Reinsurance: less regulation between EU and US

The regulation of reinsurance industry is undergoing significant overhaul due to the EU’s Reinsurance Directive. The new regulatory framework was approved by the European Parliament two years ago and is due to be implemented in all member sates of the EU and EEA by 10 December 2007. The key feature of the Directive is the harmonisation of regulation amongst the member states, which in turn will have a major impact on reinsurance business on both sides of the Atlantic. The Directive does not though have direct effect in individual countries; it is a Directive addressed to national governments to introduce implementing legislation in their own territories. Therefore, much will depend on how the Directive is implemented in individual countries.

The Reinsurance industry in Europe has prospered for 150 years without harmonised regulation, so why now?

• This new Directive represents another building block to advance consumer protection and provide equal access to markets in EU. Previously, the regulation of reinsurance companies depended on the individual member state: some states did not regulate at all whereas others, such as the UK, regulated reinsurance companies much the same as primary insurers. There are currently no harmonised reinsurance supervision rules in the EU. The different member states use common law, Napoleonic codes and some communist influenced regulation which all provide for varying degrees of supervision. The concern is that leaving reinsurance unregulated may result in primary insurers ending up with inadequate protection and therefore could have disastrous consequences for policyholders.
• Another important consideration of the Directive is to promote an efficiently-run internal market within the EU. By creating a level playing field, the reinsurance market should become more competitive which will indirectly benefit the policyholders.
• Many financial institutions such as the International Monetary Fund and the World Bank have applied pressure on the EU to change the system. A bone of contention has always been the collateral requirements imposed on alien reinsurers by the US. US regulators have been reluctant to relax this requirement without being satisfied that the regulation of European reinsurers in their home jurisdictions provides adequate protection for US reinsureds, and thus indirectly for US policyholders. Insisting on the harmonisation of regulation has therefore formed part of the US negotiating stance in transatlantic talks regarding mutual recognition.

New elements of the Directive affecting EU and non-EU reinsurers

• The Directive requires non-EU reinsurers to obtain authorisation separately in every Member State in which they want to do business. Companies will need to establish a subsidiary in a EU State if they want authorisation for the whole EU. This is a significant incentive for non-EU reinsurers who operate through a branch office or branch offices in member states to set up a subsidiary in a suitable EU member state. A non-EU and non-admitted reinsurer can still cover risks based in the EU. Member states can implement indirect supervisory rules permitting recognition of the insurance supervisions of non-EU countries. If recognition is granted then non-EU companies could do business without needing any more permits.
• The new rules eliminate collateral requirements among member states: the reinsurer will be subject to financial regulation only in its home state and will not be required to make financial filings or to maintain assets in other member states.
• The Directive grants passporting rights among member states: so long as a reinsurer is domiciled in one member state, the company can do business in the others. However a reinsurer based outside the EU with a branch within the EU will not have any passporting rights: this has had an impact on company structures (see below).
• Reinsurers in run-off will be exempt from the need to seek authorisation.
• Reinsurers can transfer portfolios across borders in the EU. In the UK, for instance, transfer of books of business have been possible for many years but before Part VII of the Financial Services and Markets Act (FSMA) 2000 it was not possible to transfer the reinsurance with the liabilities. FSMA introduced the possibility of transferring the reinsurance. It remains to be seen whether other EU member states will implement the Directive in such a way that it will be possible to transfer the reinsurance. We understand that the German implementing legislation does not permit this.
• Member states can develop their own rules regarding finite reinsurance contracts including the right to prescribe mandatory conditions for inclusion in all finite reinsurance contracts and maintenance of solvency margins for finite reinsurance activities.
• Most importantly, the solvency margin requirements for reinsurers are to be equivalent to those for direct insurers, but with the possibility of a 50% increase for certain risks categories of non-life reinsurance business.

The implications of the Directive

• International trade negotiations should be assisted. Previously, it was harder for EU reinsurers to enter the US market, because of the collateralisation requirements. One reason US regulators insisted on those requirements was the lack of EU harmonisation, which made mutual recognition agreements more difficult. The European Commission may now be able to conclude mutual recognition agreements with the US once the Directive has been implemented. This development should strengthen the EU market’s ties with the US.
• All non-US reinsurers were previously required to post collateral to US insurers and maintain reserves for all future claims. The NAIC (the National Association of Insurance Commissioners) voted last year to review collateral requirements with the intention of using a ratings- based approach to setting collateral requirements in the future. The financial strength of the reinsurer will therefore be key and no longer the domicile.
• Several reinsurers are preparing for major internal reorganisation because of the Directive. Swiss Re recently moved its corporate headquarters out of Switzerland into Luxembourg. Munich Re is planning to merge with other subsidiary companies in the EU. These moves are motivated by a combination of tax, regulatory, management and political reasons.
• The portfolio transfer provisions should make it possible for suitable books of London market business to be transferred from one member state to a UK company and finality sought by means of a Scheme of Arrangement.
• The Directive will make it easier and faster to establish insurance special purpose vehicles in the EU. This is a booming area with catastrophe bonds, for example, which have doubled in volume growing to $4.69 billion in 2006. The UK, which implemented the Directive in December 2006, has seen a great increase in the trade of these insurance-linked securities.

Conclusion

According to Michael Diekmann, chief executive of Allianz: “What we want is a single, modern and proportionate prudential framework”. By establishing the principle that one single regulator will be responsible for a EU reinsurance company, the Directive should fulfil the needs of the reinsurance industry whilst protecting insureds and their policyholders. The new structure will have a significant impact on business on both sides of the Atlantic. In Europe, it will allow reinsurers to be established in one member state (including, for example, existing subsidiaries of US-based reinsurers), whilst in the US it may allow the relaxation of collateralisation requirements and permit European reinsurers to compete with local companies on more of a level playing field. Only time will tell whether the framework Mr Diekmann refers to will actually operate across all member states in the modern, proportionate and prudential fashion he, and most people with a vested interest in the insurance industry, want.