Super-regulation is the order of the day for London market and European re/insurers, says Alexandra Booth, though this may be to the detriment of the industry.

In the Financial Times of 19/20 April 2003, Mary Francis, Director-General of the Association of British Insurers (ABI), was quoted as saying that she feared the Financial Services Authority (FSA) was heading towards "a combination of interference and rule-making that is leading us to a heavy, prescriptive form of regulation". Is that true for reinsurers?

The structure of UK financial services regulation was overhauled by the Financial Services & Markets Act 2000, which saw a move from regulation of different areas of activity by different regulators to regulation by one 'super-regulator', the FSA.

Insurance firms are now authorised and regulated by the FSA under the same regime as investment firms. Indeed, insurance, including general insurance, is treated as an 'investment', in the same way as shares or bonds are regulated. There is a common authorisation regime under which any firm wishing to carry on investment activity, including insurance, must seek authorisation from the FSA (and failure to do so is a criminal offence) with the exact scope of the business a firm is entitled to carry on being determined by the 'permissions' it is granted.

The move to a super-regulator has not necessarily meant that regulation has become less personal. In fact, the opposite is perhaps more the case. UK insurance firms are allocated their own insurance supervisor, providing an individual point of contact. Moreover, there are increasing moves to target the level of regulation required to fit the firm's risk profile. Risk-based supervision sees firms being assessed for the risk they pose to the FSA's objectives, including to consumers and to market confidence, in order to determine the level of monitoring required.

Progress is also being made towards a system of risk-based capital which will require firms to hold capital tailored to the risk they pose. At an EU level, this will be achieved by the 'Solvency II' directive, although this is still at the planning stage. The FSA is moving ahead of its EU counterparts by designing its own risk-based capital system in advance of Solvency II, and it proposes to implement the new requirements in 2004.

In a further nod towards more bespoke regulation, the FSA has developed a regulatory approach that may be termed 'comply or explain'. Its handbook does contain rules, which must be complied with, but in many cases they are fairly general. Rules may be accompanied by 'guidance' which can indicate possible means of compliance with a rule. Guidance is just that. Compliance with guidance will establish, on the face of it, that the firm has complied with the rule. In some instances, but not all, the FSA provides that failure to adhere to the guidance will tend to show that the firm has not complied with the rule. In all cases, however, it is open to a firm to explain to the FSA why it believes that it has in fact complied with the rule despite not following the guidance to the letter, or even not following it at all. How often the FSA is prepared to countenance an approach different to that contained in the guidance remains to be seen.

However, perhaps the main difference that most regulated firms will have noticed is the sheer volume of paperwork that a super-regulator generates. The FSA Handbook is in fact not one handbook but 34 manuals squeezed into 16 lever arch files. Consultation papers flow thick and fast - 178 at the last count, 43 of which have been produced in the last twelve months alone.

But these volumes of paper have failed to prevent a number of high profile failures, including Independent and the Equitable Life debacle. Increasingly, the regulator is in the frame for proceedings to be brought against it for negligence in circumstances where one of its regulated entities goes bust. Howard Davies, outgoing Chairman and Chief Executive of the FSA, has publicly said that the FSA is not aiming for a 'zero-failure' regime, which would be undesirable in theory and unachievable in practice. That may well be realistic but recognition that there will always be firms that will fall by the wayside is cold comfort for those affected by firm collapses. Creditors of Independent are pursuing the FSA following suggestions that it ignored warnings from French regulators. In Australia, proceedings have been issued against the regulator, APRA, in relation to the collapse of HIH. Internationally, regulators' statutory immunity is under threat.

Expensive action
Turning more specifically to matters affecting the reinsurance industry, regulations came into force on 20 April 2003 bringing into force in the UK the EU directive on the reorganisation and winding up of insurance undertakings. Part IV of those Regulations deals with the priority of payment of 'insurance debts' in winding up. It provides that, on the winding up of an insurer, its debts must be paid in the following order:

  • preferential debts;
  • insurance debts; and
  • all other debts.
  • Preferential debts include debts to the Inland Revenue or Customs & Excise, Social Security contributions, remuneration of employees and the like. An insurance debt is one which a UK insurer is, or may become, liable to pay pursuant to a contract of insurance, to a policyholder or any person who has a direct right of action against the insurer.

    One important purpose of the EU directive was to ensure that direct insurance creditors should enjoy precedence over other creditors, including reinsurance creditors. Given that the UK treats reinsurance as insurance for regulatory purposes, it is surprising that the Treasury has failed to make absolutely clear in the regulations that 'insurance debts' do not include reinsurance debts. Drafting aside, however, the express intention of the Treasury was to implement the terms of the directive.

    Pure reinsurers are outside the terms of the regulations, but for cedants of companies writing both direct and reinsurance business things look somewhat gloomy. If such a company were to fail - perhaps one should say 'when' such a company next fails if one takes Howard Davies at his word that 'zero failure' is not an option - reinsurance creditors can expect to be at the back of the queue.

    It may be possible for reinsurance creditors to take security. Letters of credit are an option, although there is obviously a cost to the reinsurer which may not be inconsiderable in circumstances where every cedant wants security. Floating charges have been talked of as another possibility, although their effectiveness is debatable. The obvious alternative is for insurers to hive off their reinsurance operations into a separate vehicle. One suspects that this is what the regulators are hoping to see. It will, however, no doubt be an expensive course of action and one which may have a negative impact on firms' regulatory capital.

    If the view of the regulators is that reinsurance creditors are better able to fend for themselves than direct policyholders, perhaps they will also prove better at finding ways to obtain security for themselves. It would be ironic if direct policyholders were to find themselves worse off in a liquidation where reinsurance creditors have managed successfully to obtain security.

    Looking ahead, perhaps the most significant development on the regulatory horizon for reinsurers is the prospect of a European directive bringing in a new European regime for the licensing and supervision of reinsurers. As yet, the draft directive has not been published. Nevertheless, it would seem that the insistence - some might say obduracy - of the UK has prevailed and the aspiration towards a wholly-liberalised market in reinsurance within the European Union (as exemplified by the 1964 Reinsurance Directive) has been pushed aside and an imitation of the regulatory regime for direct insurance is to be imposed.

    Some regard this as a retrograde step. At the moment, only four states within the EU require pure reinsurers be licensed before they can carry on business within that state, and principal amongst these is the UK. Arguably, such a regulatory patchwork is discriminatory and anti-competitive, but imposing a system of prior licensing and on-going supervision seems to be a cure worse than the disease. Strict regulation is not necessary for the protection of consumers, for reinsurance is quintessentially business between sophisticated commercial undertakings. There is no evidence that the collapse of even a major reinsurer poses a systemic threat to the European insurance market. More strikingly, there is no proof that a European-wide system of regulation would have done anything to avoid the fate of Gerling Re, whose S&P rating fell below investment grade in early February.

    European health hazard
    If it were the secret hope that, by being regulated, European reinsurers would gain a competitive edge, that hope seems far-fetched. Buyers of reinsurance are much more likely to be concerned with the opinion of recognised rating agencies than a company's formal status as an authorised reinsurer. Besides, it is still the case that the huge American market accounts for about half the world's insurance premiums ceded by way of reinsurance and all the indications say there is no chance at all that a European-wide regulatory system for reinsurers would lead to some form of mutual recognition, whereby European reinsurers would be admitted for the purpose of covering US reinsurance risks without the penalty they presently suffer as 'alien' reinsurers. The Reinsurance Association of America has been consistently opposed to such an idea, and insurance commissioners from the NAIC have recently taken to expressing "deep concern" about the health of European reinsurers. Indeed, the poor prospects of using a pan-European regulatory regime to assist in prizing open the North American market has already led to private initiatives between major European reinsurers to open negotiations for a 'favoured reinsurer' regime.

    To such scepticism concerning the benefits of a European reinsurance regulatory regime there needs to be added the downside risks. The first is obvious - cost. The second is relative attractiveness to capital; reinsurers have probably lost around $200bn in capital since the terrorist attacks of 11 September 2001, and only about $30bn in new capital has come in, most of which went to Bermuda. Thirdly, there is a risk of loss of creativity. Many of the most innovative products from reinsurers in recent years have straddled the line between banking and insurance or between insurance and derivatives and other capital markets products. If the regulatory regime for reinsurance follows that for direct insurance, European reinsurers will suffer a competitive disadvantage by comparison with reinsurers in Bermuda, say, or Guernsey and Jersey. They will be permitted to accept transfers of risk only in the form of pure insurance.

    At this stage, we must wait and see what eventually emerges. What can be said, however, is that the effect of a Europe-wide system for licensing and supervising reinsurers is likely to be worse if it matches Mary Francis' fears.

    By Alexandra Booth

    Alexandra Booth is a regulatory lawyer at Elborne Mitchell, a London law firm specialising in reinsurance.