UK: Are We Still Wishful Thinking? The Future Of Reinsurance Regulation

Last Updated: 1 August 2001
Article by Tim Brown

Recent events prove that reinsurers can fail even in jurisdictions which pride themselves on the effectiveness of their regulation. We look at two issues in regulation which remain problematic –the globalisation of reinsurance and the localised structure of reinsurance regulation - and consider changes underway or under consideration and whether they will rectify the present faults.

Globalisation

The reinsurance market is sophisticated and well developed in terms of international trade. The regulatory system which safeguards the interests of the public, however, is archaic and undeveloped. In October 1994 a Sub-Committee of the United States House of Representatives led by John D Dingell issued a report entitled "Wishful Thinking" following years of investigations into the collapse of a number of insurance companies, including Transit Casualty. At the time of the issue of the report, the estimation of Transit’s liabilities, nine years after it was placed in liquidation, was $4 billion although the liquidators were still seeking to determine the extent of the insolvency, and estimated the process would take until 2012. It was considered to be the "Titanic" of insurance insolvencies.

The report identified a number of important factors which gave rise to the collapse of Transit Casualty, including speculative excess and management incompetence. They considered these to be only the symptoms. The Sub-Committee identified "supervisory babble" as the real cause. That is, in their view the world-wide regulatory system suffered from divergent attitudes, laws, accounting rules, resources, languages and cultures creating an environment of local self interest which did not foster regulatory communication or co-operation.

This applied equally within the United States where each state had divergent laws and attitudes. They found, for example, that one state may have a properly funded and developed regulatory system and another a virtually non-existent system or one rife with fraud and corruption. Their primary concern was to make recommendations to rectify faults in the US system of supervision, and their recommendation was that the US Federal Government take overall responsibility for the regulation of reinsurance in lieu of the haphazard state by state approach.

Regulators can, and do, regulate insurers and reinsurers accepting risks within their regulatory jurisdiction. The chasm in the supervisory matrix occurs where the reinsurer is offshore or where the reinsurer is a subsidiary of a parent operating in an offshore jurisdiction. The regulators may supervise the companies operating in the regulatory jurisdiction but they have no control over the offshore reinsurer or the offshore parent. Thus, a London insurer is regulated insofar as they arrange reinsurance with a London reinsurer who is also reinsured in London, but if the insurer or its reinsurer obtained reinsurance from a company regulated outside the jurisdiction, little, if anything, can be done provided that the offshore reinsurer is highly rated and has a good reputation. Reinsurance is purchased from reinsurers around the globe, and yet regulation is by no means harmonised or clearly delineated. For example, the Sub-Committee sent questionnaires to 47 nations identified as being significant providers of reinsurance. Of these, 10 countries did not even respond and seven did not regulate reinsurance companies at all.

There are a number of initiatives underway to change this.

  • At the highest level is the work being conducted by a reinsurance task force from the OECD, which is working towards a multilateral agreement between supervisory authorities on the exchange of reinsurance information.
  • Parallel to this is the work of the reinsurance regulatory sub-committee of the International Association of Insurance Supervisors (IAIS) and the efforts of the Comité Européen des Assurances (CEA), which also has a working party dealing with reinsurance issues.
  • Working together with each of these, and reviewing regulation on its own is the European Union (EU).

With the exception of the EU, these organisations have developed proposals which differ significantly temporally and in comprehensiveness. There are, however, three important common factors.

  • The first phase according to the OECD and IAIS is a short term solution which imposes stricter obligations on insurance companies, and possibly reinsurers, working within any particular jurisdiction. The effect of these will be to ensure that the companies, and, in particular, the board of directors, have in place sound principles, guidelines and reporting procedures which must be followed and which are aimed at ensuring that reinsurances purchased by the insurer are with good security and comply with the boards’ requirements. In most cases, sophisticated insurers already have in place procedures of this nature.
  • The second phase, supported by the OECD and CEA, albeit in different terms, is for harmonisation of licensing systems for reinsurers which will become operational over the long term. The CEA has proposed a single "passport" for reinsurers which is still under consideration and consultation. The EU has already harmonised, or attempted to harmonise, licensing as a part of its efforts.
  • A third phase however, which may depend on the success of the OECD’s negotiations for a multilateral agreement, requires a comprehensive world-wide solution for reinsurance regulation.

That, in itself, will be subject to the vagaries of the politics between the nations involved and the OECD faces an uphill battle. There will also always be jurisdictions such as those in the Caribbean and others known for their tax advantages, which will not impose, or do not have the finances or infrastructure to impose and supervise, strict regulatory requirements. That is not to say that all the companies with reinsurance operations within those countries should be viewed sceptically. Many large and well known reinsurers and brokers have chosen those jurisdictions for very good business reasons.

What is of concern to regulators is that those jurisdictions have a higher proportion of rogue traders, and the proposed measures are aimed at them. Whether the attitudes of these jurisdictions change in the long term may depend upon the approach taken by the governments and regulators in the dominant insurance jurisdictions. Can they tell insurers and reinsurers within their jurisdiction what they may do with their businesses offshore? We do not think so, although if the analogy of the US banking market is anything to go by that may be exactly what happens. Will this prevent the fraudulent reinsurers of this world? It is unlikely. There will always be jurisdictions where a sharp operator will find a loop hole in the regulatory matrix which will allow them to operate. What these new measures will do however is increase transparency so that the less bona fide operators can be more quickly identified by both businesses and co-operating regulators. Thereafter market forces will take control if the regulators do not.

The Localised Structure Of Regulation

Will the globalisation of reinsurance regulation outlined above result in a safer environment for insurers and the public?

The role of the regulator is to protect the innocent public and ensure that any given industry is not brought into disrepute. The process by which that is generally achieved in the insurance industry is by requiring insurers and reinsurers to be authorised and thus maintain certain levels of capital and solvency margins. To ensure that these requirements are being met, insurers and reinsurers are audited, and the auditors are required to report direct to the regulators. There are other controls, but these are the mainstay of the systems generally adopted.

The structure is a balance between permitting reinsurers to conduct their business as they wish and putting in place requirements which protect the innocent public, but restrict the manner in which reinsurers may conduct their business. It is supposed to operate in a manner which will allow the regulator to step in if warned that there appears to be a problem, or to exercise additional supervisory powers if necessary to ensure that an insurer does not over-extend itself. In light of the almost complete automatic combustion of the reinsurance market in Australia (which considers itself to be amongst the tougher supervisory regimes), where the insolvency of HIH has left debts exceeding liabilities of between AUS $2.7 and AUS$6 billion, and in the United Kingdom where the Independent has also spectacularly failed, you would be right to ask whether the system is working.

The regulators of both the Independent and the HIH groups have come under severe criticism. In neither case did the regulator manage to take any steps which could have been said to protect the innocent public until it was too late. In the case of HIH, when the company was required to provide evidence of solvency to its regulators, the directors applied to appoint provisional liquidators. The regulators’ role could therefore be said to have been as a catalyst rather than anything more. Equally, it seems that the regulators were not involved in anything but the Independent’s very final moments.

This regulatory system tends to rely upon market forces, and insurers seeking potential reinsurance tend to rely on ratings by Bests, Moody’s and others. In addition, a reinsurers’ auditors should have a fair idea of whether the company is trading on a proper basis, it has proper reserves or capital and whether there has been any financial engineering within the group. HIH and Independent appear at these early stages to be clear examples of where market forces, ratings and the regulatory models have not lived up to expectations. The system is clearly not effective but what are the alternatives?

At the moment there do not appear to be any. In Britain, the FSA has reserved its position as to whether it intends to regulate reinsurers. The model it has adopted for other sectors, however, is not very different to that currently used and relies on auditors and increased self reporting requirements.

What is of true concern to insurers at the moment, however, is that regulators, for example in the United Kingdom and Australia, are under real pressure to improve their service. That means finding a way to strengthen the protection offered to the public. In the short term at least, that is likely to take the form of oppressive restrictions which may be more substantive than increased reporting or solvency levels, and which could involve restrictions on operational issues.

Regulators need, however, to be careful not to over-compensate in a knee jerk reaction which may have the effect of restricting reinsurers’ business processes. To do so could affect the competitiveness of reinsurers in the current global market. In the long term this could be more detrimental to the market than any short term gain achieved for political reasons.

In the end, therefore, we remain of the view that the attempts to co-ordinate global regulation will be a vast improvement on the present system, but like all global solutions, will inevitably not be able to prevent rogues from continuing to operate on the fringes.

On the local front the debate is likely to follow the traditional lines of whether restrictive regulation, which is bad for competitiveness, will actually achieve its aim of protecting the innocent public. As reinsurers do not deal direct with the public, one questions whether restrictive regulation of reinsurers locally is necessary at all.

'The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.'

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