while offering greater flexibility to insurers, particularly those with specialized risk profiles, such as captive insurance companies. The goal is to ensure that the framework remains adaptable to emerging risks and evolving market conditions. 

Among the most notable proposed changes for captives is the reduction in the cost-of-capital rate used in risk margin calculations. This adjustment is expected to alleviate capital reserve requirements, particularly for captives with long-term liabilities. By lowering the current rate from 6 percent to approximately 4.75 percent, the change could free up significant resources, potentially improving solvency ratios. 

Another important amendment is the expansion of the scope of the matching adjustment. This change aims to better align investments with long-term liabilities while encouraging support for sustainable, green projects. It thus allows captives to invest in a wider range of assets, including infrastructure bonds and high-quality corporate debt. 

Solvency II's volatility adjustment mechanism is set to be overhauled to make it more responsive to real-time market conditions. This improvement will help captives maintain their solvency during periods of market stress without resorting to drastic measures, such as selling assets at unfavorable prices. 

The recalibration of capital requirements, based on updated risk assessments, may encourage captives to adjust their investment portfolios, favoring more stable, lower-cost assets over equities. Additionally, the inclusion of environmental, social, and governance factors in the framework is likely to drive captives toward increased investment in long-term, sustainable assets. 

FERMA Response 

The Federation of European Risk Management Associations (FERMA) released its third EU Policy Note on the EC's review of Solvency II in October 2024. The review underscored the importance of addressing unintended consequences of the original directive, such as overly demanding requirements on smaller and noncomplex insurers. 

FERMA said that the review is also set to improve proportionality for captive insurance and reinsurance companies, with a revised framework expected by the end of 2024. A key aspect of the new framework is the introduction of small and noncomplex undertakings (SNCUs), which is anticipated to apply to the majority of EU-domiciled captives. 

"The new category of SNCUs will bring more consistency across EU member states and greater predictability, as the revised text sets out clear criteria for any (re)insurance undertaking to be classified as an SNCU," the Policy Note stated. National regulators will also be required to provide explanations if they challenge an SNCU classification, it reported. 

Michael Maglaras, principal of Michael Maglaras & Company, said, "Solvency II is a big concern for captive insurance companies located in the European Union... but I'm glad to report that in October of this year, the European Parliament decided that the most important Solvency II standards for captives to meet are those dealing with small and noncomplex undertakings. While Solvency II is onerous, and its standards are expensive to implement and administer for captives, considering these vehicles as SNCUs should greatly lessen the administrative burden." 

FERMA said that it expects most captive insurance companies in the European Union to meet the SNCU criteria or qualify through a captive-specific exception. Captives classified as SNCUs will benefit from proportionality measures in several areas, notably reporting, governance, and risk assessments. 

These reforms will also simplify regulations for smaller insurers by reducing the reporting and capital calculation burden for SNCUs, enabling them to focus on their core business operations instead. 

Following a political agreement reached in December 2023, the updated directive will be published in the Official Journal of the EU by the end of 2024. Member states will then have 18 months to implement the changes as national law. 

Implications of Amendments 

Peter Carter, head of captive and insurance management solutions at Willis Towers Watson, said that the impact of the Solvency II review and proposed amendments will be far-reaching. He said that the agreed amendments published by the European Council and the European Parliament, which cover various areas, including the risk margin, solvency capital requirement (SCR), long-term guarantee measures, and Pillar 2 and 3 requirements, aim to enhance the regulatory framework, improve governance, and address new risks such as cyber, liquidity, and sustainability risk management.  

Mr. Carter added that the EC's proposal for the review of the directive includes changes to the operation of the proportionality principle, new rules on macroprudential and climate change considerations, and changes to the structure and content of the solvency and financial condition report.  He said that the proposal also strengthens supervisory powers, particularly in relation to recovery and resolution and insurers' financial condition. 

Mr. Carter said the proposed amendments to the directive carry several key implications, including the following. 

• Risk margin. The reduction in the cost of capital parameter from 6 percent to 4.75 percent will lower the risk margin, potentially reducing the capital requirements for captives. 
• SCR. Changes to the SCR, including adjustments for interest rate risk and long-term equities, may impact the capital calculations for captives. 
• Governance and risk management. Enhanced governance requirements and the inclusion of new risks such as cyber and sustainability will probably mean that captives will need to strengthen their risk management frameworks being used to cover additional benefits over and above what the market offers.  
• Proportionality measures. The introduction of proportionality measures may benefit smaller captives by allowing for more tailored regulatory requirements befitting their overall risk profile. Although pure captives are proposed to be small and noncomplex entities and take a proportionate approach to the requirements, it would have been preferable had the definition of captives been expanded to clearly include entities that write mainly group business, immaterial of whether the risks are of an obligatory nature or not, or if they include natural persons or not. As an example, groups that offer benefits to their employees should not be penalized, especially where the captive is being used to cover additional benefits over and above what the market offers. 

Marine Charbonnier, head of captives and facultative underwriting, Asia-Pacific and Europe, AXA XL, said, "Recent modifications to Solvency II, aimed at enhancing the proportionality for captives, could potentially improve their efficiency. These changes may lead to reduced reporting requirements and capital charges. However, the long-term impact might require captives to adopt more sophisticated risk management and investment strategies to fully leverage these regulatory relaxations."  

Alex Gedge, senior captive consultant, global captive solutions at Hylant, said, "The key area is proportionality: given that captives are, largely, insuring a parent company's own insurance, it has long been argued that they should not need as much rigor around their activities as other insurance companies. Proposed changes under Solvency II will now reduce the regulator burden on small and noncomplex insurance companies, which includes captives. 

Reporting, governance, and disclosure requirements will reflect these changes for captives on the basis of their complexity, including product lines, premium size, and cross-border activity," Ms. Gedge concluded.