Omar Hameed outlines some of the current legal and regulatory issues affecting the range of products which have come to be known as alternative risk transfer, ART.

In 1998, the annual gross premium income of the global traditional insurance market was around $365 billion, while captive premium income was just $21 billion and finite risk insurance premium income a comparatively meagre $6 billion. The global capacity for property catastrophe XL cover was $53 billion, while CAT bonds accounted for a mere $3 billion.

What do these statistics indicate? The obvious conclusion must be that ART is at present to be seen as a complement to rather than as a replacement for traditional insurance and reinsurance products.

Why is this so? There are many reasons, ranging from the disproportionate amount of time it takes to conclude the typical deal to the difficulties ART customers can have in understanding the way in which their product has been priced and when trying to compare different providers' products or quotes. One of the reasons is that there are still, unfortunately, too many legal, regulatory and accounting obstacles to be overcome.

As an example, let us consider financial reinsurance in the UK. Essentially, there will be two key legal issues in relation to financial reinsurance. First what is the product in question - is it insurance/reinsurance or some form of banking product? Secondly, how do you account for it and report it properly - that is, to the satisfaction of the regulator?

In its October 1998 response to the EU Commission working paper on financial reinsurance, the Association of British Insurers made the following observations:“It is difficult to define financial reinsurance in a clear and unambiguous way although certain common characteristics can be identified. These include:
• They are multi-annual policies (typically they cover five to seven years).
• The terms of the contracts have regard to the time value of money. Future investment income is explicitly defined as a factor in the premium calculation.
• There may be limited risk transfer (especially of underwriting risk).
• There is a close connection between the cedants' own loss experience and the actual cost of reinsurance. This is because the profits or losses arising from the contract are shared between the reinsurer and the cedant to a substantial extent. Premiums may be refunded or additional premiums may become payable in the light of claims experience.”

Regulators throughout the world have struggled to pin down financial reinsurance and as a result have ended up considering individual transactions one by one as necessary by looking either at the substance of the product or at its form or at both. For example, in the US, regulators will expect the product to effect a transfer of both underwriting risk and timing risk before it will be accepted as an insurance product.

This difficulty is also evident in the way most jurisdictions approach the financial reporting of financial reinsurance. For example in the UK, the Statement of Recommended Practice (SORP) on Accounting for Insurance Business issued by the Association of British Insurers in December 1998 reflects the approach taken by FRAG 35/94 and FRS 5. Provided there has been a material transfer of insurance risk (underwriting, timing or both), the transaction is required to be accounted for as one of insurance and the principles of recognition of premium and claims set out in the SORP will apply. Where there is no significant transfer of insurance risk, the SORP requires that the contract should be accounted for so as to reflect its economic substance where this differs from the legal form. In particular, Part 7 of the SORP contains a number of detailed provisions relating to the “Determination of the Substance of an Insurance Transaction”, including the following observations:
“A key characteristic of insurance is the transfer and assumption of ‘insurance risk' which may comprise either or both underwriting risk or timing risk. In considering whether or not a significant transfer of insurance risk has taken place under a contract of insurance, the entity should consider first whether it is reasonably possible that the insurer may realise a significant loss from the contract and, secondly, whether there is a reasonable possibility of a significant range of outcomes under the contract .... Insurance risk will not have been transferred unless both of these conditions exist. If there is a significant degree of uncertainty in respect of the timing of claim payments then, depending on the effect of the contract as a whole, timing risk alone may be sufficient to constitute a transfer of insurance risk. This will only be the case provided there are no other features of the contract of insurance which affect or compensate for the timing of claim payments under the contract.”

It is true that a single regulator - the Financial Services Authority - is a step in the right direction in that it then becomes possible for any regulated firm to be given a single authorisation in respect of all regulated activities. In practice, however, the detail of the approach the FSA will take in this respect will not be apparent at the earliest until the Financial Services and Markets Bill is passed into law.

Similar legal obstacles, this time more in the nature of financial reporting hurdles, arise in relation to the use of derivatives in insurance. In Europe at least, the legal considerations associated with insurance derivatives principally concern the question of admissibility. The Third Insurance Directives set out a list of permitted assets with which insurance companies may cover their technical provisions. The Directives themselves do not prevent insurers investing in other types of assets, but if they choose to do so they cannot credit such assets with any value for the purposes of determining whether or not they satisfy their solvency requirements. Permitted assets are categorised in the following way:
(1) investments - these include debts, securities, bonds, loans, shares and immovable property rights;
(2) debts and claims - these include debts owed by reinsurers, policyholders and intermediaries, advances against policies, tax recoveries and claims against guarantee funds; and
(3) others - these include tangible assets other than land or buildings, cash and cash deposits, deferred acquisition costs, accrued income and reversionary interests.

Article 21 of each Directive provides specifically in relation to derivatives as follows:
“Derivative instruments such as options, futures and swaps in connection with assets covering technical provisions may be used in so far as they contribute to a reduction of investment risks or facilitate efficient portfolio management. They must be valued on a prudent basis and may be taken into account in the valuation of underlying assets.”

The implementation in the UK of the Directives was achieved principally by the Insurance Companies Regulations 1994 (“the 1994 Regulations”). Under the 1994 Regulations as amended, value can be ascribed to most kinds of derivatives, including options and futures. The insurer must, however, meet a number of conditions which can be summarised as follows:
• The derivative contract must either be listed on a regulated exchange or made with an approved counter-party.
• The derivative contract must be held in connection with an admissible asset or contract. (This effectively means that free-standing speculative derivatives, perhaps such as those currently offered by CBOT, may be excluded from valuation).
• The derivative contract may relate to an index, provided that the index is either one which relates to assets which are admissible or is otherwise specified in the Regulations.
• The derivative contract must be for the purposes of reducing investment risk or facilitating efficient portfolio management.• The derivative contract must be covered. (This means that if the derivative contract requires the insurer to satisfy an obligation, the insurer must have sufficient of the correct assets to perform that obligation).
• The derivative contract must be readily capable of being closed out.

Regulatory change

It is likely that the regulatory regime in the UK will change substantially with the passing into law of the Financial Services and Markets Bill. In particular, we may see important if subtle changes to the mechanisms by which insurers are prevented from doing non-insurance business and these changes may ease some of the difficulties which exist at present. In any event, the Financial Services Authority has made it clear in a number of its recent consultation and position papers that it intends to take a positive and supportive approach towards ART. However, the FSA's plans will emerge only over time and the Bill itself looks likely to be carried over into the new millennium's first Parliamentary session, so the current regulatory environment will remain with us for a while yet.Omar Hameed is a solicitor in the Reinsurance and International Risk team at Barlow Lyde & Gilbert.