Luxembourg: A Captive Leader at Europe’s Center

One of the original six-member European Economic Community that evolved into the 27-member European Union, Luxembourg has become a global financial services center with powerful market positions in fund management and captive insurance.

Victor Rod, Luxembourg’s long-serving insurance commissioner, is well known in industry circles in Europe. “He was actually here before the law on reinsurance was passed,” said Frederick Gabriel, head of broker Marsh’s captives operations in Luxembourg. “And so we have great continuity with him.”

The authorities in Luxembourg “are relatively proactive in terms of trying to help us and develop the business and develop the country,” Gabriel said.

Not least among Luxembourg’s attractions are the linguistic skills of its work force. The most difficult thing in the world is to find a Luxembourger who speaks fewer than four languages, joked Mervyn Martins, an insurance partner at PricewaterhouseCoopers in Luxembourg.

Martins said newcomers to the Luxembourg market are often surprised at the lack of “extreme details and reams of regulation.” Much of the regulator’s understanding comes from meeting with market participants, Martins said.

The main driver of the reinsurance market in Luxembourg has been the tax regime for captives, said Carlos Wong, assistant general manager of analytics with A.M. Best Europe Ltd. Most of these captives are linked to foreign operations, Wong said.

“The domestic market is very small,” he said. “You don’t expect much growth there.”

Since 1984, when captives were commercialized in Luxembourg, the country has adopted the EU reinsurance directives, allowing for a “pretty unique” system under which companies can accumulate tax-deferrable equalization reserves, said Gabriel. These reserves can be invested or loaned back to parent companies. “You get taxed one day, but that day is a long way away,” he said.

“The model has been quite successful,” Wong said. “All these incentives were set up in the mid-80s, so it’s been running for around 25 years, and Luxembourg is one of the main domiciles for captives all over the world.”

Marsh has about 25% of the captives business in the country, Gabriel said. “We are one of the leading captive management companies here,” he said.

According to Luxembourg for Finance, the public-private agency that seeks to develop the country’s financial services sector, Luxembourg is the largest captive domicile in the EU. The country is small, with a population of about 470,000 and an area of about 1,000 square miles.

Luxembourg is seeing “slow but steady growth” in the captives sector, with about 10 new captives a year having been formed over the past five years, Gabriel said.

Marsh’s captives unit in Luxembourg draws business “from Sweden right down to the Iberian Peninsula,” he said.

Both fund management and banking have been hit by the global economic crisis, Gabriel said. He believes Luxembourg is pulling out of the banking downturn. Luxembourg’s main competitors are probably Dublin and Malta, according to Gabriel. Ireland joined the EEC in 1973. Malta joined the EU in 2004. Neither of these two jurisdictions offers the kind of tax deferral found in Luxembourg, Gabriel said.

The European dimension has become even more important as the EU nears the adoption of Solvency II at the end of 2012. Solvency II has been designed to bring a uniform capital adequacy structure for insurers and reinsurers throughout the EU.

These pressures have been intensified by the EU parentage of most of Luxembourg’s captive industry. “There is at the moment some uncertainty due to the upcoming requirements from Solvency II,” Wong said.

Gabriel, who described Solvency II as “probably the most important thing that has hit captives ever,” said Marsh supports efforts by the Luxembourg authorities to lobby within the EU on behalf of the captives sector. It is important that Brussels recognize the principle of proportionality regarding captives, he said.

Proportionately refers to the regulatory burden on smaller insurers, such as captives. Under this principle, smaller organizations are not required to have the complex modeling processes used by larger competitors. Much progress has been made on proportionality since a couple of years ago, when “captives were not considered,” said Gabriel.

Wong detects pressure from captive interests in Luxembourg to seek a compromise that would allow the creation of a simplified capital model that would apply to captives. As reinsurers, the captives can be expected to argue against penalties that might effectively reduce the advantages of being a captive, he said.

In a position paper issued in September 2010, the European Captive Insurance & Reinsurance Owners Association described proportionality as “one of the fundamental principles of the jurisprudence developed by the European Court of Justice. It is a safeguard against the unlimited use of legislative and administrative powers.”

Luxembourg’s insurance profile was given a boost in 2007 when Swiss Re decided to concentrate its European reinsurance and insurance activities there.

Martins regards Swiss Re’s presence in Luxembourg as “a sign of recognition” that the country can meet the needs of a leading organization. “They wouldn’t come unless they found the right combination,” he said of Swiss Re.

Luxembourg’s small size means that it is not the first name that comes to mind when people talk about Europe, Martins said. Ten to 15 years ago, financial services companies looking at setting up in Europe were inclined to think of the bigger countries that might be expected to provide everything, he said. Today, Luxembourg is seen as a place that can complement other activities.

“And I think that’s the right approach,” said Martins.