Principles-Based Regulation Works Only In Principle

NEW YORK--The theory of principles-based regulation sounds promising, but actual application of the concept may fall short, a lobbyist suggested here drawing parallels to the development of risk transfer rules for finite insurance deals.

Bradley Kading, president and executive director of the Association of Bermuda Insurers & Reinsurers, made the assessment yesterday during a joint luncheon of the Association of Professional Insurance Women and the Insurance Brokers Association of the State of New York, in response to a question.

A principles-based regulation system for insurance was spotlighted recently in New York when Insurance Superintendent Eric Dinallo proposed rules in his state.

Mr. Kading said that the Dinallo initiative would impact property-casualty insurers, and that on the life insurance side, there is an NAIC initiative to replace life insurance reserving requirements with principles-based ones. (See NU Online News Service, Nov. 5, for details of Mr. Dinallo's proposal.)

"Principles-based regulation is a great current topic," Mr. Kading said, adding, however, that "if you look the pronouncements 10 years ago on finite risk," those were principles-based.

"What happened? People tried to develop guidelines to define what the principles were," he said.

But, Mr. Kading related, "after companies adhered to them for a number of years, the authors of the guidelines backed away from them when people thought there were problems in the business."

He referred to 2004 and 2005 investigations by the Securities & Exchange Commission, states' attorneys general and others into accounting of finite deals, which also prompted internal investigations and restatements by Bermuda reinsurers.

Generally, finite reinsurance is distinguished from traditional reinsurance in that the reinsurer's risk is more limited than it is in traditional contracts. (Finite deals can include profit-sharing features and loss caps, as well as the possibility of refunding some portion of investment income to cedents.)

Over time, accounting rules-of-thumb developed allowing such deals to be accounted for as reinsurance if they had a certain amount of risk transfer.

The principle was that a deal had the appropriate amount of risk transfer "if it was reasonably possible that a reinsurer would realize a significant loss" on the contract, explained Mr. Kading.

Insurance accounting professionals over time settled on a practical rule to interpret the principle--agreeing that a reinsurer would clear the risk transfer hurdle if there was some 10 percent probability of a 10 percent loss of premium.

While Mr. Kading did not detail the "10-percent rule" for the APIW audience yesterday, he offered the development of practical finite rules and their subsequent rejection as "an example to keep in your mind about what in the future this means with principle-based regulation."

Mr. Kading also mentioned the U.K. regulators, who are moving ahead with principles-based regulation, talk about the principles being the guiding interpretative documents that allow you to figure out how to apply the underlying regulation--but the underlying regulation stays in place.

"It's clear this is not an either-or proposition," he said. "Regulation is not being replaced by principles," he noted.

Prior to the question-and-answer session, Mr. Kading delivered a presentation outlining the benefits of a Bermuda domicile for insurers and reinsurers, at one point touching on some misconceptions about Bermuda regulation.

It is "not weak regulation, light regulation or insignificant regulation," he said, noting that Class 4 companies (those with the highest capital requirements) in Bermuda "are committed tough solvency regulations that conform to international norms." He added that these standards are audited by the Internal Monetary Fund, suggesting a high level of scrutiny to which U.S. states are not subject.

Bermuda has an efficient licensing process, he added, relating that Bermuda executives say it takes two months to get a Bermuda license, four months for a European license, and that they might still be working to secure U.S. licenses some five years after starting the process.

The main focus of yesterday's session, titled "Sustaining the Bermuda Edge," which also featured Allison Towlson, senior vice president and regional executive for ACE Bermuda Insurance, Ltd., and Sherron Williams, senior vice president of professional lines for XL Insurance Ltd., was to describe cooperative efforts of Bermuda insurers and the Bermuda government to educate citizens about the insurance industry.

The two insurance company executives, both Bermudians, described their career paths and shared details of various scholarship, internship and mentoring programs that are in place at their companies.