The next two years will see the re/insurance industry adapting to new regulatory and accounting regimes which will dramatically change the way business is transacted, says Mike Murray

Over the next two years, insurers and reinsurers will have to adapt to new regulatory and accounting regimes which will have a major impact on the way in which business is transacted. There is a marked divergence between the abilities of traditional reinsurance versus that of alternative methods of risk transfer in meeting these demands and consequently we can expect to see the purchasing behaviour of insurers depart radically from previous patterns.

Convergence of regulatory requirements

Over the last couple of years, several different regulatory organisations, accounting bodies and credit-rating agencies have been making pronouncements, seeking to improve standards of management control and reporting throughout the international insurance and reinsurance industry. Whilst there are inevitably differences of emphasis and detail, there are several common themes:

- Corporate governance;

- Transparency of reporting;

- Measurement and servicing of capital at risk;

- Recognition and management of credit exposure.

From a reinsurance broking perspective, all these themes encourage our clients to be more professional in every aspect of their business life, and it is for the industry to position itself to help them in this process.

Corporate governance

Corporate governance is undoubtedly the hottest topic in insurance company management at the beginning of 2005. Sarbanes Oxley is now being seen to impose a significant compliance overhead for any insurer required to meet US SEC requirements.

However, this is not just an American phenomenon. At the beginning of 2004, the International Association of Insurance Supervisors (IAIS) issued their Core Principles of Corporate Governance. This has influenced insurance regulators around the world to issue regulations requiring the boards of directors of insurance companies to take formal responsibility for all aspects of risk management, and to document how this responsibility is delegated and monitored.

These principles require that the board of directors sets out its responsibilities in accepting and committing to the specific corporate governance principles for its undertaking, and establishes policies and strategies, the means of attaining them, and procedures for monitoring and evaluating the progress toward them.

Transparency of reporting

2005 sees the start of compulsory reporting under International Financial Reporting Standards by all companies listed in the European Union. IFRS4, which was issued in 2004, sets out the first stage of reporting of insurance contracts, and deals mainly with minimum standards of disclosure. However, these rules also prohibit provisions for possible claims under contracts that are not in existence at the reporting date (such as catastrophe and equalisation provisions). This means that clients in countries where such provisions were allowed, or even required, are having to adjust to life without the ability to smooth reported profits by such means.

At the same time, IFRS4 imposes the need to demonstrate significant risk transfer in order to justify 'insurance accounting'. The various subpoenas issued in the US by The Office of the New York State Attorney General, the SEC and various State Insurance Commissioners have caused the financial press to wake up to the potential of finite re/insurance deals to cause major distortions to companies' balance sheets. Commentators are now calling for (even) greater disclosure, and the adverse publicity that the inevitable newspaper headlines have caused has led to a significant reduction in demand for such deals - even if they still meet the tougher accounting tests required by IFRS4.

Stage 2 of the international standard for reporting of insurance contracts is now under discussion by a sub-committee of insurance professionals, and is proving to be controversial. The original intention to 'mark liabilities to market' involves abandoning the widely understood concepts of earned premiums and incurred claims, and replacing them with estimates of future cash flows, discounted at an appropriate rate, which is deemed to be a better fit with the other accounting standards. However, there is considerable opposition to this plan, and it is therefore unlikely that an agreed position will be reached for some time.

Capital at Risk and Return on Capital

Another of the IAIS initiatives, encouraged to some extent by the banking industry's Basel Accords, has been to encourage the use of properly verified internal capital adequacy models to determine Capital at Risk. Whilst delays in Stage 2 of the International Financial Reporting Standards project have caused the timetable for implementation within the EU (the EU Solvency II project) to slip, these ideas have already been introduced in some countries, for example Australia. This has resulted in companies documenting their risk tolerance in each activity, and building complex stochastic models to examine the inter-relationships between different exposures.

In the UK, the Financial Services Authority has also introduced an enhanced solvency requirement, introducing the need for companies to model their Capital at Risk. Whilst this is intended to be a prototype for the likely requirements of EU Solvency II, this cannot yet be guaranteed.

Since the tragic events of September 2001, the insurance industry has had to raise huge amounts of new capital, both to cover the losses, and more importantly, to replace amounts that were eroded either through under-pricing or poor investment performance. This capital has had to be raised in competition with the demands of other industries, and this has focused managements' minds on the need to provide adequate returns to shareholders.

Reinsurance has long been recognised as a form of capital, or indeed a replacement for core capital. As formal measurement of Capital at Risk becomes more important, so has it become necessary to justify the purchase of reinsurance in terms not only of reducing retained risk to a level within the company's risk tolerance, but also in terms of its potential to improve or stabilise the return on Capital at Risk.

Greater computing power and ever more sophisticated risk modelling are now allowing companies to model the impact of different reinsurance structures and layers on their overall risk profiles. Of course, reinsurers know that this exercise is taking place, and are making demands for better quality information as part of their pricing exercise. Companies unable to produce this data in sufficient detail are already suffering a pricing disadvantage, and we see this tendency increasing.

Management of credit risk

Following the poor reinsurance company results of 2001/2002, there has been a general recognition by rating agencies that reinsurance is a high-risk business, and this has led to a general downgrading of the industry, by about two notches on average, although there were several large players which suffered more.

This has concentrated the minds of regulators, and insurance company managements, on the need to choose counterparties carefully, and to monitor individual exposures regularly. Several market players have been vocal in their desire to manage their long-tail exposures better, for example through the use of pro-active commutation strategies, and there is every expectation that this trend will continue. We also expect to see broader progress to introduce an optional reinsurance clause on casualty reinsurance contracts, to trigger commutation at pre-agreed terms should relationships with, or confidence in, any reinsurer suffer a downturn for any reason.

It has also been pointed out that in several major reinsurance jurisdictions, reinsurance is not actually regulated, and the EU in particular has begun work on a reinsurance directive to correct this. However, many reinsurance contracts already have some form of downgrade clause, triggering the right to cancellation in the event of the loss of a secure credit rating. This means that, almost by accident, the rating agencies, which have access to significant unpublished information in respect of their target companies, have acquired the role of regulator to the reinsurance industry.

An alternative approach

The increased awareness of credit risk, together with the general downgrade of the reinsurance industry, has opened up new opportunities for specialist hedge funds. They have been active players in parameterised risk, such as catastrophe bonds and Industry Loss Warranty products for some time, but these have not developed as widely as they had hoped, largely because far better cover is generally available to insurers from traditional indemnity-based wordings. However, insurers are now placing greater emphasis on credit ratings and the need to spread their counterparty exposure widely; ironically this has occurred at the same time as the number of 'AA' rated reinsurers has declined.

Some leading hedge funds have now started giving traditional indemnity-based catastrophe cover, but with the added advantage that credit risk has been eliminated by the full collateralisation of the contract limit.

This is a superior product for risk, which is capable of a high degree of risk modelling, and one which traditional reinsurers will find it hard to match. They will therefore need to examine how they can use their greater willingness to look at 'difficult-to-model' lines as a way of ensuring they maintain their share of catastrophe business.

The challenge for 2005

In the challenging world of the 21st century, insurance companies can no longer rely on either catastrophe reserves or finite reinsurance as a means of smoothing profits. But investors want to see stable (and increasing) profits, so insurers will either want to buy lower layers of conventional reinsurance or will need to reward their shareholders for bearing with extra volatility of reported earnings.

Listed reinsurers, whose shareholders have the same demands, will face the same dilemma, whilst also needing to satisfy the risk-transfer needs of their client base.

Will hedge funds, which currently still operate in a largely opaque environment, be able and willing to extend their risk-taking appetite into unmodelled risk to absorb this unwanted volatility? Alternatively, are these same hedge funds the natural successors to the individual Lloyd's Names, who traditionally were able to get their capital 'to work twice', by obtaining extra income earned from investments and using that capital to underwrite insurance risk?

Mike Murray is CEO of Willis Re International.