Regulating the captive market: Responsiveness

competition and legitimacy

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Article Endnotes

Regulation should have clear well-founded objectives and the methods used must be finely-tuned to the specific features of the market place. Responsiveness to external factors that are of concern to phttp://caymanianfinancialreview.cay.newsmemory.com/?date=20101006&goTo=B438-33otential and existing clients is important because the environment does naturally change. Perhaps the ability to respond is the primary factor in the attractiveness of a domicile to international clients?

It was this responsiveness that led to the first Insurance Law in 1979, an Act to recognise and thereby legitimise the Cayman captive. That remains a prime objective in insurance law and regulation in Cayman today, which is why the captive concept must remain legitimate, and this is why internationally recognised regulation must be applied.

The purpose of regulation – legitimacy
One assumes that an unregulated market is the norm and any case for government intervention should be made out by establishing an important public objective. Furthermore, to justify regulation one would also expect some form of market failure to have occurred. Typically the most relevant form of market failure in insurance markets are: inadequate information, excessive competition, unequal bargaining power, control of monopoly power, moral hazard, rationalisation, scarcity and paternalism.

All except the last do not apply to the captive market. Even paternalism only relates to onshore, whereby regulation that could affect offshore markets, may be introduced by onshore governments if thought necessary to protect its citizens. Avoiding onshore paternalistic policy2 that harms the offshore captive is the main, if not only, objective of offshore regulation of captives; it is the reason for legitimacy.

A common perception is that regulation harms business, competition and innovation. It is however, not that simple. In fact good regulation can support business in the offshore context because the objective of legitimisation is mutually beneficial.

Regulators must give some consideration to the impact upon competition, when deciding whether and how to apply the enforcement powers. Section 6(3) of the Monetary Authority Law which governs the Cayman Islands Monetary Authority pays great heed to the competitiveness of markets in performing its regulatory functions. It must do this and continue to protect the legitimacy of the captive concept. This is a balancing exercise.

Case study: The CIMA Risk Rule
As has already been widely documented and discussed in March 2009 CIMA issued a new Rule – Risk Management – Insurers requiring insurers to adopt a comprehensive risk management strategy.

Responsiveness
Risk management became a critical aspect of the financial services industry, when it was concluded that inadequate systems or poor risk management contributed to the current financial crisis.

It was stressed that regulation should seek to ensure that all companies conduct themselves in the manner that any responsible business would conduct itself. By requiring insurers to document their risk management strategy, insurers that are excessively risk tolerant would be exposed. Weeding out reckless risk takers would protect the reputation of the jurisdiction, since a disproportionally high number of failed insurers may imply poor regulation, which would negatively affect legitimacy.

Legitimisation
With respect to legitimisation, international standards of regulation must be met as a minimum and these prescribe that regulators must mandate risk management requirements. International Insurance Core Principle 18 provides that regulators should require insurers to have a formal, board approved risk management strategy and other related requirements. Thus, implementation of these and other international standards is necessary to avoid criticism of the captive. Unlike some of the other principles of insurance regulation, ICP 18 was confirmed as applicable to captive insurers.

The Rule’s effect on competition
Even though an international standard existed, it was important to ensure that by introducing the Rule Cayman was not placed at a competitive disadvantage. At the time the Rule was introduced risk management was already a widely accepted concept in many competitor jurisdictions. Many jurisdictions including Bermuda, Guernsey and Dubai had already issued comprehensive requirements and guidelines addressing a comprehensive risk management framework for insurers.

However, the closest competitors Bermuda and Guernsey had issued guidance only and the mandatory nature of the Cayman requirement, made it potentially more onerous. However, the Bermuda Monetary Authority had conducted two surveys in 2007 to assess investment and underwriting exposure to sub-prime risk and evaluate insurers’ risk management programmes.

Furthermore, after the Cayman Rule was issued, the BVI Financial Services Commission enacted its Regulatory Code in January 2010, mandating that all insurers including captives approve a risk management strategy at Board level and other prescription similar to the CIMA Rule. Thus the Rule did not have an anticompetitive effect with respect to these jurisdictions.

Market response
Although ordinarily CIMA Rules impose mandatory requirements with penalties applicable for breach, by virtue of a statement issued by CIMA to Insurance Managers Association of Cayman, a concession was granted for a transitional period of 12 months, whereby provided that captives review the risk management section of its business plan filed with CIMA and consider and make changes in line with the requirements of the Rule by December 2010, compliance would be satisfied. This statement to IMAC was considered authoritative enough by the market to place reliance upon.

Many markets have placed pressure on regulators to use guidance or other non-binding instruments to implement requirements to satisfy international standards rather than impose mandatory rules. The international standards on insurance regulation have typically provided more discretion to the national policymaker as to whether to use mandatory or non-binding requirements. This differs from the banking equivalent, which are more prescriptive in this regard. The resultant soft regulation can be useful as a transitional stage but as a long term approach it can have negative effects. It arguably creates uncertainty and inequality in the market as implementation/adoption is determined by the ethos, ethics and risk appetite of the individual market players.

On the other hand, mandatory measures by definition have a prescribed sanction, such as a fine and whilst this should deter breach, if not set high enough it will not be effective. In fact, it may actually encourage breach, as many companies cynically consider regulatory fines as a method to raise revenue and do not consider fines as raising regulatory or reputational risk whatsoever.

Thus even a mandatory requirement with sanctions may be largely ignored.

Interestingly though, there was no apparent pressure to soften the enforcement of the rule coming from the regulated in Cayman; the captive clients and other service providers. Many actually welcomed the new Rule and identified many benefits arising from it.

It was realised that the rule was beneficial to the market and would demonstrate all the good features of regulation, it being responsive, innovative and proportionate. It would not have been surprising if the Rule had been devised by the industry and adopted voluntarily, since it would:

  • Help the relationship between the captive and the parent board.
  • Be risk based a justification for lighter or less regulation.
  • Showcase the expertise of the Cayman captive management industry, and
  • Be a tool to assist the Board in considering its risks and ensuring maximum benefit from the advice provided by its service providers.

As the 2009 Cayman Captive Forum witnessed, risk management is and always was, fundamental to credible captive owners and service providers. The new Rule was described then as a tremendous opportunity for captives, on the basis that whilst it was expected, almost all captives already had the necessary components required by the Rule.

Conclusion and outlook
Offshore financial centres are useful to onshore governments. OFCs are used to process undue risks and provide capacity for risk transfer not otherwise available within its own jurisdiction.

Onshore jurisdictions wish to continue to maintain and support OFCs existence but certainly need some assurance regarding the standard of regulation therein to ensure the schemes do not backfire into their economies or political agendas. Legitimacy then should continue as the primary goal of offshore regulation, in both its design and enforcement.

The International Association of Insurance Supervisors authors and promotes the Insurance Core Principles. As noted above, ICP 18 deals with risk assessment and management (jointly with solvency) and ICP 19 with insurance activity, both of which were authority for the CIMA Risk Rule. The ICPs are currently under review and ICP 18 is scheduled to be combined and revised as a new ICP 8 – Internal governance.

The revised and restructured ICPs are due to be finalised by October 2011, so more change is to be expected. The strength and resilience of the captive market will be demonstrated by its readiness for this and other changes to come.

Endnotes

1 Breyer, “Analysing Regulatory Failure: Mismatches, Less Restrictive Alternatives and Reform” (1979)92 Harv LR 549 at pp553-559.
2 Page AC and Ferguson RB, Investor Protection (1992) considered paternalism to be an alternative to market failure as a justification for regulation.
3 The studies analysed the four main areas of potential exposure and conducted stress tests. A few companies were identified for enhanced supervision and monitoring.
4 In April 2010 the Monetary Authority Amendment Law 2010 raised the level of fine for breaches of CIMA Rules from $1,000 to $5,000.

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Lisa M. Bowyer

Lisa Bowyer is a successful project manager and intelligence expert with a high level of understanding of the purpose and risks of regulation, international legal and regulatory requirements and the drivers and strategies of financial markets and products. Highly skilled in drafting of inter alia, legislation, other mandatory provisions, guidance, and policies and procedures, she has an excellent appreciation of policy determining law and regulation.  Prior to joining Liberty, Lisa was a member of the management of the Cayman Islands Monetary Authority, and had been a consultant in the Insurance Firms Division of the FSA (UK) and manager in the Financial Advisory Services Division of KPMG in the UK.

Prior to her career as a regulatory professional she was an academic for 9 years with distinguished publications in the field of insurance and regulation.  She received her first law degree in 1991, her Masters degree in 1994, and her doctorate in 1999.

 

T. +1 (345) 525 5010
E. lisa@liberty.ky 
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Liberty Consulting

Prior to joining Liberty, Principal Consultant Lisa Martine Bowyer was a member of the management of the Cayman Islands Monetary Authority, and had been a Consultant in the Insurance Firms Division of the FSA (UK) and Manager in the Financial Advisory Services Division of KPMG in the UK.

She is a successful project manager and intelligence expert with a high level of understanding of the purpose and risks of regulation, international legal and regulatory requirements and the drivers and strategies of financial markets and products.


Highly skilled in drafting of inter alia, legislation, other mandatory provisions, guidance, and policies and procedures, she has an excellent appreciation of policy determining law and regulation.

Prior to her career as a regulatory professional she was a academic for 9 years with distinguished publications in the field of insurance and regulation. She received her first law degree in 1991, her Masters degree in 1994, and her doctorate in 1999.

 

 

Liberty Consulting Ltd
PO Box 10489
Grand Cayman KY1-1005
Cayman Islands

T. +1 (345) 525 5010
E. lisa@liberty.ky