The 100% collateral rule for foreign reinsurers doing business in the US has long been accused of unfairness. But a more level playing field could be just around the corner, explains Ronald Gift Mullins.

Glacial usually describes the speed at which insurance regulations are amended in the US. And changing the collateral rule for foreign reinsurers seems no exception. More than 50 years ago, insurance commissioners began worrying about how to best recover reinsurance on US risks ceded by primary insurers to foreign reinsurers - those domiciled outside the US. Essentially, the commissioners' concerns centred on how to recover reinsurance if the alien reinsurer failed or refused to pay. A solution was finally decided in 1982 which requires foreign reinsurers to post 100% collateral on all of their gross US liabilities, otherwise the ceding insurer cannot claim credit for the reinsurance.

Foreign reinsurers, especially Lloyd's of London, have been fighting to reduce or eliminate the 100% collateral requirement for years. They say it creates an unfair advantage for US reinsurers, which do not have to abide by such a rule, and that the rule requires foreign reinsurers to tie up huge amounts of capital that could be used for other purposes.

For Lloyd's, according to Julian James, director of worldwide markets at Lloyd's, the collateral rule after 9/11 required it to pay $3.6bn into its US trust funds, despite reinsurance being in place to cover two-thirds of those claims. After the US hurricanes of 2005, Lloyd's had to transfer more than $2.5bn into US trust funds, bringing its total to nearly $11bn.

The value of US property casualty industry recoverables in 2003 from all foreign reinsurers equalled approximately $150bn. Ninety-two percent of all US reinsurance premium ceded abroad went to foreign reinsurers from just five countries.

Few others require collateral

Citing as evidence that collateral is not required, James says the vast majority of EU countries do not require reinsurers, whatever their nationality, to deposit collateral with cedants before the cedant can take credit for non-life reinsurance purchased in their financial statements. At present, of the 25 EU member states, only France and Portugal require pledging of assets from reinsurers before such credit can be given. Germany demands collateral but only for life insurance. But like the US, Canada requires 100% collateral and more in some cases from foreign reinsurers.

However, there will soon be changes. "The EU Reinsurance Directive, to be implemented throughout the EU by December 2007," James says, "prohibits all member states from retaining or introducing systems of pledging of assets from reinsurers authorised in the EU. This prohibition has to be applied by every EU member state by December 2008 at the latest under a transitional provision in the Directive."

Reduction deserves consideration

Wiley Rein & Fielding partner Lawrence Mirel, while commissioner of insurance, securities and banking for the District of Columbia, co-chaired the Reinsurance Collateralization Roundtable, an ad hoc regulator/industry committee formed by the Reinsurance Task Force of the National Association of Insurance Commissioners (NAIC). In March 2004, in an attempt to break the deadlock on regulatory change to the collateral rule, the regulator members of the roundtable agreed that the 100% collateralisation system should be changed. They also agreed that any new rules should be "geographically agnostic" and would apply to all reinsurers operating in the US regardless of country of domicile.

In a white paper submitted to the Reinsurance Task Force in September 2005, the regulators proposed two alternative regulatory schemes. These were a "rating proposal", which was subsequently approved by the task force, and a "pooling proposal" that suggested the creation of a single, mutualised pool of capital to collateralise a portion of the US liabilities of participating unauthorised reinsurers.

In June 2006, the task force received a report on principles that should govern non-admitted reinsurers from an "interested persons" group consisting of more than 100 members representing reinsurers, ceding property and casualty and life insurers, trade associations and law firms. The task force charged the interested persons group with evaluating the rating proposal and formulating recommendations for how it could be implemented. Its report is to be presented at a future meeting of the NAIC.

The rating proposal would require all reinsurers, US and foreign, to be evaluated and assigned a rating by a reinsurer rating organisation, similar to the manner in which direct insurers are currently rated by the rating agencies. A reinsurer's rating would determine the amount of collateral, if any, it would be required to post for obligations in the US.

Strong reaction

Opposition to and endorsement of the proposal to revamp the 100% collateral rule came swiftly and broadly. A letter of protest came from a group of trade organisations - the Alliance of American Insurers, the American Association of State Compensation Insurance Funds, the American Insurance Association, the National Association of Independent Insurers, the National Association of Mutual Insurance Companies (NAMIC) and the Reinsurance Association of America. The organisations said the review of the collateral rule was the result of "entreaties from primarily Western European reinsurers who want the current 100% collateral requirement lowered ... based on an unstated set of solvency and soundness criteria."

The major reservations cited by the trade organisations to changing the rule were:

- There could be additional guaranty fund assessments caused by a reduction in reinsurance collections;

- Possible additional insurance insolvencies that may flow from uncollectible reinsurance; and

- The inability to perform detailed credit risk analyses on alien reinsurers because of the varying disclosure, accounting and regulatory requirements imposed on the reinsurers in their countries of domicile.

An argument used by those opposed to changing the collateral rule is that even with the 100% requirement, foreign reinsurers have managed to corner close to 50% of the US market. With Swiss Re taking over GE Insurance Solutions, there are now only two US-based reinsurers in the world's top ten - Berkshire Hathaway and Transatlantic Re. Opponents to change say foreign reinsurers have alternative methods to do business in the US without complying with the 100% rule. They can domesticate in the US as authorised reinsurers or establish a US branch or use letters of credit.

Furthermore, a US insurer can decide to cede to an alien reinsurer and not require the 100% collateralisation. This may occur if the insurer has more than ample capital and thus can bargain to reduce its cost of reinsurance by not requiring the alien reinsurer to post collateral. It is actually the primary insurer that makes the final determination of calling for collateral or not.

Charles Chamness, president & CEO, NAMIC, offers a worst case scenario if a failed primary insurer in the US was reinsured by an foreign reinsurer. "If, for some reason, an alien reinsurer can't or won't honour its promise to pay," he says, "then the resultant shortfall in the estate of the primary insurer must be made up via the guaranty-fund system, and the burden to pay falls on other insurers and their policyholders. Any departure from current regulation should include careful consideration of this issue."

Funding 100% collateral does not pose a problem for Swiss Re, according to Debra Hall, vice president and regulatory counsel. Though Swiss Re America is fully licensed throughout the US, it retrocedes a significant amount of its risk to its Swiss parent or other non-US affiliates. Those companies must post 100% collateral for Swiss Re America to receive financial credit.

"But there are a number of problems with the rating proposals we have seen to date," she says. "The determination of a rating of a reinsurer would be done by a non-governmental entity which is not accountable to a legislature or government body. This also brings into question the process for appealing any determination. We don't think that these are appropriate ways to make these determinations."

She also observes that the idea of a rating proposal detracts from the real challenge - comprehensive reform of reinsurance regulation in the US, including a single regulator and an optional federal charter.

The need to revise the collateral rule has been discussed in a report issued by the Group of Thirty, more formally known as the Consultative Group on International Economic and Monetary Affairs, and Competition. The report concludes that insurance industry participants and most insurance supervisors agree that mandatory collateral requirements "are not the optimal supervisory approach. Although collateral requirements have in the past provided an expedient approach to addressing concerns about reinsurance regulation and accounting differences across countries, they have a number of disadvantages."

"First," the report continues, "by immobilising assets that cannot be used elsewhere, they can in certain circumstances actually undermine a solvent reinsurer, to the extent that it experiences problems in one jurisdiction but cannot access assets because of a collateralisation requirement imposed by a second jurisdiction. Second, they fragment the capital base of reinsurers and undermine efficient capital managements, so adding to the cost of business for the reinsurers required to post them."

Psychological threshold

Chamness, of NAMIC, sees being able to translate and understand the financial strength of foreign reinsurers, for the purpose of determining their eligibility for a reduction in collateral, as a difficult task. "Further, it is appropriate to add that the ability and strength of regulators varies according to domicile," he says. "This may affect the breadth and reliability of the data available for understanding a reinsurer's financial status."

"These outdated collateral requirements do not act in consumers' best interests," Lloyd's Julian James believes, "as they add unnecessary cost and reduce competition within the reinsurance market."

Mirel, of Wiley Rein & Fielding, reminds that previous attempts to even consider changes to the 100% collateralisation requirement ended in stalemate. "Whether or not the NAIC ultimately adopts it, the fact that the rating proposal is even being considered represents the crossing of a major psychological threshold," he says.

- Ronald Gift Mullins is an insurance journalist based in New York City.