The competitive advantages of locating where regulatory costs are lowest may be disappearing Ian Poynton and Stephen Parker highlight some initiatives to establish common standards.
Reinsurance is a global business, but reinsurers themselves are established in a number of different countries throughout the world. Generally, these countries have different regulatory regimes for reinsurers established within their jurisdiction, which offers the opportunity for regulatory arbitrage. Reinsurers, and also cedents, can take advantage of these differences to strike better deals for cover.
The opportunities for regulatory arbitrage may, however, be decreasing.
A number of regulatory initiatives are seeking to establish common standards of regulation, and in some cases harmonise the regulation of reinsurance in different countries.
IAIS Principles and Standard
The International Association of Insurance Supervisors (IAIS) is a voluntary association that brings together regulators from all the major reinsurance markets around the world. It has pursued a number of projects to develop a common approach to the regulation and monitoring of reinsurance markets.
Since 2002, it has introduced its Principles on Minimum Requirements for Supervision of Reinsurance and its Standard on Supervision of Reinsurers, as well as undertaking a project aimed at enhancing transparency and disclosure in the reinsurance sector (known as Task Force Re).
The Principles and Standard developed by the IAIS identify five main elements required for effective supervision of reinsurers. These are:
- technical provisions
- investments and liquidity
- economic capital requirements
- corporate governance
- exchange of information.
The Principles and Standard are not mandatory but they carry some weight with regulators around the world. So the framework set out by the IAIS is likely to influence the development of reinsurance supervision. Therefore, the regulatory regimes may well start to show signs of convergence. Indeed, this has already been the case in the development of the draft directive for the regulation of reinsurance in the EU.
The reinsurance directive
It is natural to look to the EU for a common regulatory regime for reinsurance.
However, although steps are being taken to bring reinsurance regulation into line across member states, it is only recently that the European Commission has proposed a directive to harmonise reinsurance supervision.
If the directive is implemented, the regulation of reinsurance in EU member states will have certain common features. The position in relation to Switzerland is ambiguous. Although it is not an EU member, it has voluntarily adopted the legislation in relation to direct insurance in order to gain access to the EU market and may well take a similar line with reinsurance.
The new regulatory rules are based on the current approach to the regulation of direct insurers in the EU. Key features of the draft directive are as follows:
- Reinsurers with their head office in the EU will need to obtain a licence for their reinsurance business from their home state regulator. To be authorised, a reinsurer will have to show its home state regulator that it is managed in a sound and prudent way and submit a scheme of operations.
- Prudential requirements will be extended to cover reinsurers across the EU. These will include reinsurers satisfying solvency requirements by establishing adequate technical provisions for their business.
In addition, the draft directive includes a 'prudent person' approach to investment by reinsurers, rather than one based on defined quantitative maximum limits. Regulators in member states will not be able to refuse reinsurance contracts with a reinsurer authorised under the directive on grounds related directly to financial soundness.
The aim of the directive is to introduce a harmonised regulatory framework for reinsurance across the EU. This in turn will hopefully increase confidence in the reinsurance market and encourage the development of a single market in reinsurance throughout the EU. This single market would enable cedents to benefit from increased competition and more efficient markets.
The wider impact of a common EU approach to reinsurance regulation may also be seen in future negotiations with non-EU countries over regulatory requirements, for example when discussing the US requirement for 100% collateral to be provided to cover the US business of EU reinsurers. Further, the World Bank and other international institutions have indicated that the proposed EU directive is a good starting point to address the issue of reinsurance regulation at the international level.
The proposed directive will, for the most part, not affect companies that write both direct and reinsurance business; existing EU directives already catch the activities of these composite companies. From a UK perspective, the draft directive adds little new to the regulatory regime, as reinsurers in the UK are already regulated on the same basis as other insurers. However, UK reinsurers will be able to take advantage of the passport provisions, which allow a reinsurer to carry on reinsurance business throughout the EU without the need for authorisation in other member states.
The EU has had common rules for determining the solvency requirements of insurers for many years. The proposal for a reinsurance directive extends these rules to reinsurers. However, the EU is also pursuing the Solvency II project, which seeks to update the present rules by better matching solvency requirements to the actual risks that a re/insurer encounters.
The present regime, recently updated by the Solvency I directives, bases the calculation of the amount of capital an insurer is required to set aside on the volume of that insurer's business rather than the associated risks. Solvency II adopts a more risk-based approach. It aims to improve the method for determining an insurer's solvency margin by analysing more fully the risks facing that insurer. In future, a regulatory assessment of solvency will consider a wider range of factors, such as credit risk, the valuation of assets to cover liabilities, the matching of assets to liabilities, and the strength and nature of a reinsurance programme, as well as the implications of accounting and actuarial policies.
In addition to the more obvious improvements in regulation that Solvency II can be expected to bring, it may affect how insurers buy reinsurance.
The strength of a reinsurance programme will in part be determined by the identity and location of the reinsurers and the perceptions of the regulatory regime they operate under. Solvency II may lead to a higher solvency margin as a result of purchasing reinsurance from a reinsurer that is based in a jurisdiction with a less stringent regulatory regime.
If that is the case, the cost advantage from buying this reinsurance may be outweighed by the disadvantage of the insurer having to set aside more capital to satisfy its solvency requirements.
Developing a more sophisticated approach to managing the risk a re/insurance company faces mirrors the work that is already well advanced in the banking field on Basel II. When Solvency II is implemented, it may also affect a different type of regulatory arbitrage, that between banks and insurers.
The convergence of the assessment of risk in banking and insurance may therefore even-out the perceived underpricing of risk where insurance companies take on credit risk.
The introduction of the US Sarbanes-Oxley Act brought in wide ranging provisions intended to lead to more rigorous internal controls and more transparent financial reporting for companies. The Act only directly applies to US publicly traded companies and is not specifically aimed at increasing the regulation of re/insurance companies.
Despite this, its provisions have undoubtedly affected the supervision of re/insurance companies and how they implement their internal controls.
This is mainly because of the need for senior management to ensure the accuracy of their company's financial statements. As re/insurers' financial statements depend on factors such as underwriting quality, claims reserving and reinsurance programmes, management need to pay even more attention than before to these areas.
With this heightened focus on a company's financial statements, there may well be greater concern about the strength of an insurer's reinsurance cover. An assumption that reinsurance is 100% recoverable may no longer be justified and, as a result, the quality of an insurer's reinsurance programme will become a significant issue. And the assessment of the regulatory regime applying to the reinsurer from whom the cedent has purchased cover may be an important factor in judging the level of security provided by the programme.
Where future competitive advantage lies
The rapid development in the regulatory environment for re/insurance companies is taking two directions.
First, there is a trend towards greater international coordination of the regulation of re/insurers. Although this process is most advanced for those in the EU, IAIS initiatives are also contributing to the wider convergence of re/insurance regulation.
Second, regulation of re/insurers is becoming more sophisticated. In particular, Solvency II and Sarbanes-Oxley will lead to a more careful and detailed assessment of reinsurance programmes. As regulatory regimes around the world are updated, best practice may also be expected to emerge on a consistent basis worldwide.
In the short term, reinsurance regulation is likely to remain fragmented.
This will mean that reinsurers will be subject to different supervisory burdens and inevitably different costs of compliance. For example, Solvency II and Sarbanes-Oxley may increase regulatory costs for reinsurers covered by these provisions and therefore increase the advantages of being established in a jurisdiction with an alternative regulatory regime.
However, the opportunities for regulatory arbitrage are likely to decrease in the long-term as the regulation of re/insurance develops. The implementation of a reinsurance directive by the EU will be a significant step.
Although the opportunities for regulatory arbitrage may be diminishing, those jurisdictions that have benefited from this arbitrage are likely to remain significant reinsurance centres, even though they may lose their regulatory advantage. These centres have developed a high level of expertise, allied with home regulators who are flexible and responsive to the needs of reinsurers operating in a wholesale market. This environment will provide a separate basis of competitive advantage and so those countries will remain attractive locations in which to write reinsurance.