Amanda Bowe reviews the major developments in European reinsurance regulation.

Reinsurance is a global business and many of the firms operating in the London market have parents in the US, Europe or Bermuda. Those firms' UK operations are subject to regulation by the Financial Services Authority (FSA), the UK's single statutory financial services regulator.

The FSA's regulatory responsibilities are set out clearly in the Financial Services and Markets Act 2000, but much of the policy is derived from standards agreed internationally or in Brussels.

The FSA recognises the important business function performed by reinsurance firms through the provision of wholesale cover for the risks assumed by insurance companies on behalf of their clients. Besides insuring insurers, reinsurers are also major financial players and institutional investors.

The FSA has four statutory objectives, one of which requires it to maintain confidence in the financial markets. It is also obliged to carry out its duties in accordance with a set of principles of good regulation, and the most important of these is to have regard to the competitive position of London and not stifle innovation.

The reinsurance market is - and always has been - an international one in which sophisticated players operate. As a result, there is great diversity in the way the different players are regulated. In some countries, the market is not subject to regulation at all, whereas in other jurisdictions, particularly in Europe, it is only very lightly regulated. Looking back even just a few years, I suppose I ought to qualify the sophisticated to say 'predominantly sophisticated', as the market has seen perhaps more than its fair share of failures and financial loss. Inevitably then, the reinsurance market has become a source of increasing concern for regulators and financial institutions both at the national and international level.

We are all conscious of the effect September 11 had on reinsurers' balance sheets, the impact of ratings downgrades over the last year or so, and the need to adjust reserves to reflect the increasing costs of old risks, such as asbestos, and those newer to the fold, such as tobacco. The reduction in the number of reinsurers and the consequent concentration of risk which arises from business being placed with fewer companies means that the failure of a leading reinsurer would cause huge disruption to the proper functioning of the market.

At the widest level, reinsurance has been high on the agenda of the Financial Stability Forum (FSF), which viewed reinsurance as a potential source of systemic risk. In particular, the FSF highlighted the possible harmful impact of the discontinuation of reinsurance cover on the real economy; the threat presented by financial reinsurance, an activity that is often inadequately reflected in insurers' and reinsurers' accounts; the risk of contagion of the failure from major reinsurance players to the non-insurance sector through credit risk transfer; and the possibility of retrocession spirals, particularly as the market looks like it is going to soften.

In terms of enhancing transparency, the International Association of Insurance Supervisors (IAIS) is developing a system that will produce global reinsurance market statistics, analysis and commentary that can be used by regulators and financial stability authorities, market participants and the general public. The IAIS has also agreed an international standard on the supervision of reinsurers, aiming to elaborate on the principles of minimum requirements for supervision of reinsurers, focusing particularly on where reinsurers differ from primary insurers.

In Brussels, the European Commission (EC) has started work on a harmonised reinsurance regime across the European Union (EU). The initiative to create a reinsurance directive setting minimum standards for reinsurers in all member states has been broadly supported by the industry. The directive will bring reinsurance supervision within a single market framework on a home state basis and is largely based on current direct insurance directives but with certain adaptations to reflect the specific features of reinsurance and the market structure. With regard to solvency margin requirements, the EC is proposing that the same requirements apply to pure reinsurers and to the reinsurance business of direct insurers.

It is fair to say that at present, not all EU member states supervise reinsurers to a sufficient degree - some not at all - and this directive will bring significant progress in terms of establishing a consistent and effective regulatory approach for reinsurers across Europe. Further, the FSA supports an EU-wide regulatory regime that maintains London's competitiveness as a location for reinsurers while minimising the potential for financial instability and other risks for policyholders and the economy.

Domestically, the FSA is already well into a significant programme of reform for the London market as part of its new approach to insurance regulation. The key elements of this reform include enhanced supervision of firms; proposals for introducing risk-based capital requirements; new conduct of business requirements; and the approach to the regulation of Lloyd's.

Enhanced supervision

In practice, the FSA's overall aim of maintaining efficient, orderly and clean financial markets and helping retail consumers achieve a fair deal means improving standards within the industry by placing greater emphasis on a risk management culture within the structure of strong governance arrangements. It is not the regulator's job to manage firms. Nevertheless, the FSA does strive to be proactive, identifying risks before they become actual problems and encouraging a firm's management to take prompt action to resolve them.

Being risk based does not mean we worry about everything that could happen and it certainly does not mean that we will aim to prevent all failures; that is why the regime is described as 'non-zero failure'. Being risk based goes hand in hand with being proportionate. Further, given that the FSA resources are finite, care must be taken to ensure that resources are used in the most efficient and effective way. This means, for example, that if the FSA believes it can fix a problem through the firm's own resources, then it will.

Undoubtedly, the FSA approach is high level. When we carry out on-site work, we are not carrying out an exhaustive audit. We have no interest in trying to address every single issue and, because resources are limited, we focus on the issues that are most important. In doing so, we also focus on things which are important to firms. The risk-based approach is heavily underpinned by the concept of senior management responsibility. This means that the FSA expects firms' senior management to anticipate, engage and act on regulatory issues as they emerge.

Regarding the risk assessment itself, there is a disparity of standards between regulated firms, suggesting that overall the market still has some way to go. Also, there are disappointing examples of the variation in the ability of firms' management to control their firms appropriately.

It is absolutely paramount that firms deal with regulators openly and fully. Co-operation with the regulator is an important issue, and firms that appreciate this will benefit. Regulation is not unlike the situation that insurers, I believe, call uberrimae fides or utmost good faith with commensurate disclosure requirements.

Risk-based capital - CP190

Current capital requirements and practices have contributed to too high a risk of prudential failure amongst insurers in the past. And so, as part of its review of insurance regulation, the FSA decided to look at whether the existing approach to capital requirements for general insurers was still appropriate. The conclusions were that the current arrangements were not firm specific, not always transparent and, moreover, not sufficiently risk-sensitive.

So CP190 sets out the proposals for a new risk-based capital regime for insurers. This will involve firms holding capital at least equal to the higher of the minimum capital requirement (MCR) (dictated by Solvency I), and the enhanced capital requirement (ECR), a more risk-sensitive calculation that will be based on a capital charge to be applied to both asset and insurance risks.

The proposed new framework represents significant progress over the existing approach.

We are currently considering the feedback to CP190 and are grateful for the responses received. In the CP we propose that the ECR will be phased in, so that initially it will be a reporting requirement and only become a prudential requirement later. This is so the FSA can consult carefully on how the ECR is calibrated, assess its effect on individual firms and allow time for the market to absorb the changes without undue stress.

For some insurers, the new requirements will have only a modest effect because they hold capital well in excess of the proposed requirements for strategic reasons, risk sensitivity, or to fund expected growth or for credit rating purposes. However, for other firms it could require them to respond by either raising new capital or by reducing the risks they face or underwrite.

The ECR will calculate the minimum level of capital that a firm will be required to hold. However, the amount of capital that a firm may actually need to match its business mix and circumstances could be higher (or lower) than this minimum requirement. To capture this, we also propose a framework of individual capital adequacy standards for general insurers. Essentially, this is the firm's own assessment of its capital needs. Again, this underscores the importance placed on the role of senior management; it is for them to determine their own risk profile and make an assessment of the amount of capital they need accordingly.

Lastly, we will also have a process for giving individual guidance to firms on the capital that is deemed necessary to meet their business needs and circumstances. This will take account of firms' own assessments, but will also factor in the FSA view of their systems and controls along with their ability and willingness to comply with the regulatory requirements.

This should, therefore, provide a strong incentive to firms to put in place effective risk management functions.

Lloyd's

Lloyd's is very much a key priority for the FSA's insurance regulatory effort. The need to get the regulatory approach to Lloyd's right has become even more pronounced in the last year or so owing to a number of factors: firstly, external changes in the risk profile of the market, with greater concentration of risk in a smaller number of players; secondly, our own review of insurance regulation; and thirdly, the significant changes that Lloyd's itself has put in place.

We are applying our regulatory framework to Lloyd's in the same way as for any other FSA authorised firm, and reviewing the prudential rules.

Where necessary, the compensation arrangements have been changed so that the rules mirror those applied to other insurance firms and consumers are afforded equivalent protection.

This is an ambitious project and one that will require significant cultural change at Lloyd's and in the wider market. Good progress has been made already, but this is clearly not an overnight process, and therefore change will continue apace.

Conclusion

So to summarise, there is a great deal of change and development in prospect in regulation for reinsurers both internationally and in the UK. This volume of change means a quite substantial programme of preparation for firms themselves.

- Amanda Bowe is head of the general insurance department at the UK Financial Services Authority.