Will US regulators change their rules requiring foreign reinsurers to post collateral of 100% against gross liabilities? It is a question that is being asked with increasing interest by many in the industry, writes Dave Matcham
The debate over the imposition of collateral requirements for foreign reinsurers operating in the US is one that has raged for a number of years.
But at the start of 2004 it took an interesting turn with a decision by the National Association of Insurance Commissioners (NAIC) to initiate new discussions between the parties involved.
At a meeting in New York in March the NAIC decided to temporarily defer its own detailed examination of the current reinsurance collateralisation rules. Instead it agreed to facilitate direct consultation with US insurers and so called 'alien' reinsurers about the best way to regulate their business.
Ernst Csiszar, former president of the NAIC, highlighted the plans at a Mealey's insurance insolvency and reinsurance roundtable conference in Scottsdale, Arizona in April. There he was reported to have said: "We've encouraged interested parties to get together and develop alternatives. We hope to start dialogue between the various sides of the industry with the regulators acting more as a facilitator than anything else."
The rules require all foreign reinsurers to post collateral equal to 100% of their expected gross liabilities assumed from US cedents. These generally take the form of letters of credit and are, of course, expensive to maintain.
A number of meetings have been held following the NAIC's decision in New York between leading representatives from both the US and international insurance industries. The International Underwriting Association (IUA) is also committed to playing a full role in the discussions which were held at senior and technical levels. Indeed the association has long campaigned for an alternative solution that would address security concerns of the US industry, while at the same time providing it with a much improved range of reinsurance capacity choices.
The assertion that collateral is a critical solvency measure, dictated by prudent regulation, is not, in fact, one that holds up to serious analysis.
All of the world's other major markets, including Bermuda, London, Zurich, Munich and Tokyo, operate perfectly adequately without any such requirements at all. They have done so for decades, in some cases for centuries, without significant problems relating to the collection of reinsurance.
In any case it is not just 'alien' companies that sometimes do become insolvent. The American Insurance Association has noted that in the last three years there have been 46 new property/casualty insurer insolvencies in the US, including Reliance Insurance Company, Fremont Indemnity Corporation and Legion Insurance Company. All wrote a good deal of reinsurance, yet as authorised domestic players they were not required to post any collateral that their cedents could call on when things went wrong.
If it really is the case that collateral requirements are of such value in affording security, why are US reinsurers not required to make similar provisions? If, however, US regulators were to impose the same rules on US reinsurers, financial markets would not be able to meet such widespread demand for security. A wholesale market should be able to make its own decisions about which business partners can be relied upon.
Standard & Poor's in its own report on the issue pertinently asks: "Should regulators be in the business of protecting primary companies from their own mistakes? Or should insurers be responsible for making informed risk management decisions, based on the specific creditworthiness of individual reinsurance companies, and for taking their own precautions."
Collateralisation simply has the pernicious effect of promoting sloppy reinsurance buying practices as some cedents disregard the financial strength of their reinsurer and blindly assume that collateral will protect them.
Passing the buck onto regulators harms the confidence of both commercial buyers and the public in our industry's ability to pay up on claims.
Reinsurance is merely a counterparty credit risk. US regulators already support an insurer's right to count as an admitted asset a wide variety of unsecured debt, such as corporate bonds. Under the current system therefore it would seem that an unsecured promise to pay by a Texas energy company like Enron can be accepted as an admitted asset, while at the same time 100% collateral is required from a top rated reinsurer based in one of the world's leading financial centres and with a 100 year history.
Fundamentally, the collateralisation debate boils down to one of market efficiency. Unwarranted security requirements clearly reduce potential returns because for every $1 of liability incurred a reinsurer must not only ensure it has available cash to pay net losses, but also that it has sufficient assets to provide acceptable collateral for its gross liabilities.
The ultimate effect is to restrict capacity, reducing the choice of reinsurance available to US insurers. And that capacity which is made available is inevitably more expensive than if the market were not artificially distorted.
Letters of credit used by reinsurers to meet collateral demands are issued by banks or through various kinds of trust arrangements. Banks are popular with cedents because of their reputation for timely payment, but ironically many of the institutions providing letters of credit actually have lower financial strength ratings than the reinsurers they are backing.
Whatever the exact arrangements for posting collateral are, they will certainly entail fees. "It does not help anyone except New York bankers," commented Lawrence Mirel, commissioner of insurance for the District of Columbia when he addressed an IUA market briefing on the subject in London.
A reduced level of investment income must also be taken into consideration because of the exceptionally limited range of options for assets posted as collateral. Such assets must be liquid and easily accessible, despite the fact that in practice many claims may take years before they are originally settled by the insurer. Then there are the not unremarkable administration costs, including dedicated personnel, accounting systems and other resources, necessary to ensure collateral requirements are adjusted as claims come in and are paid.
The IUA has estimated that such costs amount to between 1% and 1.25% of the value of collateral posted. With the total amount of collateral posted by alien reinsurers for US business worldwide at somewhere around £50bn, this represents an annual burden of at least $450m to $560m.
The true figure is probably even higher since the calculations here are based on very conservative assumptions of overhead costs. But clearly collateralisation represents an extraordinary burden for the international reinsurance industry that is hugely expensive to fulfil on a number of different levels.
It artificially restricts capacity, limits the choices of US business and hampers free trade. If the restrictions were to be relaxed, cedents in the US would enjoy not only a greater availability of capacity, but also cheaper prices as market forces ensure the savings obtained by international reinsurers are passed onto clients. This could all be achieved without any threat to security considerations.
Standard and Poor's has concluded that the long term outcome of such a move would be better risk-based reinsurance placement, a stronger global reinsurance market and reduced insolvency risk. A desire to help realise these benefits has infused the discussions initiated by the NAIC earlier this year. And increasingly changes to international business and regulatory conditions are making the possibility of an alteration to collateralisation more and more plausible.
The development of international accounting standards, greater understanding of non-US financial statements, improved dialogue between state and federal regulators in the US and greater supervisory harmonisation in Europe are all projects that are more advanced than they were five years ago. Such progress has the potential to provide US regulators with the confidence they need in their ability to oversee foreign reinsurers without resort to the current rules on collateral.
The collateralisation debate is one that has raged for some time. There is now a strong argument that the US should follow the lead of the world's other major insurance markets and re-examine its demand for collateral requirements.
For and Against
For - A European delegation spearheaded by the Comite Europeen des Assurances (CEA), the IUA and Lloyd's, has proposed to NAIC and the National Conference of Insurance Legislators (NCOIL) the creation of an approved, or 'white' list of highly capitalised reinsurers that would be permitted to post collateral of less than 100% with 50% being the minimum amount allowed.
"Only the strongest and best reinsurers would be on the list and would have subjected themselves to considerable US regulatory oversight in addition to their own domiciliary regulations," says Lloyd's.
Against - Four US property/casualty insurance trade associations, together with a workers' compensation and a reinsurance association, have voiced strong opposition to NAIC allowing any reduction of collateral requirements for alien reinsurers. 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, and the Reinsurance Association of America represent approximately 85% of the property/casualty premium written by more than 2,000 primary insurers in the US.