Andrew Pincott looks at the changes in the regulatory environment over the past year
There was a time, a generation ago, when professional reinsurers could look forward to carrying on their business in an increasingly liberalised global marketplace. Seven years after the Treaty of Rome, the European Commission took its first step towards this vision with a directive to liberalise cross-border operations in the European reinsurance sector. So few were the barriers to freedom to provide reinsurance services or establish reinsurance operations in other member states at that juncture that all the offending provisions in national legislation of the then member states were cited in the directive itself. Notwithstanding the liberalising philosophy behind the 1964 Reinsurance Directive, it soon became clear that, as a piece of European legislation, it did little to foster a common market in reinsurance. In practice, member states went their own ways. Some, including Belgium, Greece, and, originally, Ireland, saw no need to institute a system for licensing and supervising reinsurers. After all, it was a business-to-business market and the participants were commercially sophisticated. Others, concerned to minimise the credit risk of a failed reinsurer upon local insurers providing insurance cover to private and commercial policyholders in that member state, limited themselves to vetting the quality of the reinsurance programme of direct insurance companies whom they regulated. The UK alone chose to apply a comprehensive licensing and supervision regime for any company choosing to carry on reinsurance business in London. When the UK joined the EEC, it took the view that the 1964 Reinsurance Directive did not specifically - and should not as a matter of principle - necessitate any change to its regime.
London's prominenceThe justification for the intransigence of the UK was that London was a major - if not the pre-eminent - marketplace for insurance risks. Much of its business was reinsurance, including significant amounts of risk assumed from the US by way of surplus and excess lines business. And London also had Lloyd's, whose syndicates wrote substantial books of reinsurance. UK Government therefore felt it needed to be able to control who did reinsurance business in London.As arguments go, this was always a bit dubious. Whilst the prospect of applying for authorisation and continuing supervision might deter fraudsters, it would not prevent the consequences of incompetent management, the usual cause of reinsurance company failures. Besides, controlling the people who carried on reinsurance business in London is necessarily circumscribed where they have full freedom to offload risks by reinsurance into jurisdictions which do not so supervise reinsurers. And as to the argument au pied de la lettre of the 1964 Reinsurance Directive, that the UK requirement was not discriminatory since it applied to foreigners and nationals alike, even this was susceptible to challenge on the basis that any restriction on a treaty freedom, including the freedom of establishment and freedom to provide services of reinsurance entities, needs to be objectively justifiable, as jurisprudence of the European Court has confirmed.If anything, the attitude of the UK regulator at that juncture was illustrative of a number of problems inherent in regulation of international financial services. Regulators tend to be maximalist, rather than minimalist, in terms of the powers they say they need, even when the objective is (more realistically) circumscribed. Regulation never seems to shrink; overall it grows. Existing regulation is never enough. And initiatives in one part of the regulatory system occasionally create an unintended problem in another part, with the consequence that regulatory failures usually generate more, not less, regulation. This is almost certainly the principal driver for the proposed 'fast track' European Directive on Reinsurance, the text of which is on the cusp of being published. Globalisation and e-commerce are creating an international flow of capital, ready to arbitrage regulatory differences between the increasingly complex and costly risk-based supervision of banks and the relatively straightforward solvency requirements and generally lower regulatory capital costs for reinsurers. Regulators were beginning to see that the system they had painstakingly put in place to monitor and control investment business risk through the intermediary of the banking industry was being side-stepped by transferring huge volumes of that risk (principally credit risk) to the insurance sector. Coupled with the fact that there is a school of thought which believes that the re/insurance industry is not adequately pricing these risks, this led to concerns voiced in international discussions between central bankers and finance ministries for international reinsurance to be brought under control. So the principal justification is not an objective assessment of the need for regulating reinsurers but more the need to shore up banking sector regulation by eliminating the lower costs of regulatory capital in the reinsurance sector.Indeed, making a positive and objective case for regulating reinsurers is rather difficult to do. There is no evidence of systemic risk, where the insolvency of a reinsurer leads directly to the insolvency of a substantial direct insurer, let alone constituting a threat to international capital markets. And the downside risks are easy to spot: regulation adds to the costs of doing business; it is always national or at best regional and can therefore be arbitraged; it easily becomes a tool of protectionists, as witness the stout defence by the Reinsurance Association of America of the economically inefficient 'credit for reinsurance' rules in the US; and it may lead to a flight of capital, jobs and creativity to offshore reinsurance centres.Indeed, in connection with this last disadvantage of regulation, it ought perhaps to be no surprise that AM Best and Tillinghast-Towers Perrin reported that captive insurance company formation had risen from 245 in 2000 to 462 in 2002. Additionally, when the National Association of Insurance Commissioners (NAIC) model regulation for valuation of life insurance policies came into effect in 37 US states in January 2000, rather than call on shareholders for additional capital, many life insurance providers resorted to reinsurance. However, the main beneficiaries were offshore reinsurers. According to a Moody's Investors Service report in February 2003, US-based life reinsurance reserves ceded to offshore reinsurers grew at a compound annual rate of 35% in both 2000 and 2001. The report pointed out that the cost of reinsurance, at 150-200 basis points (up from an historical cost of 100 basis points), was cheaper than shareholders' capital. This year has seen another instance of regulatory accident, with the implementation into national legislation of Directive 2001/17/EEC. The purpose of this directive is to simplify proceedings when an insurance undertaking in the European Economic Area is in financial difficulties, thus enabling efficient reorganisation or distribution of assets. Whereas in the UK, private policyholders have for a long time benefited from a statutory scheme (previously the Policyholders Protection Board) to compensate them in the event of insolvency of an insurance company, such state-run schemes were not the norm in Europe. The directive was intended also to provide a Europe-wide scheme of protection for insurance creditors. This protection is provided by giving insurance creditors enhanced priority in a winding-up. Policyholders (or other beneficiaries of a policy) will rank immediately behind claims by employees, tax and Social Security authorities and secured creditors. Alternatively, insurance creditors take absolute precedence in respect of assets representing the failed insurance company's technical provisions.The consequence is that claims of reinsurance creditors (along with other ordinary unsecured creditors) will be relegated behind the insurance claims of policyholders in the winding-up of an insurance company. This is of particular concern where the insurance company in question writes both direct and reinsurance business, for a cedant will find it difficult to assess the security being provided by the reinsurer where the reinsurer writes both direct and reinsurance business. For London market companies, the problem is an acute one.Potential reinsurance creditors may well decide that, in such circumstances, any reinsurer writing both direct and reinsurance business should provide security for performance of its obligations under the reinsurance contract, either by way of substantial premium and/or claims reserves, letters of credit or deposit of funds. Since a requirement to collateralise obligations like this is, in other sectors of the market, seen to be a wasteful charge on capital, any widespread move towards demanding security must be counted as a retrograde step. Whether that is a consideration which will weigh with a prudent cedant remains to be seen. What may happen, however, is that there will be increased use in reinsurance contracts of 'ratings downgrade' clauses, providing for automatic or early termination of contracts or collateralisation of obligations in the event that any major credit rating agency downgrades the credit of that reinsurer.
Market supervisionAnother example of the maximalist tendency of regulators is to be found in the new Lloyd's Underwriting Byelaw (Number 2 of 2003) which laid the basis for the new Lloyd's market supervision framework for underwriting agents and approved run-off companies, and which came into effect on 1 July 2003. This is the byelaw which gives power to the newly constituted Lloyd's Franchise Board to grant or withdraw permission to act as an underwriting agent at Lloyd's. The desire of the Franchise Board to be empowered to micro-manage the Lloyd's market is perhaps understandable in the context of the newly defined relationship between Lloyd's centre and participants in the market trading under its brand name. So, for example, the Franchise Board is entitled to establish underwriting guidelines for managing agents and set standards for underwriting. In a similar, Lloyd's-specific, vein the Franchise Board may, where it thinks reasonably necessary or appropriate, direct that any underwriting agent (not, it is to be noted, underwriting agents as a class) shall use any service specified by the Franchise Board, whether provided by the Society of Lloyd's or by any other person. Also at the level of individual participants in the market, the Franchise Board may prescribe requirements for business plans, including format and content and methods and assumptions to be used and, if it does not like the business plans submitted, may require further information, may request amendments and even require a managing agent to submit a new or revised plan. Moreover, the fact that it has once approved a plan is no bar to withdrawing its agreement in requiring a managing agent to submit a new or revised business plan. Indeed, the Franchise Board has reserved to itself the power to give directions or impose conditions or requirements on any underwriting agent as it thinks reasonably necessary or appropriate in order, amongst other things, to improve or seek to improve the underwriting or performance of the underwriting carried out by any managing agent or to protect Lloyd's credit rating or even to protect "the name, reputation or standing of the Society of Lloyd's".These are very wide and very generalised powers. They permit discrimination between managing agents, and on a scale which finds no comparison with the equivalent powers of the Financial Services Authority which regulates UK companies, either presently or prospectively in relation to risk-based capital. Given its unique structure and past history, the real challenge for Lloyd's will be to ensure that these powers are used scrupulously fairly.By Andrew PincottAndrew Pincott is a partner in the London law firm of Elborne Mitchell.