The Harmonization of European Reinsurance: In Whose Interest?

Was there a need for a unified regime?

While Europe is contemplating the simplification of European insurance legislation–insurance-related European initiatives increased significantly since 1990–and when some European countries still have not implemented certain European insurance directives into their national laws, reinsurance has been seen as a welcomed addition to what's been called "the global regulatory maelstrom" that is currently spreading across Europe. (See David Howell, Swiss Re, The Global Regulatory Framework, Global Conference of Actuaries, Feb. 15, 2005, New Delhi.)

The Directive contains four main provisions:

(1) The establishment of a "single" passport to Europe, meaning that reinsurers can operate across all European Member States as long as they meet the requirements of their home country supervisor.

(2) The suppression of the collateral requirement (e.g., letter of credit) across Europe, despite fierce oppositions from countries wanting to retain this system, notably France.

(3) Prudential rules for the supervision of reinsurance companies.

(4) Various last-minute inclusions, concerning notably finite reinsurance.

The Directive is largely based on the existing directives on direct non-life insurance. Yet, the European draftsmen seem to have overlooked that very few European countries regulate reinsurance the way they regulate direct insurance. France, for example, like Austria, Germany or Switzerland–four of the five very prominent countries where reinsurers are established–has drastically different reinsurance regimes than those applying to direct insurance.

In particular, France has enacted only a few supervisory rules that essentially regulate the market entry of reinsurance entities, and some of which have not even been fully implemented.

Also, the implementation of a system of authorization for reinsurers at a national level was not discussed in depth at a European level. In particular, if authorization at a national level provides free access to other European reinsurance markets, it is unclear why a mere notification or registration would not be sufficient. (Authorization, a much more lengthy and complex process, ultimately involves an examination of the reinsurer's financials before the reinsurer is allowed to conduct business in the European Union.)

Here again, the experience in the direct insurance industry may not be altogether relevant for reinsurance.

Moreover, as far as prudential rules are concerned, the European "Solvency II" project, covering the European insurance industry as a whole, is still underway. The project began in 1999 at the direction of the European Commission, Europe's executive body. The objective of the "Solvency II" project is to carry out a review of all the rules for assessing overall financial position of insurance companies (MARKT/2095/99 at http://europa.eu.int/comm/internal_market/insurance/docs/markt-2095/markt-2095-99_en.pdf) and introducing a risk-oriented calculation of the solvency requirements, achieving increased harmonization in the calculation of insurance liabilities and allowing convergence of supervisory practices.

The project follows on the "Solvency I" project, which completed a review of the rules for calculating the solvency margin for life and non-life insurance companies and led to the establishment of two European Directives: 2002/12/EC (now repealed by 2002/83/EC) and 2002/13/EC. Surely, prudential rules relating to the reinsurance industry could have been integrated in this more comprehensive, industrywide process of assessment of risk management, finance methods, accounting, supervision, actuarial analyses and practices, and financial reporting.

Lastly, the last-minute inclusion of "optional" provisions relating to finite reinsurance is but the latest example of the sheer impossibility of Europe agreeing on a common vision pertaining to specific aspects of reinsurance. (See related sidebar.)

The "soft law" (entirely optional) regime introduced by the Directive on finite reinsurance is very unlikely to produce harmonized results across Europe. For example, U.K. Rapporteur on the Directive, Peter Skinner, supported the European Council's position that Member States are currently better placed to regulate finite reinsurance. If so, why then did this last-minute amendment make its way to the final draft?

The war on collateral

As noted, the Directive got rid of the collateral requirements: certain European countries, like France, forced foreign reinsurers to lodge very large sums in trust funds for business written as a guarantee toward paying reinsurance in the event of a claim. Hannover Re, for example, estimated that additional charges and administrative costs linked to collaterals added $618 million annually to operating costs (according to a report in the French economic paper, La Tribune, on Feb. 12, 2004). A similar system is in force in the United States. For example, Lloyd's has billions of dollars of collateral tied up in the United States.

France has often been criticized for maintaining its system tailored, according to critics, at protecting its market from competition. A similar criticism was launched more recently against the U.S. collateral system.

However, it seems that the main objective for the introduction of a reinsurance Directive was lost when it came to evaluating the requirement for collateral in the reinsurance sector. In its impact assessment of a possible Directive on reinsurance, the European Commission stated that of the alternatives–status quo, supervision or market measures–the most positive economic impacts come from supervision. In particular, it stated that the social impacts (i.e., primarily the interests of the policyholders), would be best served by a supervisory alternative.

When it comes to the suppression of the collateral requirements, one can hardly say how, if at all, this measure serves the interests of policyholders. In particular, this suppression, targeted at European reinsurers, could benefit non-European reinsurers through, for example, the establishment of subsidiaries in Europe. These subsidiaries would then be in a position to retrocede their risks to other entities outside Europe, in a regime where prudential and solvency issues are much less favorable than the current various European regimes. This would dramatically increase the risk of defaults of reinsurers and would, in turn, put policyholders in jeopardy.

European policyholders who thought they were safe behind the European legislative smokescreen would be shocked to find that their risk was ultimately ceded to a defaulting retrocessionaire located thousands of miles away from Europe, with no physical address other than a post box. The primary liability of the direct insurer to the policyholder could accelerate financial distortions of the true state of solvency of the insurer. Without collateral, the debt owed by the reinsurer to the direct insurer becomes a fortuity, and no longer a certainty.

The United States has appreciated this risk. But, the European Union, even before the vote of the European Parliament on the Directive, was already threatening action over U.S. insurance collateral demands in front of the World Trade Organization unless the U.S. dropped its strict rules that govern foreign reinsurers.

Charlie McCreevy, European Commissioner for the European Internal Market and Services at a Comit? Europ?en Des Assurances Conference in Paris in June 2005, stated that the European Commission was working with the U.S. Treasury and National Association of Insurance Commissioner's (NAIC) to have their "voice heard in the United States and also make the case for the abolition of the collateral requirements."

No doubt Mr. McCreevy will have to explain to U.S. regulators why the voices of those European countries that implemented the collateral system were eventually ignored. The distortion of competition might well be a relevant argument in the context of the European Internal Market but is unlikely to be so powerful in the context of US/EU relationships.

Last-minute amendments: the missed opportunity for finite reinsurance

Although the Directive takes the innovative step to define finite reinsurance (article 2(1)(nnn) of the Directive), the suggested and particularly broadly worded condition that European Member States have the "option" to implement the regulations governing finite reinsurance activities cuts against an effort to harmonize practices at a European level.

Already, Member States are taking very different approaches concerning finite reinsurance.

During a committee on Economic and Monetary Affairs in Brussels, France, through the voice of Insurance Commissioner Florence Lustman, warned against the regulation of this activity aimed, according to her, at "smoothing the results of the cedents."

The United Kingdom, through its Financial Services Authority ("FSA"), sent on March 16, 2005 a letter to insurers asking them to consider the most effective way to supervise insurers' use of "financial engineering."

Lastly, the need for disclosure of these specific types of transactions, highlighted as early as 2000 at a European level, was mysteriously overlooked in the final draft of the Directive.

So was there really a need for a uniformed finite reinsurance regime?

Certain insurers and reinsurers have recently faced investigations by U.S. or State regulators in relation to the conduct of this particular branch of reinsurance. However, these investigations do not necessarily mean that a radical overhaul of finite reinsurance regulation was called for. European countries have elaborate rules of criminal, contractual and tortious law that are well designed to redress any wrongdoing.

If the ambit of the Directive, however, was closer regulation and supervision of finite reinsurance, then the last-minute inclusion of this area of reinsurance deprived Europe of a pool of experience of no less than 25 Member States.

The Directive is an example of yet another tightening of complex and burdensome regulation across Europe, which does not reflect the flexibility of the industry as a whole.

For full text of the Directive, 2007/0097, see: http://europa.eu.int/comm/internal_market/insurance/reinsurance_en.htm.

Michael Haravon is an associate in the Reinsurance Group of Milbank. He is admitted to the bars of California, England & Wales and Paris, France.

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The last-minute inclusion of 'optional' provisions relating to finite reinsurance is but the latest example of the sheer impossibility of Europe agreeing on a common vision pertaining to specific aspects of reinsurance.