A proposed fast track EU directive to regulate reinsurance business has raised concerns about solvency requirements
Sergio Beristain looks at the reasoning behind the proposed solvency margin for life reinsurance and its possible impact.
The European Commission, the EU's executive arm, has proposed a 'fast track' directive that will regulate reinsurance business ahead of the Solvency II project. The bill - if approved by the European Parliament and by the Council - will harmonise requirements for life reinsurance companies with a solvency margin of 3 per mille of the sum at risk and 4% of reserves. The Reinsurance Directive also intends to remove the collateral requirements imposed in some EU member states and aims at establishing a single EU passport for reinsurance companies.
The Commission wants a fast track directive because completion of the Solvency II project still appears to be a long way off, and is not anticipated until 2008, even if it uses the so-called Lamfalussy approach, a legislative shortcut. The Commission believes that its mid-term proposal is necessary to start the process of harmonisation.
According to Yannis Samothrakis from the Comite Europeen des Assurances (CEA), the European Federation of National Insurance Associations, reinsurance companies have to adjust to different requirements and supervision. "Today reinsurance companies have to find their own ways to meet the different requirements and supervision regimes across Europe. Each country sets its own rules for reinsurance supervision. This is why companies have to find different ways to be able to operate across borders", he said.
At present there is no single market in the EU for reinsurance and member states are free to regulate - or not - this business. The lack of a common EU regulation on reinsurance supervision in the EU has triggered differences in the methods of supervising the reinsurance market in the various member states.
According to the Commission, the differences between national legislations have created uncertainty in the international arena. The Financial Sector Assessment Program, an IMF and World Bank initiative, has highlighted in its reports the lack of supervision in certain European countries.
Although these country reports are not public, a Commission official said that the Commission keeps a close eye on their impact assessment and is in contact with insurance specialists at the IMF. "The overall concerns voiced by high-level bodies such as IMF triggered detailed general work, in particular by the Financial Stability Forum, of which the IAIS (International Association of Insurance Supervisors) is a member. It also had a decisive impact on the timing for the starting of reinsurance supervision projects in the IAIS, EU and OECD (Organisation for Economic Co-operation and Development)," he said.
Although the EU has started harmonising the insurance market, it has never harmonised the reinsurance market directly, nor has it legislated on the market's supervision or its requirements. In fact the last time the European Commission looked at reinsurance activities was when it legislated the direct insurance market. The so-called Third Generation Insurance Directives harmonised the insurance industry in three steps: freedom of establishment, freedom of services and freedom of trade by means of a EU insurance passport. The activities foreseen in this legislation covered only reinsurance activities by direct insurers. Indeed, this legislation was never aimed at direct reinsurance companies, as it was all about direct insurance business.
The reinsurance market has no harmonised way to calculate risk, which is why it is impossible to set a barometer for requirements such as a solvency margin. According to Mr Samothrakis, there is no harmonised way of calculating these figures. So how did the Commission go about it?
Due to the inconsistent way capital requirements are calculated in the EU, the European Commission decided to base its proposal on previous harmonisation for direct insurance. It came up with a different combination of regulatory standards, before arriving at its final proposal.
In fact, the European Commission's third public draft of September 2003 used the non-life direct insurance margin as applied to health business to calculate the life reinsurance solvency margin. The final solvency margin was translated into one third of the premium and claims index of the non-life direct insurance. Later, after several rounds of public consultations, the Commission changed its proposal so that the reinsurance solvency margin was based on the direct life insurance solvency requirements.
According to a Commission official, the treatment of life reinsurance is one of the most complex aspects of this proposal. "During the preparation phase, we have considered different models to determine the solvency requirement for life reinsurance," he said. In fact, the Commission studied three alternatives: one in which it approximates the solvency requirement using general non-life reinsurance rules; another which approximates with direct insurance health rules; and a third which applies the direct life rules for life reinsurance.
But time did not allow the Commission to find the appropriate solution that would suit the life reinsurance market. "Given that the reinsurance fast track proposal is an interim step before the introduction of the more comprehensive Solvency II approach, the project's timing did not allow the elaboration of more risk-based solutions," the Commission official said. It had been decided not to use non-life rules for life reinsurance because these rules were technically difficult to apply. "A significant number of member states expressed concern with the use of non-life approximation methods and several other member states have expressed hesitation about an EU regime with different requirements for direct life and reinsurance life business," he said. However, basing the solvency requirements on the direct life insurance rules drastically changes the solvency margin to 3 per mille of the sum at risk and 4% of reserves.
According to the Association of British Insurers (ABI), the present proposal as it stands may force life reinsurers in some member states to raise more capital. For example, the UK life reinsurance market, known to have strong supervision and legislation, will not be favoured by this approach.
The main issue that puts the UK life reinsurance industry at stake is the combination of two requirements. The first key concern is that the proposed directive will raise the capital at risk component to 3 per mille.
The second concern is that the credit in the reserve element of the required solvency margin for retrocession will reduce from 50% to 15%. "Both factors in combination represent a significant increase in the amount of capital reinsurers will be required to hold under the proposed directive," said an ABI report.
The insurance industry did not greatly challenge the 3 per mille of capital at risk which was introduced in the EU directive for direct insurers.
According to the ABI, direct insurance offices are predominantly focused on investment business, which makes their capital at risk component relatively minor. This is why for most direct offices the required margin is dominated by the reserves built up to cover investment claim amounts for savings products.
The same does not apply to reinsurers. The risk characteristics are different, and the required solvency margin is dominated by the capital at risk which puts the 3 per mille requirement in the centre of their core business (see figure 1).
Indeed, if the capital at risk is raised, UK life reinsurers may be faced with the need to raise more investment capital from their investors. According to the ABI, the UK's top eight reinsurers will have to raise their capital by an additional £700m (EUR1000m) if the capital requirement is raised from 1 per mille to 3 per mille. "Many reinsurers will be unable to continue to operate in this environment, at least not without considerable injections of capital," said the ABI report.
The European Federation of National Insurance Associations is calling for a compromise from the EU so that the solvency requirement is based again on the non-life direct reinsurance requirement, with the addition of new provisions that would still involve some investment requirement.
"CEA has supported the health basis for the reinsurance solvency margin as the most appropriate proposal for the life reinsurance solvency margin. But we are prepared to go for a non-life basis for the life reinsurance solvency margin with an option for the life basis to cover linked life and other life business with a heavy investment content," said Mr Samothrakis.
Collateral requirements gone
One of the main objectives of this bill is also to get rid of the collateral requirements imposed mainly by France. The requirement to pledge officially authorised assets to cover outstanding claims provisions has made reinsurance business difficult in some member states. Technical provisions could be represented by a claim only up to the amount pledged as collateral security either in a balance sheet or through a letter of credit issued by a bank.
The EU proposal aims at abolishing these systems by setting out a required standard on technical provisions. The prudential rules detailed in the bill include the establishment of technical provisions and the rules on the investment of assets that cover these technical provisions.
The hope is that the bill will not only get rid of the collateral requirements in the EU, but also those pertaining on the other side of the Atlantic.
In fact, collateral requirements are a key discussion point when the EU is negotiating with non-member countries on the recognition of reinsurance supervision. In its negotiations with the US, the EU hopes to gain some ground by harmonising the rules and supervision for reinsurance companies.
Yet to get political ...
The proposed bill will have to pass through the Council and the European Parliament. The Working Party on Financial Services Group, representatives of the governments in charge of financial services in the EU Council, have already started to debate this directive. Although the content of their discussions has not been made public, our sources say that they have discussed the prudent person approach that is a qualitative risk management technique, the solvency margin for life and non-life, the removal of collaterals and capital requirements.
Commission officials have already admitted that there will be some changes in the solvency calculation method for life reinsurance, but there are no concrete proposals. Most likely, the Council will co-ordinate with the European Parliament which may well call for a less liberal approach.
In fact the Economical and Monetary (ECON) Committee is now chaired by a Socialist MEP who is known to have strong opinions against liberal markets, Pervenche Beres. At the time of writing, no-one has been appointed to lead the debate on this directive in the European Parliament. The ECON Committee met on 31 August, and were due to make this appointment at their next meeting on 21 September.
Another shift in the decisions through the European corridors of power will be the use of comitology. Under the comitology procedure, the Commission together with representatives of member states can decide on technical details of EU legislation. The Commission may try to define things such as solvency requirements and technical reserves through this procedure.
However, the use of comitology by the Commission requires the blessing of the Parliament and the Council. In future debates, EU institutions will have to agree if things such as solvency requirements are just small and unimportant details that the Commission can work at on its own or if they lie at the core of this bill.
"We believe this is an example of use of comitology for very specific, technical issues. The directive lays down the general use of the comitology tool and the implementing measure is prepared by the Commission. We have highlighted that the comitology solution will only be used after proposal from supervisors and thorough public consultation," said Commission spokesman, Jonathan Todd.
The proposal includes an element of comitology in the determination of the non-life solvency requirements (through comitology the requirements could be increased up to 150% of the initial requirements). "Our reasoning for proposing this was that reinsurance business is diverse and other requirements than in direct insurance may be needed; at the same time the logical starting point is the 100% direct non-life requirements. Through comitology there could be more specific differentiation between reinsurance classes and also types of contracts than what would be possible in directive text," he said.