Will an end to collateral requirements in the EU simply shift the burden downstream to policyholders and cedants? asks Michael Haravon

The European Reinsurance Directive (approved by European Parliament on 7 June 2005) prohibits member states from imposing a collateral requirement for reinsurers established in the European Union as one of its provisions. While the directive will not be implemented for another three years, the European prohibition is already being used as leverage to convince the US to abolish its system of collateral requirements.

What are the potential consequences of the prohibition of collateral? In Europe, foreign reinsurers have been relieved of the burden of posting a costly security for their balance sheets. But should this burden really be removed in the wake of catastrophic events such as 9/11 or Hurricane Katrina, which are profoundly changing the global reinsurance industry? Will this burden, in fact, simply shift to cedents and policyholders who may have to bear the risk of the collapse of a reinsurer? Will the US overlook these issues and be tempted to remove its collateral requirement to attract foreign reinsurers and increase reinsurance capabilities, especially for catastrophic events?

Potential pitfalls

When looking closer at the reasons put forward by the European institutions to prohibit the collateral requirement in Europe, one is struck by the lack of considered answers given during the European legislative process.

The Extended Impact Assessment on the Directive made by the European Commission (21 April 2004) deals with the issue of collateral only in a few paragraphs. The most persuasive reason put forward by the study is that the collateral requirement will no longer be necessary if the reinsurer is subject to specific supervision according to mutually agreed standards aimed at ensuring its financial position within the unified framework of the directive. The report of UK Rapporteur Peter Skinner(1) on the directive is also brief on the issue. It explains that the collateral requirement is no longer an effective regulatory tool and represents an inefficient use of capital. The robust rebuttal offered by Florence Lustman, head of France's Insurance Commission of Control(2) (France currently maintains a system of collateral), which focused on the risk of financial failure of reinsurers, was dismissed.

In the context of an overhaul of the regulatory environment for Europe on reinsurers aimed at the security of policyholders, it is uncertain why Europe did not consider extending the requirement of collateral, instead substituting a more complex regime, modeled on that currently in-force in the direct insurance market.

The collateral prohibition was also substantially driven by a desire to give Europe "negotiating leverage with respect to the US market" according to a Note from the Comite Europeen des Assurances (CEA) on 31 March 2005. This is a market where EU reinsurers provide more than 50% of the reinsurance capacity. In the same note, the CEA was adamant that "reinsurers from countries imposing discriminatory collateralisation ... to EU reinsurers should be subject to equivalent measures when operating in the EU". Unfortunately, and as Florence Lustman pointed out during her hearing before the European Committee on Economic and Monetary Affairs, nothing will prevent a foreign reinsurer whose home system requires collateral (for example, a US reinsurer) to set up a subsidiary in Europe and benefit from the absence of collateral. This reinsurer will even be able to retrocede the risk to an entity located outside of Europe.

This highlights one of the main issues which was not adequately addressed at a European level. This is that the lack of knowledge of the ultimate risk bearer in the reinsurance/retrocession industry, of their state of solvency and of their regulatory environment renders supervisory systems based on the mere quantitative and qualitative rules of the directive far less efficient than in the direct insurance context and therefore, overall, less justifiable. A collateral system, described as old-fashioned, does however favour the old-fashioned saying that "a bird in the hand is worth two in the bush" which few cedants or policyholders would easily dismiss.

Will the US play ball?

Barely three days after the vote in the European Parliament, under the UK presidency of the EU, Irish European Commissioner for the Internal Market and Services, Charlie McCreevy at a CEA conference on 10 June 2005 in Paris reiterated that "the adoption of the directive will further strengthen our case for the removal of the collateral requirement in the United States". This overlooks three elements.

Firstly, the US collateral system is the supervisory system for foreign reinsurers; it addresses a legitimate concern to protect policyholders and cedants in the case of the failure of a foreign reinsurer, failure which US regulators may be ill-equipped to detect. Any abolition of collateral is therefore likely to be preceded in the US by a debate on what rules should help prevent or at least detect the possible collapse of a foreign reinsurer. Blind trust by the US in foreign reinsurance regulations is unlikely to occur. Nor is it a responsibility European regulators are likely to want to take. This is also a symptom of a shift of responsibility from the reinsurer to the regulator whose job it will be to provide the "security" through tighter controls, which the collateral hitherto provided.

Secondly, insurance and reinsurance laws and regulations are not harmonised in the US but vary from state to state. The collateral system is the common factor in this scattered landscape of rules as far as foreign reinsurers are concerned. Abolishing collateral will mean that the work of detecting and avoiding potential defaults of foreign reinsurers will take place at a state level. Such a process is bound to be lengthy and produce variable results and this may not put foreign reinsurers wanting to do business in the US in a more favourable position.

Thirdly, the abolition of collateral, according to commentators, represents a further step in the integration of the European internal market and of the freedom to provide services in Europe. However, this element is unlikely to play a significant role in a determination by US regulators of whether to abolish the collateral requirement in the US.

These elements must be balanced against the need of the US for a better penetration of foreign reinsurers in its market in order to spread the risk of catastrophic events more adequately. This foreign reinsurance capacity is likely to only be possible if the US is willing to make a compromise regarding its collateral requirements.

A likely rise in premiums?

Curiously, an anomalous situation has been created in certain European countries whereby the insolvency of European insurers is generally protected by national industry-funded indemnity funds or safety nets for the benefit of policyholders, but insurers are no longer protected by the security that the collateral provided in case of default of foreign reinsurers.

Although some account must be taken of the possible increase in the price that a reinsurer charges for taking over risks from direct insurance companies under a collateral system (an increase which, unfortunately, has not been widely studied or measured), one may legitimately wonder whether the loss of collateral will prompt insurers to likewise increase premiums in order to cover the risk of failure of their foreign reinsurers. The abolition of the collateral system would then simply shift (or maintain) the risk (or part of the risk) of default from the reinsurer to the insurer and, in turn, to the policyholder.

The prohibition of the collateral requirement will also mean that disputes between cedants and reinsurers are likely to start with satellite litigation whereby the reinsurer will be required to lodge a security (eg letters of credit) pending resolution of the dispute on the merits by a court or an arbitration panel. The tests used by courts and arbitration panels, including in the US, are likely to be revisited and security may more easily be ordered against a foreign reinsurer.

While foreign reinsurers have long argued that the collateral system should be abandoned given the supervision they enjoy at home by their regulators, recent investigations into finite reinsurance practices show that regulators cannot possibly contemplate every risk the industry faces. Yet, the prohibition of collateral requirements means the expectations of both policyholders and cedants of the standard of control and prevention by regulators will dramatically increase. In turn, should regulators be seen to have failed to prevent the insolvency of a foreign reinsurer, insurers are likely to turn to the regulators, through court proceedings, to account for it and argue that tighter mechanisms should have been in place.

In short, will the concern for security which occurred hitherto upstream simply move downstream?

- Michael Haravon is an associate in the Reinsurance Group of Milbank.

1. Draft Report on the proposal for a directive of the European Parliament and of the Council on reinsurance, Committee on Economic and Monetary Affairs, 2004/0097 (COD), 14 March 2005.

2. Florence Lutsman, 30 November 2004, Committee on Economic and Monetary Affairs hearing on the Reinsurance Directive.

Website: www.globalreinsurance.com

EU Directive may not be winning argument in US discussions; CEA "satisfied" with final version of Reinsurance Directive; Directive "fills gap" in EU legislation, says McCreevy.