January 15th, 2009

Financial Catastrophe Drives Regulation in 2008

Posted at 1:00 AM ET

Guy Carpenter Business Intelligence Unit
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Governments around the world have moved swiftly and radically to respond to the turmoil in global financial markets. Many are concerned that efforts to create a level playing field through the harmonization of accounting rules, Solvency II, and other international agreements, will be swept away by governments anxious to be seen as prioritizing economic stability in their own countries.

A New Reinsurance Framework for the United States

The National Association of Insurance Commissioners (NAIC) approved a new reinsurance framework in December 2008. If the plan will reduce or eliminate completely collateral requirements for non-U.S. reinsurers (depending on credit rating).

The framework specifies two classes of reinsurer: U.S.-domiciled companies “national reinsurers” and non-U.S. “port of entry” (POE) reinsurers. Under the plan, a new NAIC supervisory department will evaluate the reinsurance supervisory regimes of other countries and decide which jurisdictions can be mutually recognised. Only reinsurers from countries that are mutually recognized would be allowed access as a POE reinsurer. The department would also establish standards for individual states to qualify as either a home state for national reinsurers or a POE state for non-U.S. reinsurers to regulate reinsurance on a cross-border basis. A U.S.-domiciled reinsurer, when licensed by the home state, will be able to access the U.S. market through a single state regulator (the home state). Both U.S.-licensed insurers and non-U.S. reinsurers can choose to remain under the current system of regulation. The new framework has been welcomed by the EU, Lloyd’s, and other foreign players, but ratification and full implementation may take several years. However, in the United States, most cedents are not happy with the proposed changes.

Three New Insurer Classes in Bermuda

On July 30, 2008 the Insurance Amendment Act came into force, creating three new classes of insurer:

  • Class 3A: more than half of net premiums are from third party business and net premiums are under USD50 million
  • Class 3B: more than half of net premiums are from third party business and net premiums are over USD50 million
  • Special Purpose: the insurer fully funds liabilities through a debt issue or other financing scheme approved by the Bermuda Monetary Authority.

Class 4 (re)insurers are now required to file audited GAAP financial statements together with annual statutory returns, and in most cases, these accounts will be made available to the public. The Bermuda Capital Solvency Requirement, a risk-based capital (RBC) model, is now expected to apply to Class 4 (re)insurers for year-end 2008 filings and for certain Class 3 insurers for year-end 2009 filings.

Progress on Solvency II

The “three pillars” approach - solvency, governance, and information - will affect 5,000 (re)insurance companies in the EU. Approximately 1,100 small entities, with premium income under a threshold of EUR5 million, will not be covered. An interim measure, the Reinsurance Directive, was to have been implemented by all EU member states by December 10, 2007. Its goal was to harmonize supervision across the EU in advance of Solvency II. To date, however, Belgium, Greece, Poland, and Portugal have not transposed the directive locally.

The EU Council of Ministers approved a version of the Solvency II Directive in 2008. Because of opposition by some smaller member states, all reference to group support and group supervision was removed. Group supervision is a measure to promote capital efficiency and rationalise the regulation of multinational insurance groups across the EU with only one lead regulator being involved rather than one in each jurisdiction. Some country regulators regarded the proposals as an unwarranted dilution of their powers. The Directive still has to be approved by the European Parliament, and although it is quite likely that further revisions to the draft will be eventuated by February 2009, this may delay the timetable for implementation from 2012 to 2013 or later.

Rating agencies warn that certain insurers are far from ready for Solvency II. Their abilities to measure diversification benefits are a key area of concern. Non-EU insurers may find themselves operating at a competitive disadvantage in the EU unless they have supervisory equivalence. This could become a moving target, as the regime may still be altered. The Minimum Capital Requirement (MCR), for example, is more sensitive politically than the Solvency Capital Requirement (SCR). The Committee of European Insurers and Occupational Pension Supervisors’ (CEIOPS’) report on its fourth Quantitative Impact Study for Solvency II (November 2008) found that 99 percent of insurer participants surveyed had enough capital to cover the MCR and that 89 percent had enough to cover the SCR.

Broadly speaking, regulatory supervision will become more qualitative and prospective. Consequently, it seems as though regulatory practices will converge with rating processes. Standard & Poor’s (S&P) asserts that the rating process should help insurers prepare for Solvency II and give the following examples:

  • The capital adequacy model resembles the SCR (Pillar 1)
  • ERM criteria are aligned to risk management reviews (Pillar 2) 
  • The capital analysis model is similar to supervisory internal models
  • Transparency in the ratings process is similar to disclosure requirements (Pillar 3)

Fitch Ratings predicts that there will be no widespread, immediate effect on ratings with the introduction of Solvency II. The regime is going to affect supervisory capital rather than capital held (which has a direct impact on the rating), some capital reallocation within groups, and scope for M&A activity. The agency will continue as before to evaluate capital strength, review each insurer’s internal capital model if available, and consider regulatory capital, as part of the overall rating process.

ReTakaful

The international Takaful industry is being positioned to attract clients from around the world, regardless of religious affiliation. Two groups of regulators, the IAIS and the Islamic Financial Services Board, have announced a working agreement to establish a regulatory and supervisory framework, including a guiding principles exposure draft and a solvency standard requirement.

Solvency Margin Ratio Revisions in Japan

The Financial Services authority released an exposure draft of proposed revisions to the solvency margin ratio in early 2008, with proposals to restrict the types of assets to be used in the solvency calculations and revised risk coefficients. The ratio itself is scheduled to be reviewed by 2010.

The IASB and the Accounting Standards Board of Japan have launched a project to reduce the differences between IFRS and Japanese GAAP. Commentators have indicated that it is unlikely that IFRS will be adopted because of the desirability to maintain separate catastrophe reserves which attract tax relief for inward transfers.

Australia

A consultation paper was circulated concerning the Australian Prudential Regulatory Authority’s (APRA’s) requirements, which are due to take effect on January 1, 2009, for the use of internal models in determining an insurer’s MCR. A framework for the supervision of groups, including the withdrawal of concessions in respect of intra-group reinsurance, is also to be implemented on January 1, 2009. It is intended to improve the security of insurers by introducing a higher capital charge on the long-term reinsurance recoverables due from foreign reinsurers, even if they have the same rating as a domestic reinsurer. Heeding the lessons learned from HIH, the regulator has directed that reinsurance contracts entered into after June 30, 2008 must be subject to Australian law, and recoverables may only be paid out to cedents in Australia.

Additional Contributor

  • Andrew Poray, Assistant Vice President
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