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Credit for Reinsurance Rules

U.S. Credit for Reinsurance Rules: A Growing Call for Change

By Stephen W. Workman

Introduction

Insurance companies will often make the decision to transfer a portion of their portfolio risk to one or more other insurers. The method by which this is achieved is termed “reinsurance.” Essentially, reinsurance is a transaction whereby one insurance company indemnifies another insurance company against all or a portion of a loss that may arise under one or more policies.1 Termed another way, “reinsurance is insurance for insurance companies.”2 The insurance company acquiring the risk is known as the “cedant,” “assuming insurer” or the “reinsurer.” The company transferring risk is known as the “ceding insurer” or the “primary” or “direct” insurer.3 Reinsurance companies themselves also purchase reinsurance, creating a multi-tiered indemnity structure. This tiering of risk is known as retrocession.4

“Credit for reinsurance” laws are a critical component of reinsurance regulation in the United States.5 These laws determine when a ceding insurer licensed or domiciled in a state can take credit on its financial statement for risk ceded to a reinsurer, either as an asset or a reduction in liabilities.6 When the reinsurance company is not licensed or accredited in the state of domicile of the ceding insurer, the ceding company cannot take financial statement credit unless the ceded risk is fully collateralized.7

These collateralization requirement represent significant capital expenditures, and are obligatory where the cedant is a non- U.S. reinsurer who is not licensed or accredited in the United States (i.e., an “unauthorized alien reinsurer”).  However, unauthorized alien reinsurers play a key role in the U.S. insurance market.8 Today, more than 4,000 foreign reinsurers assumed business from U.S. ceding insurers. Those reinsurers were domiciled in more than 100 foreign jurisdictions.9

These alien reinsurers, and some domestic regulators, are voicing increased criticism over the efficacy of the U.S. credit for reinsurance laws.  Opponents to the current system note that besides the U.S., only Canada, France and Portugal have collateral requirements, and France and Portugal will eliminate these requirements in 2008.10

Before examining that debate, some background information on the nature and purpose of the reinsurance industry is in order.

The Purpose of Reinsurance

Reinsurance is a key component of the insurance marketplace and serves to reduce volatility and improve insurers’ financial performance and stability.11 Reinsurance performs multiple functions in this regard, including:

  • Expand the Insurance Company’s Capacity:  Insurance company capacity is the maximum amount of risk the insurer can undertake per the company’s surplus. Reinsurance allows the company to assume more risk and receive premium income while transferring a portion of the risk to the assuming insurer.
  • Spread of Risk:  Reinsurance allows companies to increase the amount of risks assumed, and policies written, and provides the opportunity to engage in a variety of types of risk among classes and businesses.
  • Stabilize Underwriting Results: By transferring a portion of risk to reinsurers, a company can limit the impact of large losses on its overall underwriting results.
  • Catastrophe Protection: A catastrophic event could render single insurers insolvent unless the financial impact is spread amongst many companies.
  • Expertise: Insurance companies will often look to reinsurers for information, advice and guidance on underwriting, rates, loss experience and claims reserving for certain lines of business.
  • Withdrawal from a Line of Business: A company may decide to withdraw from a certain line of business, and can achieve this by transferring that portfolio to reinsurers.
  • Establish a Balanced Portfolio:  Insurance portfolios can be structured in various ways, but companies strive for balance, such that the portfolio includes many similar and equivalent risks. Reinsurance can help achieve this portfolio “homogeneity.”12

Thus, reinsurance allows direct (or primary) insurers to free themselves from all or part of a risk that, for one reason or another, they do not wish to bear alone.

Types of Reinsurance

There are two types of reinsurance contracts: facultative and obligatory. Facultative contracts allow the primary insurer to negotiate separately for each policy it wishes to reinsure, and a reinsurer retains the right to reject all or part of any such policy. Obligatory reinsurance involves the automatic underwriting of every policy falling under the terms of the “treaty” (i.e., the obligatory reinsurance contract).13 Due to the transactional costs and inefficiencies involved in negotiating single policies, facultative reinsurance is used primarily for risks of an unusual nature, such as low probability natural disasters or new technologies with no or limited loss experience.14

It is important to note that, regardless of the type of reinsurance, the primary insurer remains liable for all claims to the policyholder. The policyholder has no rights against the reinsurer. If the primary insurer cannot pay the claim and the reinsurer is solvent, the funds provided by the reinsurer will supplement the assets of the primary insurer. If the reinsurer fails, the primary insurer remains fully liable for its contractual obligations to the policyholder.15

Both forms of reinsurance, facultative and obligatory, may be either proportional or non-proportional.16

Proportional reinsurance: this type of treaty provides that the direct insurer and the reinsurer apportion premiums and losses at a contractual defined ratio.  The ratio may be the same for all risks included in the contract, or may vary from risk to risk.  In any event, the reinsurer’s portion of premiums is directly proportional to its obligation to cover losses.17

Non-proportional reinsurance: this type of treaty defines an amount up to which the direct insurer will pay for all losses (the deductible). Over this amount, the reinsurer will pay all losses, up to a contractually stated amount. The reinsurer will share in the premiums paid, but not pursuant to a defined ratio, but rather pursuant to a loss and exposure rating based on statistical data.18

Reinsurance is a global industry.  Of the top ten reinsurers ranked by premium volume, seven are non-U.S. companies.19 Two European companies, Swiss Re and Munich Re, dominate the industry. In 2000, Munich Re’s net premium volume was nearly 15 billion dollars, and Swiss Re’s was approximately 14 billion.20 The largest U.S. reinsurance company, Kansas City-based Employers Re, was acquired by Swiss Re in 2006, making Swiss Re the world’s largest reinsurance company.21 The global insurance business is becoming ever more highly concentrated. Companies from a mere ten countries collected 97% of all reinsurance premium ceded by U.S. insurers to overseas companies in 2004.22 The bulk of this business is handled by a fraction of the 2300 unauthorized alien reinsurers that accepted risk from U.S. cedants in 2004. Just 149 companies (6% of the total) assumed more than $50 million in business, and 97% of these companies were domiciled in just ten countries.23

U.S. Regulatory Scheme

With regard to reinsurance, the U.S. system includes both a direct and indirect regulatory approach.  Direct regulation is imposed on any insurance company licensed in one or more U.S. states by that state’s department of insurance.24 A reinsurer licensed by a state is subject to the full spectrum of insurance regulations to which a primary insurer is subject.25 While state insurance laws vary, most are based in large part on model laws and regulations developed by the National Association of Insurance Commissioners (“NAIC”).26

The NAIC is the trade association of the insurance regulators of the fifty states and the District of Columbia.27 The NAIC has developed an accreditation program to encourage substantial similarity of state laws and procedures in key areas of insurance regulation.28 Among the matters regulated by the states are:

  • Minimal Capital and Surplus Requirements
  • Risk-Based Capital Requirements
  • Investment Restrictions
  • Disclosure of Material Transactions
  • Licensing Requirements
  • Discolures/Prohibitions on certain Fronting Transactions
  • Asset Valuation Requirements
  • Examinations
  • Insurance Holding Company Requirements
  • Fraud Prevention
  • Annual Statement Disclosures, Accounting and Filings
  • Unfair Trade Practices
  • Annual Independent Auditor Reports
  • Certified Loss Reserves Opinions29

U.S. regulators recognize that given the enormity of the insurance marketplace, the reinsurance capacity can only be satisfied by allowing non-U.S. insurers to assume reinsurance business in the U.S.30 In fact, nearly one-half of the reinsurance premiums are reinsured outside of the U.S. According to the NAIC, more than 4,000 reinsurers from more than 100 countries either assumed premiums or owed recoverables to U.S. insurers in 2004.31

The regulatory approach to reinsurance in the U.S. has traditionally been focused on the ceding company’s reinsurance arrangements, with the overriding concern being the solvency of the assuming company (the reinsurer), the impact of reinsurance on the ceding company’s financial position and the ultimate impact on consumers.32

The challenge for regulators is that they lack of jurisdiction (and resources) over reinsurers domiciled abroad and not licensed in any U.S. state. Since U.S. regulators cannot directly regulate such non-U.S. companies, the indirect mechanism by which state regulators exert control over the reinsurance market is through the “credit for reinsurance” laws.33

Credit for Reinsurance Laws

Credit for reinsurance laws are a key component of reinsurance regulation in the United States. While each state has a “credit for reinsurance” law, nearly all are based on, and substantially similar to, the NAIC’s “Credit for Reinsurance Model Law.”34 These laws allow regulators to permit a licensed ceding insurer to take credit on its financial statements for reinsurance recoverables and to reduce its loss reserves by the amounts ceded, so long as the contract for reinsurance, and the reinsurer itself, meet specified state standards.35 Thus, a credit for reinsurance allows an insurer to increase its surplus and expand its capacity to write new business.

A U.S. insurer, that has ceded business to a reinsurer, cannot take statutory credit to either reduce liabilities or increase assets on its balance sheet, unless the reinsurer meets one of the following requirements:

  • The reinsurer is licensed in the same state of domicile as the ceding company for a like kind of business (i.e., same line or class of insurance product).36
  • The insurance department of the state of domicile of the ceding company “accredits” the reinsurer.  “Accreditation” requires: submitting to the jurisdiction of the domicile state; submitting to examination by such state; reinsurer is already licensed in at least one U.S. state; reinsurer must file annual financial statement with ceding company’s domicile state; reinsurer must maintain a policyholder surplus of at least $20 million.37
  • The reinsurer is domiciled and licensed in a U.S. state having substantially similar credit for reinsurance law as the domicile state of the ceding company.38
  • The reinsurer provides collateral in the form of a multiple beneficiary trust to secure its gross liabilities to all U.S. ceding insurers, plus a $20 million surplus.39
  • The reinsure provides collateral or other security to the ceding company, in the form of a single beneficiary trust or a letter of credit, with the ceding company as the beneficiary, or by the withholding of funds by the ceding company.40

Thus, a U.S. insurer cannot take financial statement credit for business ceded to a reinsurer unless: (i) the reinsurer is subject to the full spectrum of state regulatory requirements; or (ii) the reinsurer provides full collateralization to secure reinsurance recoverables. Since there are few situations where an insurer would be willing to cede risk - and pay out premiums - to a reinsurer without being able to show a corresponding increase in assets or reduction in liabilities, the credit for reinsurance laws are a powerful incentive for compliance.41

Where the cedant is an unauthorized reinsurer, collateralization can be achieved through any one of several means, including letters of credit (issued by authorized U.S. financial institutions), creation of a single beneficiary trust, creation of a multi-beneficiary trust, or through establishment of funds withheld by the ceding company.42

Letters of Credit

The most widely used collateralization methodology, a letter of credit (LOC) is a document issued by a bank through which the bank agrees to pay any draft presented by the beneficiary so long as any stated conditions have been met.43 In terms of credit for reinsurance laws, the LOC must not be subject to any conditions or limitations, other than amount; it must not be subject to cancellation prior to its stated expiration date; it must contain automatic twelve month terms extensions unless thirty days’ advance written notice of termination has been provided to the beneficiary; and it must be issued by a qualified U.S. financial institution approved by the NAIC.44

Single Beneficiary Trust

In lieu of an LOC, an unauthorized reinsurer can provide collateral to a U.S. ceding insurer through a single beneficiary trust, without the need for funding a surplus.45 However, because the beneficiary must be the ceding insurer, a reinsurer assuming risks from multiple U.S. insurers must establish separate trusts for each ceding insurer if it is to avoid the surplus funding requirement, resulting in significant transactional and administrative costs.

Multiple Beneficiary Trust

Another approved method of collateralization is the multiple beneficiary trust (“MBT”).  This allows an unauthorized reinsurer to fund all of its U.S. liabilities through a single trust, so long as a surplus of $20 million is also funded.46 MBT’s involve a significant amount of regulation, because the trust instrument must be filed with and approved by the insurance commissioner of the domicile state of the trust. The trust must also file financial statements with the commissioner.47

The Case of Lloyd’s of London

Lloyd’s of London is one of the world’s largest reinsurers, having gross reinsurance premiums in excess of $8 billion in 2001. But Llloyd’s is not an insurance company, but rather an insurance marketplace, that allows for its members or groups of members to form “syndicates” to capitalize assumption of risks.48 Today, the vast majority of Lloyd’s capital providers are corporations, not individuals, although individuals may and do participate, typically through Scottish Limited Partnerships.49 Each syndicate is operated by a “managing agent.”50

In 2006, there were 46 managing agents running 66 syndicates at Lloyd’s.51 Some syndicates specialize in direct insurance, while others focus on reinsurance. The syndicates cover a wide variety of non-life insurance risk, including aviation, marine, professional liability, casualty, property and health, although Lloyd’s is perhaps best known for underwriting of catastrophic risk.52

The syndicates compete for customer business, which is placed with accredited Lloyd’s brokers into the market. The Lloyd’s market had the capacity to write approximately $30 billion of business in 2006.53 The natural disasters of 2005 caused claims payments of more than 3 billion pounds, resulting in a small loss of 103 million pounds.54 However, Llloyd’s has experienced significant losses in prior years.  In a five year span in the early 1990’s, Lloyd’s suffered losses of over five billion pounds.55 These losses were compounded by other problems at Lloyd’s. Among these problems were charges of negligence and self-dealing, lawsuits filed by thousands of members seeking compensation for those massive losses, and questions as to whether Lloyd’s could meet its U.S. loss obligations.56

In response to the special risks attendant syndicates such as Lloyd’s, the credit for reinsurance laws require them to post collateral for 100% of gross liabilities, plus $100 million in trusteed surplus (instead of the $20 million surplus required of reinsurance companies).57 This, despite the fact that Lloyd’s has been underwriting risk in the U.S. since 1840, has never failed to pay on a single claim, and is rated “A” (strong) by Standard & Poor’s, across all syndicates and all accounting years. 58

Criticism of Current U.S. Credit for Reinsurance Laws

Most major reinsurers conduct business around the world. There are approximately 150 active reinsurance companies, collecting over $200 billion in annual global premiums.59 More than 90% of the world’s reinsurance is written by the top 20 companies; the top 10 groups write 60%.60 Notwithstanding this fact, the U.S. credit for reinsurance laws require state regulators to insist that alien reinsures post collateral for 100% of their gross estimated actuarial liabilities to U.S. cedants, yet no such demand for collateral is placed in domestic companies, regardless of their financial security rating. The current credit for reinsurance regime make no distinction between financially strong reinsurers, located in well-regulated countries, from other financially weak reinsurers, located in lesser regulated countries.  The credit for reinsurance rules treat a BB- rated company located offshore in exactly the same as an AA rated reinsurer located in a prominent European financial center.61

Insurance companies, including reinsurers, manage their operations on a “net liability” basis.62 Companies leverage their capital through the use of retrocession and determine their risk exposures based on net liability.  This results in increased capacity, and decreased cost, to the company.  The current U.S. credit for reinsurance regime, however, require the non-U.S. reinsurers to operate in the U.S. on a gross liability basis, being required to post collateral on 100% of their gross liabilities to U.S. ceding insurers despite the fact that some, perhaps even most, of these liabilities have been further ceded out in retrocession to other reinsurers.63

Such rigid regulatory treatment is unnecessary and unfair, according to critics of the system.  They note that most reinsurance companies trade risk on a global basis, that such cross-border trade is essential to a balanced and diversified portfolio, and any inefficiency in the market results in billions of dollars of lost capital.64 Moreover, because approximately 90% of the world’s reinsurance is written by the top 20 reinsurers, critics argue that there must be a better, more targeted, approach to securing recoverables than by requiring all companies, regardless of financial strength or payment history, to fully collateralize their U.S. liabilities.65 Industry statistics show that net reinsurance recoverables on all paid an unpaid property/casualty losses in 2000 represent 144.2% of surplus in U.S. property and casualty insurers.66

Since 1999, Lloyd’s and the London market have been lobbying for the NAIC to revisit this issue, such that credit for reinsurance requirements are tailored to the global nature of the reinsurance industry and to achieve open markets on “fair terms” (i.e., where non-U.S. cedants are not forced to tie up excess capital under U.S. collateralization rules).67 The world’s largest reinsurance company, Swiss Re, is also in favor of reform.  Swiss Re’s chief executive, Jacques Aigrain, is in favor of removing collateral requirements worldwide for demonstrably strong companies “for the sake of open markets.”68

The major international insurance trade associations also favor reform, as part of their larger efforts to promote cross-border cooperation and standardization.

The International Association of Insurance Supervisors

The IAIS was established in 1994 to develop international principles and standards for insurance oversight and to improve supervisory standards, through international cooperation and assistance. Its membership of Insurance Supervisors represent 180 countries.69 In 2005, IAIS adopted a position paper outlining key elements for the formulation of regulatory requirements for assessment of insurance company solvency worldwide. According to the IAIS, “[t]his common structure will serve to enhance transparency and comparability of insurers’ solvency situations and of solvency regimes worldwide, to the benefit of consumers, the industry, investors and other interested parties. Such comparability is expected to engender convergence of regulatory regimes and solvency worldwide.”70

In 2006, IAIS issued a further paper aimed at creating a working plan and timetable for the development of international supervisory standards on solvency assessment. Referred to as the “roadmap paper,” it builds upon the 2005 position paper and charts a course for future work in the area of convergence of regulatory regimes.71

The IAIS position is reflected in a recent position paper authored by Nikolaus von Bomhard, Chairman of the Munich Reinsurance Company.72 In that paper, entitled “A Framework for an International Supervisory System for Reinsurance Companies,” he observes that “by its very nature, reinsurance is an international business” and that this requires that “reinsurers have free market access in as many different countries as possible and that this access is not hampered more than necessary by the authorities supervising these companies.”  With particular regard to the U.S. credit for reinsurance laws, Mr. von Bomhard writes “reinsurers not only need to have the necessary ordinary share capital, they are also required by supervisory law to cover the risks they carry with solvency capital. This requirement can result in inefficiencies induced by national supervisory laws, which may lead to redundant guarantee capital . . . and administrative costs to the reinsurer.”73

The EU Reinsurance Directive and Solvency II

There was no harmonized framework for reinsurance regulation in Europe until recently. In 2005, the EU Council of Ministers adopted the “European Reinsurance Directive.”74 This directive is aimed at reinforcing the insurance markets by creating a single pan-European market for reinsurance.75 The directive establishes supervision of reinsurers by proper authorities of their home country allowing them to operate throughout the European Union.76 The directive is in line with the reinsurance supervision and regulatory projects being carried out by the IAIS, of which all EU states are members.77 However, the directive is intended to be a temporary measure, pending adoption of a more thorough set of EU-wide regulations by Europe’s governmental insurance group, the Comite Europeen des Assurances (CEA).

CEA is the insurance trade association of Europe.78 It has 30 full members, comprised of 25 EU member states’ national associations, plus Iceland, Norway, Switzerland, Lichtenstein and Turkey.79 CEA initiated two projects aimed at coordinating the solvency requirements among its member jurisdictions.80 The first, commonly known as “Solvency I,” has been adopted and its provisions represent legal requirements to its members.81 The more recent “Solvency II” project is, at present, a “proposal” and not binding. Solvency II aims at creating a more risk-related solvency model. Beyond imposing quantitative solvency requirements looking at insurance risks, Solvency II considers the overall management of risks and the structure of insurance supervision.82

In 2006, CEA tasked the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) with assessing the impact of Solvency II’s risk-based approach to regulation and supervision on the assets and liabilities of non-life insurers and reinsurers.83 CEIOPS tested Solvency II’s capital calculations on the balance sheets of companies of various sizes, from 23 countries with an estimated 50% market share, and submitted a report to CEA, stating that the impact on solvency positions differs depending on the type of organization, but the solvency ratio remained above 100% for most companies in most countries.84

The CEIOPS report has been criticized for not including a sufficient number of small insurance companies.85. This criticism is also directed at Solvency II, itself, which some view as having been written for the benefit of large, multi-line insurers, at the expense of small mono-line companies.86

While Solvency II is a European initiative, it is being developed with a view towards the global marketplace.87 The solvency and accounting requirements are designed, in part, to address the criticisms of the RAA, and others, regarding European regulatory practices.88 CEA seeks a “convergence of supervisory practices” amongst its members.89 Among its key goals, CEA supports appointment of a Lead Supervisor for the supervision of pan-European groups. According to CEA, this would avoid the overlapping reporting and complications which several groups are facing under the Reinsurance Directive.90

Opposition to Change

The arguments in favour of the status quo, and against change to U.S. credit for reinsurance laws, are reflected in the position of the Reinsurance Association of America. RAA president Frank Nutter presented these arguments to Congress in June 2002.91 The RAA argues that state regulators cannot be expected to know, or to learn, the intricacies of accounting systems and regulatory schemes used throughout the world to determine the financial strength of non-U.S. insurers.92 Moreover, the RIAA argues, because the ceding insurer is allowed financial statement credit for transfers to non-U.S. reinsurers, it is imperative that U.S. regulators have confidence that the alien company is able and willing to pay its obligations as they become due.93 According to the RIAA, this confidence is achieved through the collateralization mechanism, as it eliminates the regulator’s need to assess the level of regulation, and financial strength, of the non-U.S. reinsurer.

Mr. Nutter reiterated these sentiments in an interview with US Insurer magazine in 2005.94 He argued that the credit for reinsurance rules have worked very well to date to foster a “highly competitive marketplace” serving the U.S. and can hardly be said to represent a barrier to trade, given that “alien reinsurers now control 45% of the U.S. market, and if you add to that the market share of alien companies that have established U.S. domicile through a subsidiary, that figure rises to 77%.”95

Mr. Nutter observes that “[i]f Lloyd’s or any other entity is arguing that the costs of doing business here are higher than elsewhere – or that the system is inefficient – that is because their unique business model makes it so. The U.S. recognizes the position of Lloyd’s and offers a trust fund option.”96

Also opposed to any change in the credit for reinsurance rules is the Property Casualty Insurers Association of America (PCI). Commenting on the Nutter interview, PCI voiced support for the RIAA’s position, and offered further observations in support of current law. PCI considers the issue to be of most concern to the primary insurers, and the companies of these companies are lost in the discussion.97 According to PCI, a primary company having collateral has a greater likelihood of collection of a recoverable, particularly given the fact that domestic judgments are not always enforceable in other jurisdictions.98 This is because the Hague Convention on Choice of Courts Agreements does not prevent a court from refusing to enforce a judgment that it considers within a “due process exception” or a “public policy exception.”99 The due process exception applies to situations where the judgment was obtained in violation of the due process standards or procedures of the foreign state.100 Public policy exception applies to a judgment that is manifestly incompatible with the public policies of the foreign state. Pre-answer security requirements of U.S. states, such as New York, could render a judgment unenforceable in Switzerland or under British Common Law.101

PCI also notes that primary companies are concerned that reduction of collateral could mean additional insolvencies may occur should reinsurance become uncollectible. In that event, not only would primary companies face additional assessment for the insolvency, their assessments would ultimately be greater than with collateral because it will be difficult for receivers, seeking to recover assets into the estate that ultimately could repay the guaranty funds, to enforce judgments elsewhere.102

Regarding accounting issues, PCI notes the recent General Accounting Office report on risk retention groups and differing accounting methodologies, which points out the differences between US GAAP accounting and Statutory Accounting Principles.103 It also points out some problems in reconciling, from a regulatory perspective, difficulties arising from analyzing these differing standards. Absent uniform international accounting standards, according to PCI, the problem is compounded with the financial information from non-US GAAP countries. Accordingly, PCI rejects the notion put for the by member of the Ad-hoc Committee that European accounting practices are readily “translatable” into U.S. GAAP standards.104

The Collateralization Rules Roundtable

In 2004, nine U.S. insurance regulators, all members of the NAIC, decided to establish the Ad Hoc Reinsurance Collateralization Roundtable.105 This Roundtable would work independently of the NAIC and the NAIC’s longstanding Reinsurance Task Force, to encourage discussion and facilitate debate among interested parties to the reinsurance collateralization rules.106

Perhaps not surprisingly, several U.S. industry trade groups flatly opposed any such discussions, and demanded the Roundtable disband.107 These groups argued that changes to the current reinsurance collateralization rules were impossible because: (1) interested industry parties could never reach agreement on this issue; and (2) other international issues must be resolved before any alternative rules could be discussed; specifically (i) the lack of a single international accounting standard; (ii) the lack of enforceability of some U.S. judgments in some foreign courts; and (iii) the absence of sound reinsurance regulation in some countries.108 Despite these objections, the Roundtable moved forward with its work.

The Roundtable posed this question to executives from select U.S. and non-U.S. insurance companies and industry trade groups: “Is there a technically sound alternative to the current 100% collateralization requirement imposed on unauthorized alien insurers operating in the US market?”109

The Roundtable met with interested parties for 18 months, and issued a report to the NAIC Reinsurance Task Force in December 2005.110 Although no consensus as to any specific proposal was achieved among the members of the Roundtable, two preliminary points of agreement were reached: (1) the current U.S. system of requiring 100% collateral should be changed; and (2) any new U.S. rules should be “geographically agnostic” – that is, they should apply to all reinsurers operating in the U.S. regardless of country of domicile.111

Based on those two guiding principles, the Roundtable’s attention came to focus on two, of many, proposed regulatory alternatives to the current system.112 The first, and most highly recommended, proposal contemplates creation of a regulatory entity that would assign a rating to reinsurers, based on their financial strength, payment histories and other factors.  The second proposal would create a single, mutualized pool of capital to collateralize U.S. liabilities of unauthorized alien reinsurers.113

The Rating Proposal

State insurance regulators, through a collective body known as the Reinsurer Rating Organization (“RRO”), would establish procedures to evaluate reinsurers participating in the program, and assign a rating each such reinsurer.114 The RRO would review the financial strength, business operations, management expertise and overall performance history of the reinsurer and rate it into categories RRO1 – RRO5. The ratings factors would include incentives for those companies that can demonstrate an ability to manage credit risks, including appropriate credit for qualification and diversification of risk.115

The five ratings categories would represent the percentage of gross U.S. liabilities that required capitalization, ranging from 0% to 100%. Acceptable collateral would include: (i) Cash; (ii) Securities approved by the NAIC and qualifying as admitted assets; (iii) Clean, irrevocable, unconditional and evergreen LOCs; (iv) and any other form of security acceptable to the RRO.116

U.S. ceding reinsurers would be authorized to take financial statement credit provided the reinsurer meets its applicable collateral requirement and that the reinsurance agreement meet other regulatory criteria, such as transfer of risk, U.S. agent for service of process and U.S. choice of law.117

Reinsurers who are not rated would still be authorized to reinsure in the U.S. market, but the financial statement credit to the ceding insurer would be limited to the extent of collateral posted by such reinsurers.118 Moreover, this proposal would not restrict U.S. insurers from demanding additional collateral as a condition to ceding risk, as a condition to a commercial reinsurance contract.119

The Pooling Proposal

This concept calls for the creation of a single, mutualized pool of capital that would be used to collateralize U.S. liabilities of unauthorized reinsurers.120 As with the Rating Proposal, the Pool Proposal would not prevent any ceding insurer from demanding 100% collateral through a reinsurance contract, nor would it replace other forms of acceptable collateral the ceding insurer may prefer, such an irrevocable evergreen LOCs.121

For those reinsurers who desire to participate in this program, the initial level of capitalization would be determined by U.S. regulators acting collectively through the NAIC.122 The regulators would perform an actuarial analysis and, after consideration of worldwide default rates and other relevant factors, set the capitalization amount. This amount would then be expressed as a percentage of all outstanding U.S. liabilities of participating unauthorized reinsurers (less any liabilities collateralized outside the pool). Participating unauthorized insurers would then deposit capital into the pool in an amount equal to their gross U.S. non-collateralized liabilities multiplied by the prescribed percentage rate.123

The actuarial analysis would be performed annually, but U.S. and alien insurers and trade groups would be encouraged to perform their own studies and submit them to the NAIC for review and consideration.124

Status of the Current Debate

The Roundtable Report was intended to explore potentially viable alternatives to the current credit for reinsurance regime in the U.S., and to facilitate further discussion by interested parties. Both the Rating Proposal and the Pool Proposal were circulated and discussed by industry executives and the participating regulators comprising the Roundtable, but no consensus was reached as to either.125 While the Rating Proposal received the widest support, the roundtable decided that both proposals should be submitted to the NAIC’s Reinsurance Task Force for further study and consideration.126

The NAIC Task Force has yet to make any formal recommendation to the NAIC, but there is a growing acknowledgement among its members that a change in the current U.S. system is appropriate. Larry Mirel, Insurance Commissioner for the District of Columbia and co-chair of the Ad-hoc Reinsurance Collateralization Roundtable, believes the collateralization debate should be framed in terms of “reliability of commitment.”127 He acknowledges that nothing is safer than 100% collateral, but there are systemic costs to this approach, since it involves tying up capital that could be put to better use elsewhere.  Reinsurers with a “sterling record of paying claims” should not be forced to put up a “gold-plated guarantee.” 128

Several issues remain unresolved, but the principle arguments of those opposed to any change in the current system, such as lack of uniform and adequate supervisory standards abroad, the lack of readily-translatable foreign accounting standards, and questions regarding enforceability of judgments, have been addressed, in part, through the various IAIS Principles and Standards, the EU Reinsurance Directive and the pending Solvency II regulations.

Indeed, NAIC President Alessandro Iuppa delivered a keynote address to delegates at the meeting of the EU Insurance Commissioners on June 21, 2006, discussing Solvency II.129 In his address, Mr. Iuppa stated “[t]he beauty of the Solvency II initiative is that, when completed, it will truly stand as the crowned jewel of the European single market on insurance. . . and a model for the rest of the world.”130 In his remarks, Mr. Iuppa also called on Europe to join with U.S. insurance regulators to further develop international standards through the IAIS.131 Mr. Iuppa then held meetings with the EU Commissioner for Internal Markets and Services (having jurisdiction over EU insurance regulation), Charles McCreevy.132

In March 2006, the NAIC and CEIOPS approved a “Memorandum of Understanding,” to establish a formal basis of cooperation between EU insurance authorities and U.S. regulators.133 The Memorandum provides for the free exchange of information, upon request, relevant to each other’s supervisory, regulatory and examination responsibilities concerning companies and persons engaged in the insurance business in their respective jurisdictions.134

Conclusion

Despite the opposition of the many domestic insurers and trade groups, it appears inevitable that the U.S. credit for reinsurance laws will be modified in the near term.  The international community, primarily through CEA, CEIPOS and the IAIS, have taken strong affirmative steps towards adoption of comprehensive regulatory and supervisory measures in which U.S. regulators can have confidence.  As observed by EU Commissioner McCreedy in a speech before the NAIC in February 2006: “We are working with the National Association of Insurance Commissioners towards a roadmap that would define and set a target date for ending collateral in the U.S. The collateral requirements are not justified from a prudential perspective. It forms a barrier to market access, diminishes available reinsurance capacity and therefore reduces the efficiency of the market.”135 It appears that more and more U.S. regulators are being converted to this point of view.