Law-Now

November 2005

The EU directive on reinsurance

The EU Council has formally adopted the Directive on reinsurance which will introduce, for the first time, a harmonised regulatory regime for "pure" reinsurers. When implemented in just over two years time, reinsurers across the EEA will be subject to a common system of authorisation, prudential regulation and solvency and, like direct insurers, will have a single home state authorisation valid for the entire EEA.

Why was the Directive needed?

Council Directive 64/225/EEC removed discriminatory restrictions on the right of establishment and the freedom to provide services. Historically, Member States have operated very different regulatory regimes for reinsurance. For example:

The UK, like Finland, Portugal and Denmark, operates a comprehensive regulatory regime for reinsurers. "Pure" reinsurers must be authorised, like direct insurers, under the Financial Services and Markets Act 2000 (FSMA) and are subject to prudential regulation including the solvency regime in PRU.

On the other hand Belgium, Greece and Ireland have had no regulatory regime for reinsurers and have not required reinsurers to be authorised. Other Member States have regulatory regimes which are less comprehensive than the UK (such as Austria, Italy, Spain and Sweden).

The aims of the Directive

The two key aims of the Directive are for all "pure" EEA reinsurers:

• to be subject to harmonised prudential/supervisory rules; and
• to be able to take advantage of the passporting rights which insurance intermediaries, credit institutions and direct insurers already enjoy.

In theory, UK reinsurers should benefit from the level playing field, ie the introduction of higher regulatory requirements for some EEA competitors. In practice, however, the financial strength of a reinsurer is often a commercial issue, irrespective of regulatory solvency requirements.

The Commission hopes that:

• The finalised Reinsurance Directive should create a consistent, transparent, more efficient and secure cross-border EEA market in reinsurance.
• EU and worldwide insurers will have greater confidence in dealing with reinsurers anywhere in the EEA.
• In turn, a level regulatory playing field should create a more competitive market for reinsureds which will indirectly benefit their policyholders. 

The main provisions of the finalised Reinsurance Directive/differences

to Commission's draft

1.    Who is in – who is out….. ?

In

There have been no changes since the Commission's draft.

Article 1(1) highlights that the Directive will apply to reinsurers who only conduct reinsurance activities and are currently established or wish to be established in the EEA (Article 1(1) and EEA Agreement).

Article 6 includes the requirements that a reinsurer (like insurers) limits its objective to the business of reinsurance and related operations.

Related operations includes:

• statistical or actuarial advice;
• risk analysis or research for its client; or
• holding company functions and activities with respect to financial sector services where financial sector includes credit institutions, investment firms and mixed financial holding companies (Recital 14).

Recital 11 provides that the Directive also applies to captives. A reinsurance captive is a reinsurer belonging to a company/group of companies (not engaged in primary insurance or reinsurance) and which only offers reinsurance protection to that company/group.

Out

Certain entities are specifically excluded from the scope of the Directive, including:

• direct insurers that carry on reinsurance business (as those activities are already regulated under the Recast Life Directive and Non Life Directives as highlighted in Recitals 3 and 12 of the Directive). The solvency margin for reinsurance undertakings will apply to the reinsurance business of the direct insurers, if the volume of their reinsurance activities represents a significant part of their entire business. The Directive contains provisions amending the Recast Life Directive and Non Life Directives accordingly.
• Reinsurance undertakings which go into run-off by a specified date. The cut off date will be 24 months after the date of entry into force of the Directive (Article 62). This exclusion was not contained in the Commission's draft.

2.    Supervision

Reinsurers are to be supervised by the authority in the Member State where their head office and registered offices are based (Article 15 and Article 8) – they must have their head office in their state of incorporation. 

3.    Authorisation requirements

The conditions for authorisation have not changed since the Commission's draft. Member States will need to require every reinsurance undertaking for which authorisation is sought to:

• limit its objectives to the business of reinsurance and related operations (see above);
• submit a scheme of operation: this must include particulars or evidence of:
• the nature of the risks which the reinsurance undertaking proposes to cover;
• the kinds of reinsurance arrangements which the reinsurance undertaking proposes to make with ceding undertakings;
• the guiding principles as to retrocession;
• the items constituting the minimum guarantee fund; and
• estimates of the costs of setting up the administrative services and the organisation for securing business and the financial resources intended to meet these costs. (Article 11).
• possess the minimum guarantee fund of not less than EUR 3 million. Member States may provide that as regards captive reinsurance undertakings the minimum guarantee fund is not less than EUR 1 million (Article 40); and
• be effectively run by persons of good repute with appropriate professional qualifications (Article 6).

Reinsurance undertakings will also have to have a specific legal form (Article 5).

Grandfathering: reinsurance undertaking subject to the Directive which already are authorised or entitled to conduct reinsurance business before the Directive enters into force, shall be deemed to be authorised in accordance with the Directive, i.e. they will be "grandfathered in" provided they comply with certain requirements (Article 61). They will have 2 years to meet the solvency requirements. They will be able to "passport" during this interim period even though they may have insufficient capital.

4.       Solvency

There have been some changes to the solvency requirements since the Commission's draft in June 2004.  In the Commission's draft life reinsurers solvency margin had to be calculated in accordance with the rules laid down in the Recast Life Directive.

Under the finalised Reinsurance Directive, both life and non-life reinsurers are subject to the same solvency margin regime applicable to direct non-life insurance business, ie the Solvency I regime for non-life business (Article 38(1)). Member States will be allowed to apply the rules provided for in the Recast Life Directive in certain circumstances, for example in respect of certain life reassurance activities which are linked to investment funds or participating contracts (Article 38(2)).

The Commission can, after consulting the European Insurance and Occupational Pensions Committee, make certain adjustments to the calculation of the solvency margin (Recital 26, Article 37(4)).

The solvency provisions are an interim measure, pending finalisation of the EU Solvency II which will set new solvency requirements for insurers and reinsurers.

5.    Passporting

The single home state authorisation will enable reinsurers to carry on business throughout the EEA under the right of establishment or the freedom to provide services. The Member State of the branch or of the provision of services may not require a reinsurance undertaking which wishes to carry on reinsurance business in its territory and which has already been authorised in its home Member Sate to seek fresh authorisation or impose additional supervision checks (Recital 10). The home state regulator (which will be FSA for UK reinsurers) will be responsible for the solvency of the reinsurer's entire business including business conducted from branches in other EEA states. Where insurers are currently authorised/registered in several Member States, the host state will cede responsibility to the home state regulator. UK reinsurers will therefore be able to use their passport to set up branches or provide services across the EEA.  EEA reinsurers will be able to passport into the UK (and underwrite in the London market) without UK authorisation. (Those operating under FSMA Schedule 4 "Treaty Rights" will switch to the Schedule 3 single market directive mechanism.) These provisions are unchanged from the Commission's draft.

6.    Collateralisation

The finalised Directive amends the existing legal framework for insurers which are reinsured by an EEA reinsurance company. One of these changes will abolish the practice, in some Member States, to require, as part of an insurance undertakings' technical reserves, the pledging of assets covering unearned premiums/outstanding claims provisions by a reinsurance undertaking authorised pursuant to the Directive (Recital 40, Article 57(3), Article 60(6) (the collateral provisions).

The finalised Reinsurance Directive allows Member States to postpone these changes (abolishment of collateral provisions) to the Recast Life Assurance Directive and Non Life Directives for 3 years (Article 63).  The Commission's draft did not contain these transitional provisions.

7.    Finite reinsurance

Unlike the Commission's draft, the finalised Reinsurance Directive contains provisions on finite reinsurance. The finalised Reinsurance Directive defines finite reinsurance as being:

" Reinsurance under which the explicit maximum economic risk transferred, arising both from a significant underwriting risk and from a timing risk transfer, exceeds the premium over the lifetime of the contract, by a limited but significant amount, together with at least one of the following two features: i) explicit and material consideration of the time value of money; ii) contractual provisions to moderate the balance of economic experience between the parties over time to achieve the target risk transfer." (Article 2(1)(q)).

The finalised Reinsurance Directive permits Member States to implement regulations dealing with reinsurers that are writing finite reinsurance business. This is a direct response to the recent controversy upon this particular activity (see FSA's latest proposal in CP05/14 "Quarterly Consultation No 6") . Permissible regulations include mandatory contractual provisions, accounting and risk management controls and solvency requirements (Article 45).

8.    Special purpose vehicles

The finalised Directive also includes provisions (not in the Commission draft) relating to Special Purpose Vehicles (SPVs) which are defined as SPVs which accept risk from insurers/reinsurers and are funded by debt insurance (or other financing) subordinated to the SPVs' reinsurance obligations.  The Directive permits Member States to allow the establishment of SPVs, without complying with the directive's requirements for reinsurers. However many states must lay down conditions under which the activities of such undertakings can be carried out and establish rules for various areas, such as scope of authorisation, and accounting, prudential and statistical information requirements (Article 46). These must be communicated to the Commission without delay (Article 46(3)).

Impact

In a recent speech, Julian Adams, Head of wholesale insurance at the FSA commented that the FSA expects to consult on the implementation of the finalised Reinsurance Directive in 2006 with a view to implementing changes to rules by the end of 2007. He commented that " whilst reinsurance companies are already regulated in the UK, this Directive (finalised Reinsurance Directive) will help establish a sound and prudent regime across the EU that does not impose additional requirements on pure reinsurers that are not justified on prudential grounds".

The Directive is likely to have international implications as well. Daniel Schante, Director general of the CEA commented "Ultimately, we hope that the directive will reassure the US sufficiently to abandon the collateral requirements it imposes on EU reinsurers. The fact that they are imposed on non-US reinsurers only is discriminatory and unjustified. Moreover, this form of supervision is old-fashioned, costly and inefficient". Similar views have been put forward in the UK too. FSA's Chief Executive, John Tiner has stated: "…We look forward to the removal of barriers such as requirements for domestic collaterisation of reinsurance in the member state of the reinsured. Once this is achieved it will put the EU in a stronger position to press the US to re-examine its own collaterisation requirements which at present some in the US justify by citing the absence, or in their view lack of proven adequacy, of direct regulation of reinsurance in some member states".

Conclusion

The directive has significant implications for:

• UK pure reinsurers – will the UK maintain "gold plate"?
• EEA reinsurers – will be able to passport, will (eventually) need to meet the Directive requirements but in the meanwhile can passport into the UK without complying fully with the solvency regime
• Captive reinsurers established within the EEA
• Non EEA reinsurers who may find it desirable to establish an EEA subsidiary