European Commission

Study into the methodologies forprudential supervision of reinsurance

with a view to the possibleestablishment of an EU framework

31 January 2002Contract no: ETD/2000/BS-3001/C/44

KPMG

This report contains 157 pages

Appendices contain 16 pages

mk/nb/552

Contents

1 Introduction 41.1 Summary 41.2 General Approach 5

2 Similarities and differences between insurance, reinsuranceand other risk transfer methods 6

2.1 Scope 62.2 Approach 62.3 Definitions 62.4 Similarities between insurance and reinsurance 72.5 Differences between insurance and reinsurance 92.6 Other methods of risk transfer 132.7 Preliminary conclusions 15

3 Reinsurance and risk 163.1 Scope 163.2 Approach 163.3 Risks 163.4 Systemic risks 213.5 Assessing the importance of different risks 223.6 Conclusion 27

4 Description of the global reinsurance market 284.1 Scope 284.2 Approach 284.3 The global reinsurance market 284.4 The major reinsurance products 304.5 The role of offshore locations 354.6 Captives 364.7 The future evolution of the market and developments in products 374.8 Competitive position of EU reinsurers from a global perspective 38

5 Description of the different types of supervisionapproaches currently used in the EU as well as other majorNon-EU countries 39

5.1 Scope 395.2 Approach 395.3 Introduction: reasons for supervision 395.4 Supervising authority 405.5 Forms of supervision 415.6 Supervision of reinsurance in the EU 425.7 Supervision of reinsurance in major non-EU countries 61

6 The rationale with regard to supervisory parameters 716.1 Scope 716.2 Approach 716.3 Extent of supervision 716.4 Overview of supervisory parameters 746.5 Parameters relating to direct supervision 766.6 Parameters relating to indirect supervision 97

7 The arguments for and against reinsurance supervision anda broad cost-benefit analysis 106

7.1 Scope 1067.2 Approach 1067.3 Arguments for reinsurance supervision 1067.4 Arguments against reinsurance supervision 1097.5 Impacts on the different approaches to supervision 1127.6 Cost-benefit analysis 112

8 Summary of reinsurance market practice for assessing riskand establishing technical provisions 117

8.1 Scope 1178.2 Approach 1178.3 Market practice for assessing risk 1178.4 Establishing adequate technical provisions 1188.5 Management of underwriting risks 1238.6 Monitoring credit risk 1328.7 Management of investment risks 1338.8 Management of foreign currency risks 1348.9 The role of securitisation 1368.10 Financial condition reporting 1408.11 Summary 141

Appendix I – Description of certain reinsurance arrangements 142Appendix II – Overview of other important captive domiciles 146Appendix III – Lloyd's: summary of the regulatory approach 147Appendix IV – Detailed description of actuarial reserving methods used 151Appendix V – Main sources 155

This report was commissioned by Internal Market Directorate General of the EuropeanCommission. It does not however reflect the Commission’s official views. Theconsultant, KPMG Deutsche Treuhand Gesellschaft, Cologne, is responsible for the factsand the views set out in the document. Reproduction is authorised, except for commercialpurposes, provided the source is acknowledged.

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Foreword by the Commission Services

The reinsurance sector has seen important changes during the last few years. The concentrationto a few large players has continued through mergers and acquisition, new financial productshave been developed and new information technology tools have emerged. The tragic events of11 September 2001 will also have strong repercussions on the reinsurance industry, both asregards practices and available capacity. These developments make it even more important thata solid system of reinsurance supervision is in place to ensure that companies fulfil theirobligations. The security of the reinsurance arrangements of a primary insurer is clearly of vitalimportance for the protection of its policyholders.

In a changing market it is important that supervisory practices keep pace with developments. Inthe EU there is currently no harmonised framework for reinsurance supervision, and this has ledto significant differences in approach between Member States. Such differences may duplicateadministrative work and may also create barriers to a properly functioning internal market forreinsurance services.

In January 2000, the Commission Services and Member States therefore decided to initiate aproject on reinsurance supervision to investigate the possible establishment of a harmonised EUsystem. As a thorough investigation of all the different aspects involved is very complex andextensive, the Commission Services and Member States agreed to commission a study toprovide the working groups with background research and discussion material.

The Commission Services are pleased to present this study, which was prepared by a team fromthe KPMG under the supervision of Keith Nicholson and Joachim Kölschbach. We believe thatthe study presents a clear and pedagogical overview of the reinsurance market and reinsurancesupervision. We also hope it will stimulate further debate in Member States, at the EU level andinternationally. Please note that although the study was commissioned by the Directorate-General Internal Market, it does not express the Commission’s official view. The consultantsremain responsible for the facts and the views set out in the report.

The Commission Services invite interested parties to send their comments on this study to:MARKT-C2@cec.eu.int.

Please also note that the Insurance Unit of the Commission has a website, where otherdocuments of interest can be found:http://europa.eu.int/comm/internal_market/en/finances/insur/index.htm

Brussels, January 2002

Jean-Claude ThébaultDirector

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1 Introduction

This report outlines our findings on the “Study into the methodologies for prudentialsupervision of reinsurance with a view to the possible establishment of an EU framework”.

1.1 Summary

Chapter 2 of this report gives an overview of similarities and differences between insurance,reinsurance and other risk transfer methods. The section focuses on those similarities anddifferences which are relevant to the prudential supervision of insurance and reinsurance. Themajor methods of risk transfer in reinsurance business are described. The concept of alternativerisk transfer solutions is also considered, by reference to different types of contracts.

Chapter 3 identifies the main risks that reinsurance companies are exposed to. The sectiondifferentiates between different kinds of products, different lines of business and other activitiesperformed by reinsurance companies. This section summarises the most relevant risks in a riskmatrix and gives preliminary views of mitigating strategies. The section includes a discussion ofspecific risks relating to different reinsurance activities.

Chapter 4 provides an overview of the global reinsurance market. It discusses the main marketplayers, different jurisdictions, the role of offshore locations, the major reinsurance products andthe likely evolution of the market and product developments.

Chapter 5 provides a description of the different approaches to supervision adopted in the EUand in major non-EU countries. It includes a comparison of the principal characteristics anddifferences of major or leading jurisdictions, with the aim of clarifying the rationale underlyingthe adopted supervisory approach. This section is based on discussions with industry specialistswithin the relevant jurisdictions (both within and outside KPMG).

Chapter 6 analyses the rationale underlying various supervisory parameters and the relativeimportance and feasibility of supervising the parameters in question. Based on key risks, theanalysis prioritises the products / activities of reinsurance companies by their relative need forsupervision.

Chapter 7 analyses the arguments for and against reinsurance supervision. Based on the goalsof supervision, the risk analysis, and current practices, this section includes a broad cost-benefitanalysis of supervisory approaches.

Chapter 8 provides a summary of techniques currently employed for monitoring key risks. Itanalyses the impact of securitisation and how reinsurers measure or take into account portfoliodiversification in assessing their own capital requirements.

The study also examines approaches adopted by reinsurance companies and other interestedparties (such as rating agencies) to assess and monitor reinsurance risks. The study considers theways in which supervisory approaches may benefit from existing market practices.

Our analysis is focused on individual reinsurance companies as well as on reinsurance groups.

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1.2 General Approach

The work was performed using our knowledge of the reinsurance industry and based on detailedinformation requested from various KPMG offices. We have also researched informationsources to obtain articles and data.

We have had regard, in particular, to the Issues Paper on Reinsurance1 produced by theInternational Association of Insurance Supervisors (IAIS) Working Group on Reinsurance(dated February 2000), and references are made as appropriate throughout the report.

We have conducted a programme of visits to a wide selection of reinsurance undertakings inorder to obtain detailed views and opinions on a variety of issues within the scope of the study.

1 Reinsurance and reinsurers: relevant issues for establishing general supervisory principles, standards

and practices, February 2000

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2 Similarities and differences between insurance, reinsuranceand other risk transfer methods

2.1 Scope

In accordance with the Terms of Reference, this chapter provides “an overview of thesimilarities and differences between insurance, reinsurance and other risk transfer methodsespecially from the supervisory point of view”.

2.2 Approach

In reporting on the above objective, we undertook the following approach:

§ Use of existing specialist knowledge to describe various major methods of risk transfer usingexamples of policies and contracts.

2.3 Definitions

2.3.1 Insurance

As defined by the IAIS Working Group on Reinsurance, “insurance can be defined as aneconomic activity for contractually reducing risk for the policyholder in return for a premium”.

Whilst the transfer of risk is the underlying feature of all insurance products, there are otherfinancial elements which may be present in certain types of contract, such as guarantees,investment components and derivatives.

The Insurance Steering Committee of the International Accounting Standards Committeesuggests the following definition of an insurance contract:

“An insurance contract is a contract under which one party (the insurer) accepts an insurancerisk by agreeing with another party (the policyholder) to compensate the policyholder or otherspecified beneficiary if a specified uncertain future event adversely affects the policyholder orother beneficiary (other than an event that is only a change in one or more of a specified interestrate, security price, commodity price, foreign exchange rate, index of process or rates, a creditrating or credit index or similar variable).”2

2 Draft Statement of Principles (DSOP); Insurance Steering Committee, IASC, June 2001

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2.3.2 Reinsurance

The IAIS Working Group defines reinsurance as “the form of insurance where the primaryinsurer reduces the risk by sharing individual risks or portfolios of risks with a reinsurer againsta premium”.

Reinsurance is “insurance for insurers”. The basis of most reinsurance arrangements is thespreading of risk and, in essence, reinsurance allows the insurer to take on an insurance risk andsubsequently pass on all or part of that risk to a reinsurer. As a result, the original company isleft with only a part of the original risk (although in law the insurer remains liable to thepolicyholder for the full amount of the claim, and if the reinsurer defaults or becomes insolventthe insurer is obliged to meet the full amount of any claims).

Reinsurance contracts can take a number of different forms. Appendix 1 provides details of thecommon forms of reinsurance contract.

Reinsurance business is similar to insurance business in a number of ways, and supervisors incertain jurisdictions, both within and outside the EU, have developed regulatory regimes forinsurance business which encompass reinsurance. In some cases, whilst the legislativeframework of regulation makes little or no distinction between insurance and reinsurance,supervisors may take a somewhat different approach in practice. In other cases, reinsurance istreated differently within the regulatory legislation. Despite the similarities, there arefundamental differences between insurance and reinsurance, which can have a significantimpact upon supervisory objectives.

In order to assess the rationale for different supervisory approaches, it is necessary to examinethose similarities and differences between reinsurance and insurance which are of relevance toprudential supervisors.

2.4 Similarities between insurance and reinsurance

The areas of similarity between insurance and reinsurance business help to explain the rationalefor a similar regulatory approach in certain jurisdictions. The main similarities are discussedbelow.

2.4.1 Transfer of insurance risk

Both insurance and reinsurance contracts allow for the indemnification of an insured (orreinsured) in the event of loss in consideration of a premium. The key features of the businesscycle involved in both cases are very similar, through underwriting, investment, claims, controlover expenses, and the reinsurance (and for reinsurers, retrocession) programme. Both theinsurance and reinsurance cycles generally have similar types of systems and controls.

The types of risk which both types of business are exposed to are also broadly similar, forexample, occurrence of claims events, timing and quantum of claims, severity, development,and specifically for life business, mortality, morbidity and longevity. Reinsurers are subject tothe same sources of risk, for example, the random occurrence of major claims events andfluctuations in the number and size of claims.

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Because the transfer of risk is a common feature, it could be assumed that the reasons forpurchasing insurance and reinsurance protection are also similar. Insurance provides protectionfor policyholders; reinsurance also provides protection, to primary insurers. However, there area number of reasons why insurers buy reinsurance:

§ it allows the insurer to increase capacity to underwrite business;

§ it allows insurers to limit their exposure to risk and reduces volatility and uncertainty in theinsurer’s results;

§ reinsurers can provide experience and expertise in new lines of business or new geographicalmarkets;

§ reinsurers can provide a financing role.

Primary insurers are dependent, to a varying extent, upon the reinsurance industry. A keyfeature of reinsurance is the need to diversify risk. The spreading of insurance risk around themarket through the use of reinsurance creates a highly inter-related marketplace in which amajor loss event can impact upon many participants in the market. At a fundamental level,failure in the reinsurance industry will have an impact upon insurers and in turn on theirpolicyholders.

The special case of financial reinsurance is described in section 2.6.1.2.

2.4.2 Credit risk (exposure to bad debts)

Among the risks faced by both insurers and reinsurers is the possibility of exposure to baddebts. For insurers, whilst bad debts can arise from a variety of sources (includingintermediaries), exposure usually arises principally from the outward reinsurance programme,and the same is true for reinsurers in respect of their retrocessionaires.

From a supervisory point of view, the security of reinsurers (and retrocessionaires) is a majorissue when assessing the financial position of an insurance or reinsurance undertaking.

2.4.3 Investment risk

A key feature of both insurance and reinsurance business is the investment of assets to supportinsurance and reinsurance liabilities. Investment return is usually a key component of totalprofits generated by such operations. Both insurers and reinsurers need to manage theirinvestment risks, balancing the need to maintain a prudent spread of investments, whose risk isappropriate to the risk profile of the insurance and reinsurance liabilities, with the need foradequate investment returns.

Whilst some in the industry argue that investment activities are managed separately from theunderwriting activities, there is a trend towards the view that investment activities are anintegral part of the management of insurance or reinsurance business. In either case, reliance oninvestment returns is a major feature of insurance and reinsurance, and exposure to thevariability of stock market performance and interest rate movements is common. In the case ofnon-life insurers and reinsurers, investment in equities is generally less common, althoughshareholders’ assets can be significantly affected by changes in values of equities and, to alesser extent, bonds.

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From a supervisory point of view, it is important to be able to distinguish between theunderwriting results and the results of investment activities. It is difficult to assess real trends inunderwriting performance if the results are obscured by investment returns. Also, it is importantto be able to assess the additional strains on capital arising from investment losses. This appliesto insurance and reinsurance.

2.4.4 Distribution channels: Use of intermediaries and direct writers

Both insurers and reinsurers have traditionally obtained business through the use ofintermediaries. In recent years, various insurance companies have set up direct sellingoperations to market and sell their products avoiding the use of intermediaries.

Direct selling can reduce costs and puts insurers in direct contact with their customers at thepoint of sale. It also creates potential for greater understanding of their policyholders andincreased opportunities for marketing their products. However, the traditional involvement ofbrokers continues to be important.

A similar trend has occurred in the reinsurance industry, where a number of companies havestarted to deal directly with their customers in the primary insurance market. The reasons citedinclude the potential for developing direct long term relationships as well as savings incommissions paid to brokers. Nevertheless, brokers in the reinsurance markets continue to havean important role.

2.5 Differences between insurance and reinsurance

2.5.1 Types of contract and complexity

Whilst the effects of insurance and reinsurance contracts are fundamentally similar (that is, thetransfer of risk), the types of contract involved are usually different.

Broadly, insurance usually involves the use of standardised policies. This is certainly the case inpersonal lines business (such as private motor and household). For commercial lines (includingindustrial risks), it is common to find more customised policies, especially for larger risks.Reinsurance contracts, however, usually tend to be drawn up on an individual basis to meet theparticular requirements of the cedant. Reinsurance contracts may include limitations andexceptions that are not common or permitted for direct insurance contracts. These contractualprovisions usually limit the reinsurer’s exposure to risk.

A contract of insurance usually involves coverage of a single risk, or a package of risks,between the policyholder and the risk carrier. Reinsurance is often underwritten on a treatybasis. Whilst facultative reinsurance involves an individual risk, treaty business covers aportfolio of insurance contracts over a specified period. Appendix 1 provides examples of thecommon types of arrangement. These differences should be of importance to supervisorsbecause the population of risks in a reinsurer’s portfolio is usually more complex. Reinsurersnot only underwrite contracts with primary insurers, but also other reinsurers, asretrocessionaires.

These factors mean that a deep understanding of the business is required in order to be in aposition to make sensible assessments of a reinsurer’s true financial position.

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2.5.2 Volatility

Reinsurance business tends to be more volatile than primary insurance. There are a number ofreasons for this:

§ for insurers involved in conventional personal and commercial lines business, the book ofbusiness usually consists of a greater number of policies, each of which has relatively smallexposure. Reinsurers tend to write business on a treaty basis, and are exposed to theaccumulation of losses and greater likelihood of significant losses;

§ primary insurers generally tend to have lower retentions than reinsurers; the outwardreinsurance programme offloads risk and reduces uncertainty at the level of the primaryinsurer;

§ reinsurers are involved, particularly in relation to non-proportional (excess of loss) business,in higher levels of cover, where the incidence of claims is less frequent but larger in amount.Exposure to catastrophes is a particular feature of the reinsurance industry. A singlecatastrophic event will usually lead to claims on numerous reinsurers, as risks are typicallyspread around the market.

The volatility of business is closely linked to the underlying complexity in reinsurance business,and this has implications when assessing financial strength. However, the effects depend uponthe individual situation; volatility, whilst still present, will be lesser for a reinsurer which allowsfor better diversification and pooling of individual risks within a larger or well structuredportfolio. Also, volatility will be mitigated to some extent by retrocession arrangements.

It has not been proven that the residual risk of pure reinsurance companies is higher than therisk of direct insurance companies.

2.5.3 Globalised portfolios

Reinsurance is normally a global business. Companies tend to reinsure risks from a number ofinsurers located in many jurisdictions. Therefore, reinsurers usually have a broad range ofgeographical exposures. This is a key feature of reinsurance in achieving diversification of risks.The insurance industry, on the other hand, tends to be more local in nature. Whilst there aresome global insurance companies, they usually operate with local subsidiaries in differentterritories. The reinsurance industry is far more concentrated in the hands of a small number ofmajor global participants, combining international risks within one portfolio. Due to the natureof reinsurance business, diversification in the portfolio is an essential feature in the riskmanagement process. Diversification tends to be geographical as well as by risk-type.

From a supervisory point of view this is a key difference. Supervisors tend to be aligned on thebasis of nation states, but reinsurers often manage their business on a wider geographical basis.The globalised nature of a reinsurer’s business means that supervision on a local basis isinherently difficult. For example, global knowledge of major claims events in markets in whichthe reinsurer has exposure can be of critical importance in assessing the impact on the financialposition of a company.

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2.5.4 Delay in claims reporting, other information, and cash flows

Compared to insurance business, reinsurance is often characterised by time delays in the receiptof information about contracts entered into. Reinsurance is at least one additional stage removedfrom the underlying insured event. There are various reasons for delays:

§ insurers need to process policies and claims first before passing on information, which inturn may be passed via brokers;

§ reinsurance contracts often involve a number of different reinsurers taking lines; a reinsurermay lead or follow on a contract. Even with central processing and settlement systems, therecan be time lags in the receipt of information;

§ insurance companies may also suffer from some time lags in receipt of information, but theposition for reinsurers is usually worse as they rely on the submission of information fromcedants.

Reinsurers receive their premiums later than ceding companies, (due to procedures forsettlement of accounts), but may on the other hand be required to make immediate cashpayments when large losses occur. This can result in fewer opportunities to compensateunderwriting losses by investment income (“cash flow underwriting”) than for direct insurers.

A related issue is that reinsurers will not necessarily know about the impact of certain claimsevents until the claims have worked through the retentions and lower levels of cover. Areinsurer therefore needs to have effective processes to monitor exposures and the likelyimpacts of claims events in the markets. For example, the incidence of subsidence claims onhousehold policies may take some time to accumulate to the point where insurers start to makerecoveries on their excess of loss protections.

From the supervisory perspective, these differences are important because they can make itmore difficult to detect potential problems which may impact upon a reinsurer’s financialposition.

2.5.5 Reliance on others’ knowledge

As a result of various intermediaries involved (insurers or lead reinsurers), the reinsurer mayhave a diluted understanding of the risk being transferred. Reinsurers therefore tend to be relianton second-hand knowledge to obtain an understanding of the underlying risks. They also needto have sound management systems and controls in order to ensure that sufficient understandingof the book of business being reinsured is obtained. This applies both to underwriting andclaims management.

In proportional treaties, for example, the reinsurer follows the fortunes of the reinsured and, inorder to make accurate assessments about the risk involved in writing a treaty, needs to knownot only the type of business being written, but also the risks posed by the insurer’s own internalarrangements, the quality and track record of its management, its systems and controls overacceptance of risks and claims, and its approach to risk management and pricing.

Various examples can be cited to demonstrate this lack of knowledge or understanding of theunderlying risks, which has ultimately led to financial difficulties for reinsurers. For exampleEuropean reinsurers, writing employers and environmental liability policies in the United Statesfaced a subsequent surge in claims, particularly relating to asbestosis.

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The larger reinsurers tend to be in a better position to cope with such problems, havingresources to acquire deeper technical expertise in the markets and lines of business in whichthey are involved.

The relative remoteness of reinsurers from the underlying risks, and the consequent reliance oninformation supplied by insurers and intermediaries, combined with the ways in whichreinsurance contracts operate, results in the possibility for sudden impacts upon claimsprovisions as information becomes available to the reinsurer. This tendency is important inunderstanding the financial position of a reinsurer and is therefore relevant to prudentialsupervisors.

2.5.6 Profit commissions and premium adjustments

Due to the generally higher uncertainty and less detailed knowledge of reinsurers of theunderlying risks, the pricing mechanisms in reinsurance contracts are often adjustable.Insurance contracts can also have adjustable terms, but this tends to occur in the case ofcommercial lines, especially for larger risks, rather than personal lines business. This feature ofthe contract gives the reinsurer more scope to collect further premiums should the business turnout to be less profitable than expected. Profit commissions, reinstatement premiums andpremium adjustments are incorporated in contracts as a way of sharing the risks and rewardswith the cedant as well as minimising the costs of reinsurance.

The risk exposure in the case of reinsurance contracts with adjustable pricing arrangementstends to be lower than that in the case of those with fixed price arrangements. Accordingly, anunderstanding of the types of contract written is important in making an assessment of areinsurer’s overall risk profile.

2.5.7 Professional counterparties

Reinsurance business takes place in the professional marketplace. Whether directly withprimary insurers, or through intermediaries, reinsurers deal in virtually all cases withprofessional counterparties. Whilst this would be relevant in the context of conduct of businessissues, the question arises as to the relevance from the viewpoint of prudential supervision. Thepoint is relevant because it can be argued that the inter-professional market place is to someextent self-regulating.

2.5.8 Use of rating agencies

As part of an insurer’s assessment of the credit-worthiness of a reinsurer, there is normally asignificant reliance on the ratings provided by rating agencies. The largest reinsurancecompanies all have ratings from the main agencies. Credit ratings are also important in thecontext of primary insurance companies, but tend not to be used extensively where privateconsumers are concerned, due to the protection afforded by guarantee schemes in manyterritories.

From a supervisory perspective, this difference is of relevance because there may be scope forsupervisory authorities to make greater use of the market mechanisms which exist in relation tocredit ratings. Also, downgradings in credit ratings will act as signals to supervisors, particularlyas financial difficulties of reinsurers may in turn result in difficulties for insurers, withconsequent implications for the protection of policyholders.

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2.6 Other methods of risk transfer

Other methods of risk transfer include the following:

§ Securitisation of the risk

§ Derivatives

§ Financial reinsurance

Global Reinsurance magazine in its June 2000 issue described Alternative Risk Transfer (ART)as a creative approach to funding the predicted losses in a risk area. There is however nogenerally accepted definition of ART.

ART arrangements usually include a substantial retention level by the reinsured, with only apartial transfer of risk that includes elements of a traditional reinsurance contract. Some ARTproducts are essentially a form of deferred lending, and most include a financing element ofsome kind. ART programmes include a variety of mechanisms such as:

§ large deductible programmes;

§ self-insured retention programmes;

§ individual and group self-insurance;

§ captive insurance companies;

§ risk retention and purchasing groups; and

§ finite risk and integrated insurance programmes.

The importance of ART products is likely to increase, particularly in view of the contractingmarket for retrocession and the increasing involvement of investment banks in alternativesolutions. ART solutions are driven by a number of factors and often some form of arbitragemay be involved, whether connected with accounting, taxation or regulation, or a combinationof factors.

There is generally little transparency in the accounting of ART products, and this can make itdifficult for regulators to understand the true effects of transactions and the motivational factorsunderlying them. It is essential for supervisors to understand the commercial effects andsubstance of transactions. Understanding the amount of credit risk assumed by the reinsurer isalso important.

2.6.1.1 Securitisation

Securitisation is a process where the risk is transferred through a Special Purpose Vehicle(“SPV”) and swapped into bonds. In this case, bond holders themselves act as “reinsurers” tothe risk. Thus, capital markets can also act as “reinsurers” in the process of risk transfer.

Some reinsurers invest in such bonds themselves, in order to derive a further return fromunderwriting with enhanced interest rates.

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Commonly, the SPV is established in an offshore location, and this in itself may be a source ofregulatory arbitrage. A number of investment banks have established reinsurance vehicles insuch locations, particularly Bermuda. Reinsurers themselves have begun to invest in bondsissued by such vehicles as a means of increasing investment returns, and this results in insurancerisk appearing on the assets side of the reinsurers’ balance sheet, in addition to its liabilities.3

2.6.1.2 Financial reinsurance

Pure financial reinsurance contracts, with little or no transfer of insurance risk, have ceased tobe effective in most major jurisdictions due to accounting and regulatory constraints. However,finite risk solutions, in which a limited transfer of underwriting risk takes place, have becomemore common.

Products which combine underwriting risk transfer with financial elements can provide directinsurers with significant benefits. In a single reinsurance programme, insurers can obtain multi-year and multi-line cover, and benefit from reduced rates and transaction costs. With this type ofpackage it is also possible for insurers to include risks which have traditionally been considereduninsurable (such as political and financial markets risks). Such products may have an impactupon cyclical trends in the insurance markets, by tying in rates for a number of years andestablishing long term relationships between reinsurers and their clients, facilitating insurers’access to the capital of reinsurers.

Financial reinsurance is sometimes seen as an effective means of “regulatory arbitrage”. Anexample can be a financial guarantee contract involving risk transfer, which in its purest form isa mechanism to access capital markets through insurance markets rather than banking markets.The motivation for the development of these products, which often take the form of financialguarantee insurance contracts, is the relative advantage in regulatory assessment for solvencycalculations under insurance contracts rather than banking contracts.

As “Reinsurance” magazine, in its September 2000 edition, pointed out, “in recent times therehas been a marked increase in financial guarantee insurances that compete directly with thebank guarantees and standby letters of credit that have been a substantial area of business forbanks. The likelihood is that increasing market share will pass to insurance companies becauseof the pricing advantage enjoyed by insurers as a result of their different regulatory costs”.

However, there is another school of thought which suggests that insurers and reinsurers are notadequately pricing these risks. In particular, some are of the view that the models used byinsurers to price such risks are not always as sophisticated as those used by banks (although‘monoline’ insurers often do use sophisticated modelling techniques). It is not clear to whatextent the competitive advantage gained by insurers is as a result of potentially lower costs ofregulatory capital.

3 The Tillinghast report provides details of the special features of the regulatory aspects of

securitisations

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2.6.1.3 Derivatives

Derivatives in themselves are “derived” from a particular product and provide protection againstadverse movements in the product exposure. Examples of derivative products, which are similarto products offered by the insurance industry, include “weather derivatives” which provideprotection against possible climate changes that could result in natural calamities. Theseproducts are primarily offered by Banks.

Like securitisations, derivatives can be obtained by reinsurers in connection with theirinvestment and underwriting activities in order to increase investment income. Derivativetransactions can result in assets and /or liabilities, and the important point is that the risk profileof the reinsurer’s assets can be significantly affected.

2.7 Preliminary conclusions

Insurance and reinsurance are both designed to achieve the same basic objective: a transfer ofinsurance risk in return for a premium. Although the objectives are the same, there are some keydifferences which are of relevance to prudential supervisors:

§ the greater complexity of reinsurance business;

§ greater volatility of reinsurance;

§ the (increasingly) global nature of reinsurance business; and

§ the fact that reinsurance is transacted in the professional marketplace and there is no directrelationship with policyholders of insurers.

The broad similarities between reinsurance and insurance lead to common regulatoryapproaches in many territories, but the differences are significant. In particular, the greaterpotential for volatility in reinsurance business (especially higher levels of excess of lossbusiness) leads to greater uncertainty in the outcome of contracts and, ultimately, the potentialfor reinsurers to encounter financial difficulties and insolvency might be greater. Volatility willbe lesser for a reinsurer which allows for better diversification and pooling of individual riskswithin a larger or well structured portfolio.

Reinsurance companies are professional market players. There is usually no direct link betweenreinsurance companies and the policyholders.

Primary insurers are usually able to pursue marketing and risk selection strategies that enablethem to obtain homogeneity of risks in their portfolios of business. They are able to maximisethe pooling effect of a large portfolio of risks, reducing the risk of random deviations from themean value. For reinsurers, this effect is usually present to a lesser extent and the risk of randomdeviation is usually more significant.

However, the reinsurance marketplace is a professional one, in which ceding companiesgenerally have the ability to assess the claims paying ability of their reinsurers. Nevertheless,despite the expertise of the participants in the market, it has not been unknown for reinsurancecompanies to face financial difficulties, or for insolvencies to occur.

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3 Reinsurance and risk

3.1 Scope

In accordance with the Terms of Reference, the objective of this chapter is to “identify the maintypes of risks that a reinsurance undertaking is exposed to (including systematic risks in thereinsurance sector) and make an assessment of the general importance of the different risks”.

3.2 Approach

In reporting on the above objective, we undertook the following approach:

§ use of existing specialist knowledge;

§ use of questionnaires to KPMG offices and a limited number of interviews with reinsurers;and

§ reviews of existing published sources.

3.3 Risks

The risks of reinsurance business can be considered at the following levels:

§ risks specific to the individual reinsurance undertaking;

§ systematic risk faced by the reinsurance industry; and

§ systemic risk faced by the local / global economy.

3.3.1 Risks specific to the individual reinsurance undertaking

The risks faced by the individual reinsurers are similar to those faced by insurers, but theweighting and importance of the various risks impacting on an individual reinsurer depend onmany factors, including:

§ classes of business underwritten and geographical coverage, which will affect the nature andseverity of losses and the length of tail for claims development;

§ types of contract underwritten (for example “losses occurring” contracts compared to “risksincepting” or “claims made” contracts, proportional compared to non-proportional treaty,conventional risk transfer compared to alternative risk transfer, etc);

§ the underwriting philosophy of the reinsurer;

§ the retention policy and the retrocession programme.

A summary of the main risks facing a reinsurance undertaking is set out below.

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3.3.1.1 Underwriting risk

The fundamental risk associated with reinsurance business is that the actual cost of claimsarising from reinsurance contracts will differ from the amounts expected to arise when thecontracts were priced and entered into. The key risk is that the reinsurer has either received toolittle premium for the risks it has agreed to underwrite and hence has not enough funds to investand pay claims, or that claims are in excess of those projected4. This could occur for thefollowing reasons:

1. Risk of mis-estimation: the expectations regarding losses are based on an inadequateknowledge of the loss distribution, or the underlying assumptions are erroneous. This canbe due, for example, to sampling errors, or lack of experience with new insurance risks.This risk can be mitigated, to some extent, by diversification of risks.

2. Risk of random deviation: expected losses deviate adversely due to a random increase inthe frequency and/or severity of claims or because losses fluctuate around their mean.Reasons for this kind of deviation are, for example, that one event triggers multiple losses(accumulation, for example, in the case of natural catastrophes); or a loss experiencetriggers other events (for example, contagious diseases in health insurance or a fire whichaffects neighbouring industrial properties leading to business interruption claims). Thesignificance of this type of risk in a portfolio depends on various factors, such as thenumber of risks involved, the distribution of probabilities of incurrence of claims andprobable maximum losses. This risk is systematically decreased by the pooling approach,that is, assembling as many homogenous and independent risks as possible in theportfolio (pool).

3. Risk of change: adverse deviation of expected losses due to the unpredictable changes inrisk factors that have brought about an increase in the frequency and/or severity of lossesor payment patterns (for example, changing legislation, changing technology, changingsocial and demographic factors, changes in climate and weather patterns). Again,diversification of the reinsurer’s portfolio of business may contribute to the mitigation ofthis type of risk.

4. Reserving (provisioning) risk: In addition to the insured risk itself, there is a derived riskcaused by the reserving process of the insurer. This is the risk that technical provisions areinsufficient to meet the liabilities of the reinsurance undertaking (reserve risk). Ifsufficient data on historical claims development is available, this risk may, to a limitedextent, be mitigated by proper actuarial estimation of the provisions for claims incurredbut not reported (IBNR) and those incurred but not enough reported (IBNER). The riskcan rarely be completely extinguished, even where sophisticated actuarial estimationmethods are used, due to the inherent uncertainties of insurance (and reinsurance)business.

4 Babbel, D. / Santomero, A.: Risk Management by Insurers: An Analysis of the Process, in: Wharton

Financial Institutions Center Research Papers, No. 96-16, 1996.

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As reinsurance is essentially a form of “insurance” the key risk facing reinsurers is driven by thequality of underwriting. The underwriting risk is therefore exposed to the following factors:

§ competence and expertise of underwriters;

§ level of underwriting control and the quality of information available to underwrite risks; and

§ nature of the risks underwritten.

The extent of exposure is therefore driven by the level of control exercised in accepting riskssuitable to the company. Poor underwriting from a lack of knowledge of the underlying riskscould have severe impacts on the resulting claims profile. This can be a particular problem whenentering new lines of business. Proper management of underwriting exposure is therefore key.This includes the need to maintain effective expertise and knowledge of the areas which canimpact upon the reinsurer’s business.

This risk category does not include the risks arising from management override. This includes,for example, the risk that management overrides the pricing process in order to chargepremiums that have been consciously calculated in order to gain market share.

In addition to the risk resulting from inadequate or incomplete information there is a riskresulting from the use of false information obtained from fraudulent cedants. The correctness ofthe reinsurer’s risk assessments depends significantly on information provided by cedants.However, since reinsurance is a professional market with relatively few reinsurance companiesinvolved, fraudulent behaviour of one cedant, when detected, will rapidly be known within theindustry and result in the exclusion of this cedant from the market. On the other hand, the higherthe underwriting risk the more careful reinsurers will be in assessing information received bycedants. Nevertheless, fraudulent actions of cedants is a risk that in principle exists in thereinsurance market.

Underwriting risk is unique to insurance and reinsurance business. Reinsurers tend to managerisk by pooling and, for unique risks, diversification. Pooling is easier to achieve for a largerreinsurer than a smaller one. However, reinsurers do tend to accumulate risks, and it is quitepossible, even for a large reinsurer, to build up accumulations of exposure in particulargeographical regions, with consequential significant exposure to catastrophes in those regions.

The reinsurers’ approach of managing risk by pooling, and diversification, is in contrast to thetraditional approach to risk in banking, banks tend to manage risk by hedging. This hasimplications for reinsurers as they begin to enter into an increasing number of ART transactionswith investment banks.

3.3.1.2 Retrocessions

The risk management techniques employed by the reinsurer itself play a critical role in thesustainability and solvency of the business. A key part of this process includes the purchase ofadequate reinsurance protection (known as retrocession).

The extent and quality of retrocession purchased will establish the level of protection availableto the reinsurer. The purchase of insufficient cover can lead to financial difficulties in the eventof major unexpected claims. Accordingly, the risk of an inadequate retrocession programmeshould be recognised as a key risk.

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It is typical for reinsurance to split up large and unique risks and to distribute the risks on theinternational reinsurance market. This allows cover to be obtained even for risks which are toolarge for the largest individual reinsurers. Such risks are shared by many reinsurers.

3.3.1.3 Credit risk

The use of retrocession as a key part of the reinsurer’s risk management process creates asignificant level of credit risk that amounts due under a retrocession contract are not fullycollectible owing to insolvency. Underlying the process of retrocession is the essential need forthe financial stability of the retrocessionaires. In particular, the reinsurer usually makes asignificant upfront payment of premium in the hope of future recoveries when it settles claims.The time period which elapses between the payment of premium and claims recovery can besignificant, particularly where long tail business is concerned.

Consequently, the management of credit risk is of critical importance, particularly in placingretrocession cover. In addition, there is also some risk that the failure of intermediaries couldresult in bad debts.

3.3.1.4 Investment risk

Investment risks affect the assets of a reinsurance undertaking. A major element of investmentrisk is market risk. This includes the risks of asset and liability value changes associated withsystematic (market) factors. Some forms of market risk relating to investment risk are, forexample, variations in the general level of interest rates and basis risk (the risk that yields oninstruments of varying credit quality, liquidity, and maturity do not move together)..

Other risks that have to be considered in relation to investments of a reinsurance undertaking arethe default risk / credit risk, call risk, prepayment risk, extension risk, convertibility, real estaterisk and equity risk.

Investment risks can result in:

§ lower investment yields than expected when pricing insurance contracts due to a changingcapital market environment (for example, changing interest rates, changing currency rates,adverse development of borrowers credit rating with respect to interest payments on abond);

§ asset losses (for example, due to a decrease in the value of equity investments as a result ofsystematic risk or as a result of the performance of the issuing company); and

§ cash-flow risks (for example, reinsurers operate in markets where they may receiveclustered claims due to natural catastrophes. Their assets, however, are sometimes lessliquid, particularly where they invest in private placements and real estate).

The area of investment risk will be investigated further in the insurance solvency study5.

5 A KPMG study commissioned by Internal Market Directorate General of the European Commission:

“Study into the methodologies to assess the overall financial position of an insurance undertakingfrom the perspective of prudential supervision” (2002).

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3.3.1.5 Globalised risk portfolios

As described in chapter 2, reinsurance is a globalised market whereby reinsurers accept risksfrom different parts of the world. Although this can be an effective risk diversification strategy,it can also result in adverse impacts being felt from distant geographical regions. Thus, manyreinsurers can be exposed to a “high profile disaster” irrespective of their geographical origin.

3.3.1.6 Currency risk

Strongly related to the globalised portfolio is currency risk. Most reinsurers write business in anumber of currencies. As a result of an international risk portfolio, reinsurers usually need toinvest in equivalent currency assets to match the liabilities. Reinsurers are therefore exposed toa certain level of currency risk arising from the spread of investments in different currencies.Currency matching is not always achievable, due to uncertainties in cash flows and theinfluence of accounting principles and practices. Also, it may not always be desirable to holdassets in certain currencies, where the currency of liabilities is weak. In addition, foreignexchange control restrictions may limit the extent to which liabilities in certain currencies canbe matched by assets in the same currency.

3.3.1.7 Timing Risk

Timing risk is interrelated with both underwriting risk and investment risk. The extent to whichinvestment returns contribute to the profitability of an insurance portfolio depends both on theinvestment yield (influenced by investment risk) and the speed of settlement (which can beaffected by underwriting risk, especially by unpredictable changes in risk factors). An increasein the speed of claims settlement reduces return on investment6. Investments need to bematched, in terms of their maturity, with the expected settlement of claims liabilities.

Timing risk can be fundamental in financial contracts. Some financial contracts involve limitedtransfer of underwriting risk but nevertheless include timing risk.

3.3.2 Systematic risk

Systematic risk is defined as risk which affects the entire industry. A discussion of some of therisks is given below.

3.3.2.1 Market pricing trends

The reinsurance industry appears to undergo pricing cycles with periods of high and low prices.In addition (as noted by the IAIS Reinsurance Working Group), the price of catastrophereinsurance is strongly influenced by the laws of supply and demand. However, when marketconditions are soft (rates are low and reinsurers do not have the power to obtain the increasesthey desire), it is not uncommon for reinsurers to continue writing business at uneconomic rates.There may be various reasons for this, but the principal reason is competition: the desire toretain clients and maintain market share.

Low price cycles can be very damaging to the industry as they leave smaller reinsurance playerswith the exposure of meeting claims with inadequate premium flow. In these circumstances, ahuge natural disaster could trigger potential insolvencies.

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3.3.2.2 Interaction of insurance and reinsurance markets

As the reinsurance market is driven by claims development in the insurance sector, anysignificant developments in the insurance industry are likely to lead to losses in the reinsuranceindustry. In terms of claims development, an example is the sudden surge in asbestosis claimswhich has recently been recognised in the insurance industry and consequently the reinsuranceindustry.

Other examples of insurance industry trends which have also affected the reinsurance industryinclude:

§ increasing costs of litigation;

§ legal rulings which affect large numbers of claims;

§ improvements in medical technology leading to better chances of surviving accidents butleading to higher incidence of “loss of earnings” claims; and

§ smaller players in the market following the actions of larger players.

3.3.2.3 Failure of a major reinsurer

The financial failure of a large reinsurance player may have consequences within the overallreinsurance and insurance sector, due to the sheer dominance of the global market by the largestreinsurers. As a result of the complex spreading of risks around the market, failure of a largereinsurer to meet its obligations can have an impact across the market, both for other reinsurersand for primary insurers. In fact there have been until now no significant breakdowns of areinsurance company.

3.4 Systemic risks

In contrast to systematic risk which is limited to a particular industry, systemic risk is defined asthe risk which arises in relation to the entire economy (local or global). It is a general riskaffecting every market participant. Therefore, the insurance and reinsurance industry areaffected as well. Relevant factors include:

§ economic cycles (for example, recessions lead to a downward cycle in the insuranceindustry as demand for insurance products, and consequently for reinsurance, falls, buthigher unemployment leads to an increase in theft related claims);

§ political instability: the level of political stability affects the overall performance of theeconomy, which is an important factor in wealth creation. Insurance (and reinsurance) islikely to see higher demand under more wealthy economic conditions. Also, internationalbusiness can be affected by capital transfer restrictions;

§ interest rate movements (affecting the returns gained from investments which are primarilybond based for reinsurance companies); and

§ collapse of the financial sector (due to insolvencies of large banks or insurance companiesleading to a possible economic slowdown).

6 Carter, R. / Lucas, L. / Ralph, N.: Reinsurance, 4th Ed., 2000, p. 735

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3.5 Assessing the importance of different risks

3.5.1 Risk matrix for reinsurance

The table below provides a risk matrix for reinsurance. This has been constructed based on theidentified “activities” of a reinsurer. Against each activity, the relevant risks have beenmentioned in order of importance. For the risks mentioned, further analysis is provided on thecomponents of these risks, the factors triggering the risks and common mitigation strategies.

It has to be noted that this is only a snapshot, and does not necessarily reveal the impacts ofsophisticated reinsurance strategies on risk profiles. Furthermore, this snapshot does notexamine the impact of special market environments on the risk profile; traditional one yearcontracts are not exposed to heavy risks resulting from the change of risk factors (see actuarial /underwriting risk), but, due to soft reinsurance markets in the past, many reinsurance companieswere forced to sell traditional one year contracts featuring multi-year characteristics.

Reinsurance Risk Matrix

Activities Risks RiskComponent

Factors triggeringRisk

Mitigation Strategies

ReinsuranceNon-life –proportional

Underwriting Randomfluctuation(especiallysurplus treaty)

Class of insurance,type of reinsurancetreaty, limits on treatycapacity

Pooling; retrocession

Randomfluctuation(natural perillosses)

Class of insurance,limits in treatycapacity

Exclusions or event orcession limits

Erroneousassumptionsmade by cedant

Lax underwriting byceding company,cedant’s experience inthe respective market,market environment(competition),reinsurer’s liability

Adjustment of reinsurancecommission (i.e. slidingscales), non-proportionalcover, use of cession limitsexperience in therespective insurancemarket, diversification

Credit Risk Cedant’s creditrating

Payment patterns Monitoring of cedant,deposits

Non-life –non-proportional

Underwriting Erroneousassumptions

Class of insurance,market experience,accumulation oflosses, cedant’sretention, reinsurer’sliability, reinsurer’sprofit loading

Retrocession, diligentpricing process, use ofunderwriting guidelines,diversification

Profit sharing Use of adjustablepremiums experience onthe respective insurancemarket

Fluctuation inloss experience

Class of business Pooling, retrocession

Credit Risk Cedant’s creditrating

Payment patterns Monitoring of cedant,deposits

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Activities Risks RiskComponent

Factors triggeringRisk

Mitigation Strategies

ReinsuranceLife –proportional

Underwriting Changes in riskfactors

Mortality/morbidityexperience, earlycancellation/lapseprobabilities

Diversification,retrocession

Erroneousassumptions(esp. surplustreaty)

Adverse selection byceding company,accumulation oflosses

Quota share treatiesretrocession

Randomfluctuation inloss experience

War Exclusion

Randomfluctuation inloss experience

Contagious disease Pooling; retrocession

InvestmentRisk

Interest raterisk, marketrisk, credit risk

Bonus declarationdetailsWide range of marketfactors

Reinsurer uses investmentdiversification strategies;matching assets andliabilities

Life – non-proportional

Underwriting Erroneousassumptions

Class of insurance,market experience,accumulation oflosses

Support by healthexamination

Changes in riskfactors

Mortality experience Diversification,retrocession

Randomfluctuation onloss experience

War Exclusion

Randomfluctuation onloss experience

Contagious disease Pooling, retrocession

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Activities Risks RiskComponent

Factors triggeringRisk

Mitigation Strategies

ART/Fin Re Credit Risk Cedant’s creditrating

Payment patterns Monitoring of cedant

InvestmentRisk

Interest risks onLong-Tailclasses ofbusiness

Other Risk Business notadmitted for taxor supervisorypurposes

Investments InvestmentRisk

Fluctuation inequity prices,fluctuation ininterest rates

Diversified investmentportfolio, asset-liabilitymatching

Credit Risk Cedant’sdiligence/creditrating

Delays in theaccounting for and theremittance ofpremiums by cedant

Monitoring of cedant,established businessrelations with cedant

Debtor default Debtor’s financialrating

All activities ExchangeRate Risk

Fluctuations inexchange rates

Asset – Liabilitymatching/Hedging

CountryRelated Risks

Changingeconomicenvironment,legal, tax, andregulatoryenvironment,declininggrowth,inflation, war

Regional diversification,regional expertiseunderwriting guidelines

3.5.2 Proportional versus non-proportional contracts

3.5.2.1 Diversification

The reinsurer is exposed to different risk profiles depending on the type of treaty reinsurancebusiness it writes. In the case of proportional reinsurance contracts, the reinsurer essentiallyparticipates in the same risks as the ceding insurance company. Its risk profile is therefore verysimilar to the ceding company.

In contrast, by writing a non-proportional contract the reinsurance company generallyparticipates only in high exposure risks, in excess of the stated retention limits. However, whilstwriting a non-proportional contract, the company is exposed to a higher risk of randomdeviation of loss occurrence from its mean that does not necessarily result in a higher mean riskexposure for the reinsurer, as compared to writing proportional contracts.

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This is due to the pooling effects from writing other non-proportional contracts. The overallexposure to fluctuations in the loss experience is likely to be reduced when looking at theoverall portfolio compared to a single contract. Therefore, the risk profile of a reinsurer dependson the size of the total portfolio, with the risk of random fluctuations in loss experience likely todecrease with the increasing size of the reinsurance portfolio. Geographical and risk typediversification can also be achieved in addition to the pooling achieved within a portfolio ofrisks. Geographical diversification is more common in reinsurance companies, becausereinsurance companies generally do business on a more international basis than insurancecompanies.

3.5.2.2 Structure of contract

The risk profile of a particular reinsurer will be significantly affected by the terms andconditions of the business it writes. In particular, the future claims profile is likely to beinfluenced by the retention levels, restrictions and exclusion clauses contained in a treaty. Aproportional contract with a high retention by the cedant also exposes the reinsurer to highseverity losses rather than to high volume losses, resulting in a potentially higher volatility ofresults compared to a contract with a lower retention.

3.5.2.3 Premium Structure

A reinsurer may write a contract with a high premium combined with a profit sharingagreement. In this situation it is more likely that the reinsurer is prepared for unexpected lossdevelopment compared to writing a contract without a profit sharing agreement (and therefore arelatively lower premium). Similar effects can be achieved by using sliding-scale commissionrates. The reinsurer can reward a ceding company for ceding profitable business and converselypenalise it for poor experience, giving the cedant an incentive to cede high quality business.

3.5.2.4 Information asymmetry

For non-proportional contracts the risk of mis-estimation might be considered to be moreimportant than for proportional contracts, since information asymmetry is potentially morelikely between the insurer and the reinsurer with respect to the characteristics of the originalbusiness written and past loss experience. Under proportional cover the reinsurer participatesnot only in the original losses but also in the original premium, and can rely to a greater extenton the underwriting experience of the ceding company.

3.5.3 Life and health contracts

Life business is especially exposed to the risk of change with respect to the parameters used inpricing, such as mortality and morbidity assumptions. The higher exposure to the risk of mis-estimation is related to the longer term of life (re)insurance contracts compared to non-lifecontracts. For the same reason and due to the savings component being more important thanwith non-life contracts, life contracts in general involve higher investment risk than non-lifecontracts.

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Additional risks for insurance and reinsurance companies can emerge from the privatisation oftraditional social security systems, for example health insurance, workers’ compensation anddisability insurance, pension benefits etc, that can be noted in several European countries.Reinsurance companies might be tempted to write such business in consideration of its purevolume. As a result, they may under-estimate the administration effort and policyholdersexpectations with respect to benefits related to this business (this reflects expense risk: the riskthat expense levels associated with administering policies may in practice be different to thoseoriginally expected, in writing the business).

Due to the longer term nature of the contracts, further risks arise for example from economiccycles. Economic downswings might trigger increased payments relating, for example, todisability insurance with employees preferring to try to qualify for disability benefits overunemployment benefits. Due to the reinsurer having to rely on the insurer to submit informationon changing loss experiences and increases in payments and/or reserves, the risk for thereinsurer relating to all kinds of changes is more important than for the insurer, because inaddition to the risk of change the reinsurer is exposed to the risk of untimely reporting by theinsurer.

Non-proportional life reassurance contracts are related mostly to coverage of low probabilityinsured events such as death, with high sums assured. The reassurer relies heavily on the riskselection and health examination processes of the insurer but often has the ability to influencethis. The reduction of risk of random deviation is normally achieved by pooling and retrocessionof sums assured.

Proportional reassurance in life business normally involves the transfer of the original insurancerisk and a significant financing element, relieving the solvency and cash flow strains associatedwith the acquisition of new business by the primary insurer. Proportional treaties are also usedwhere the reassurer effectively underwrites the business but uses the primary insurer in aterritory where it is not licensed to write the direct business, or does not have the administrativecapabilities to do so. In such cases insurance risk will be present, and life insurers may useproportional reinsurance to transfer unknown elements of risk (such as the emergence of dreaddisease). Proportional business often includes a significant profit share element.

3.5.4 Property / casualty contracts

Property reinsurance contracts are especially exposed to random fluctuations in loss experience,especially where high levels of catastrophe cover are provided. While this risk is dominant withnon-proportional contracts (see explanation above), it also exists with proportional contracts.

The dominant risk related to casualty reinsurance contracts is the risk of mis-estimation. Thisrisk increases in long-tail lines of business, where significant claims can emerge after aconsiderable lapse of time since the policy was originally underwritten (depending on the typeof policy). For reinsurance companies this risk is exacerbated, because of the additional risk ofuntimely reporting by the insurance company.

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Reserve/provision risk can be particularly important for non-proportional contracts. Here thereinsurer is exposed to the risk of a failure in the loss reserving practice of the ceding company.If the claims department of the ceding company does not set up loss reserves for single claims inan accurate manner, the reinsurance company is exposed to the risk of not receiving notice of aclaim in a timely manner, especially if the contract covers new business, where extensivehistorical data on past loss experience is unavailable and the calculation of the IBNR/IBNERreserves is therefore difficult.

3.5.5 Alternative risk transfer (ART) products

Most ART products do not transfer as much insurance risk as traditional reinsurance products.Credit risk is likely to be of greater importance due to a substantial financing element in suchcontracts. A reinsurer could incur significant losses if the cedant is unable to repay the financingelement of the contract. Underwriting risk tends to be less important in these contracts and inmany cases the reinsurer is not exposed to significant risk.

It should be noted that ART is still an emerging area. Although financial contracts have beenpresent in the reinsurance and insurance industries for many years, new products have begun toemerge in recent years which are increasingly complex and involve a new approach to riskmanagement for many reinsurers. Accordingly, some reinsurers view such developments with adegree of caution, but nevertheless, ART appears set to continue to be a growth area.

3.6 Conclusion

Risks facing the reinsurance industry are based on many variables. The variability and theirdifferent weighting is the main reason for the relative complexity of this industry. The size ofthe reinsurer can also play a part in determining the risk profile. Larger undertakings generallytend to be more diversified in their risk portfolio and are better placed to absorb unexpectedfluctuations in claims.

As a result, reinsurance supervisors are faced with a range of risk factors that they must befamiliar with in order to appreciate the risk exposure of an individual company. It is clear thatthere are wider macro risks which affect the reinsurance industry as opposed to relatively microrisks affecting the insurance industry. A significant issue for supervisors is that, given the globalnature of the business, there is a need for understanding of the macro issues and this requiresinternational information sharing and a wider knowledge base than can be obtained by focussingon individual states alone.

Due to the remoteness from the original insured risks, the risk of error in the recording of claimsis of relatively greater importance for reinsurers than for insurers. This is the risk that claimsprovisions established initially may subsequently prove to be inadequate, and this hasimplications for the reinsurer’s capital at risk, its solvency position, its retrocession programme,and pricing. Risk of random fluctuations caused by the inherent volatility of the business(especially catastrophe excess of loss business) is also of major importance, although such riskscan be reduced by effective risk management in large, well diversified and structured portfolios.The increasing advent of ART solutions leads to the increasing importance of credit risk relativeto underwriting risk. Currency risk can also be a major factor in a reinsurer’s risk profile,depending on the geographical spread of assets and liabilities.

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4 Description of the global reinsurance market

4.1 Scope

In accordance with the Terms of Reference, this chapter provides “a description of the globalreinsurance market, covering in particular the following items: the main market players(including captives), their broad market share and the jurisdictions in which they are located,the role of offshore locations, the major reinsurance products, the likely future evolution of themarket and developments in products, the trend from proportional to non-proportionalbusiness, the advent of ART (“alternative risk transfer”) and securitisation, convergencebetween reinsurance and investment banking activities, the competitive position of EUreinsurers from a global perspective. The study should also identify possible discriminations insome countries concerning reinsurers based in certain other countries, as well as analyseexisting barriers to cross-border reinsurance”.

4.2 Approach

In reporting on the above objective, we undertook the following approach:

§ Use of existing specialist knowledge;

§ Use of questionnaires to KPMG specialists in major reinsurance markets, to be furtherfollowed up by discussions with market participants where necessary; and

§ Review and analysis of existing published material.

4.3 The global reinsurance market

In 1999 direct insurers ceded business worth US$ 125 billion to reinsurers worldwide(“Reinsurance”, August 2000). The market has remained relatively flat since 1998, due tovarious factors, including consolidation in the primary insurance industry and the general lowinflationary environment. Soft conditions in the market have also limited growth, as reinsurershave lacked the power to increase rates. In such conditions, an increased use of proportionalcover has been noted over the past two years, as reinsurers have sacrificed quality inunderwriting in order to retain their key clients, whose portfolios may be under performing themarket.7

A study prepared by “Reinsurance” magazine (August 2000) of 1999´s top 100 reinsurancecompanies showed that in 1999 the reinsurance companies made an average underwriting lossof 11% on their net written premiums. Reinsurance business is relying on substantial returnsfrom investments rather than underwriting income to contribute to profits. Although of the 87companies reporting underwriting results, 72 made an underwriting loss, only 18 out of 85 (thatprovided pre-tax results) recorded an overall pre-tax loss.

The same study reveals that 33% of the premiums written by the world’s top 100 reinsurancecompanies were written by the top five in 1999 (1998: 37%), and almost half (48%, 1998: 50%)were written by the top ten.

7 Noted by Standard & Poor’s in their Global Reinsurance Highlights 2000 edition

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Big companies, despite underwriting losses, continue to dominate the reinsurance market. Thetop ten reinsurance groups, as identified by market share (ranked by net written premiums) areas follows:

Reinsurer Primary jurisdiction Total Net premiums written(US $ million)

Combinedratio (%)

Munich Re Germany 13,566 118.9

Swiss Re Switzerland 12,839 116.0

Berkshire Hathaway USA 9,453 116.3

ERC USA 6,921 114.0

Gerling Group Germany 3,938 114.0

Lloyd’s United Kingdom 3,799 N/A

ASS Generali Italy 3,533 113.5

Allianz Re Germany 3,299 107.4

SCOR Re France 2,721 109.7

Hannover Re Germany 2,564 95.9

Source: Standard & Poor’s Global Reinsurance Highlights (2000 edition)

The trend towards concentration is frequently noted, but it has become more accentuated sincethe mid 1990s. The effect of concentration is that reinsurers themselves are obliged to growthrough the absorption of some of their competitors. Also, as risks are becoming increasinglysophisticated, smaller or medium sized reinsurers are not always able to meet the increasinglycomplex needs of their clients.8

Industry consolidation: recent mergers and acquisitions

1995 was the first of several years of significant mergers and acquisitions. As noted in GlobalReinsurance9, “General Re acquired Cologne Re and ERC bid for Munich based Frankona. Thefollowing year, Munich Re bought American Re and Swiss Re acquired the Mercantile &General, from the Prudential and Unione Italiana.”

“In Bermuda, ACE bought property-catastrophe reinsurer, Tempest, followed by CAT Ltd. Forits part, XL added the property-catastrophe reinsurer, Global Capital Re, to its portfolio, andlater took control of Mid Ocean Re.”

8 Source: As noted in Global Reinsurance, September 2000 “The French reinsurance market 1999”9 Source: Global reinsurance – Dec 1999 “Ten years in Reinsurance”

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“In 1997 and 1998, the process continued. The largest of the Bermuda property-catastrophereinsurers, PartnerRe bought France's SAFR, and another Bermudian, Terra Nova, boughtCorifrance. Munich Re acquired Reale Ri in Italy. Berkshire Hathaway acquired General &Cologne Re, and ERC bought the US companies, Industrial Risk Insurers and Kemper Re, plusthe UK's Eagle Star Re. Further moves followed in 1999, XL, now XL Capital, took over theUS company NAC Re. More recently US insurer Markel agreed to buy Bermuda's Terra Nova.”

During the 1990s, the number of reinsurance companies worldwide has decreased and businesshas become significantly more concentrated. For example, between 1990 and 1996 the numberof US professional reinsurers fell from 130 to 41. In 1990, the five largest reinsurers wereestimated to control 21% of the world non-life reinsurance market estimated at $90 billion ayear; by the end of 1998, the five largest controlled 37% of the global market (Source: GlobalReinsurance).

4.4 The major reinsurance products

1999 saw the first year of growth in the global reinsurance market following three years ofcontraction. According to a study by Swiss Re, reinsurance business was split 83% non-life and17% life and health. Ceded premiums in relation to direct insurance volume were 14% in non-life and 1.5% in life and health. Life reinsurance has been a steady source of growth,counterbalancing some of the weaknesses in the non-life market (Sigma 9/1998).

4.4.1 Life and health

The definition of life and health reinsurance varies, but the core business is clearly stillprotection against mortality. Other main components include guaranteeing of investmentincome and protection against morbidity and medical expenses.

The growth in life and health reinsurance is a relatively recent trend. Unlike the volatile natureof catastrophe reinsurance business, life and health reinsurance provides much steadier cashflow and more stable results. The life sector is thought to be growing by at least 15% perannum. Some experts estimate the growth to be in the region of 30%10. Various factors liebehind the growth in life reinsurance.

First, direct life assurance is increasing globally. The reason for this is that the world economyhas experienced high growth rates in the past few years and people are investing their increasedwealth in life insurance and investment products. Also, social security systems in highlyadvanced, mostly European, welfare states no longer have the capacity to cover the countries’life assurance and pensions demands.

Secondly, direct life assurers are reinsuring a higher proportion of their business. This is notonly for capital adequacy reasons, but also because they are focussing increasingly on their corestrengths of distribution and asset management. By doing so, they rely on the reinsurers’ riskassessment expertise and innovative skills. Life assurance and reinsurance are highly technicaland actuary-dominated. In consequence, life assurers tend to outsource their risks throughreinsurance (that is, they outsource the management of mortality).

10 Source: Baylis Mark, Global Reinsurance, appendix 4, pages 1-3

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An analysis by Swiss Re, shown below, illustrates the breakdown of ceded premiums in the lifeand health sector in 1997.

Regional breakdown of ceded life & health premiums 1997

Ceded premiumsIn US$ billion As a % of the total

North America 10.6 49.1Western Europe 9.1 42.1Asia/Pacific 0.6 2.6Japan 0.6 2.8Latin America 0.6 2.8Eastern Europe 0.2 0.6Total world 21.7 100.0Source: Sigma 9/98

In life reinsurance, size counts. Cedants prefer trading with companies that are regarded as ultra-secure. Smaller companies usually either have the backing of a parent or find their opportunitiesrestricted. The market shares of the major market players in 1997, according to Swiss Re, areshown below.

Market shares in the life and health reinsurance market 1997

Swiss Re 19%Munich Re 9%Employers Re/Frankona 7%Cologne Re 6%Lincoln Re 5%Hannover Re 5%Transamerica 3%RGA 3%Manulife 2%Other 41%Total 100%Source: Sigma 9/98

Reliable market-wide figures in relation to the breakdown between proportional and non-proportional reinsurance in life and health industry are not available. According to an estimatein Global Reinsurance11, 75%–80% of reinsurance is sold via quota treaties (proportional),although there are some significant territorial variations.

11 Source: Baylis, Mark, Global reinsurance, appendix 4, page 1-3

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4.4.2 Non-life reinsurance

Non-life reinsurance includes all classes of reinsurance other than life and health reinsurance.The major classes in non-life reinsurance are: property, accident (casualty), liability, motor,marine, engineering, nuclear energy, aviation and credit and surety.

North America and Western Europe together account for 74% of the worldwide non-lifereinsurance market.

Regional breakdown of ceded non-life premiums 1997

Ceded premiumsUS$ billion As a % of the total

North America 39.9 38.9Western Europe 36.1 35.1Asia/Pacific 12.4 12.1Japan 4.3 4.2Latin America 3.3 3.2Eastern Europe 1.7 1.6Rest of the World 5.0 4.9Total world 102.7 100.0Source: Sigma 9/98

The table below provides further illustration of the domination of the global market by a smallnumber of major reinsurers.

Market shares in the non-life reinsurance market 1997

Munich Re 10%Swiss Re 8%General Re 5%Employers Re 5%Hannover Re 3%Gerling Globale Re 2%SCOR 2%Zurich Re 2%AXA Re 1%Generali 1%Other 61%Total 100%Source: Sigma 9/98

Within the EU, non-life business is dominated by motor, accident and health, and propertybusiness. Factors which influence the proportion of business reinsured include the pricing andavailability of reinsurance cover, the volatility inherent in the underlying business, and thedegree of uncertainty involved in predicting underwriting results. Longer tail classes ofbusiness, and those which can be subject to catastrophic losses, are in general likely to attractgreater levels of reinsurance protection. The table below illustrates this, with higher percentagesreinsured in property, liability and MAT classes.

33

Breakdown of non-life business in EU and percentage of business reinsured

Type of non-life businessAs % of all non-life Percentage reinsured

Motor 34% 12%Accident & Health 24% 7%Property 21% 31%Liability Insurance 6% 25%Marine, aviation & transport 7% 36%Others 8% 14%Total 100%Source: EU Commission, Report: Results of Questionnaire on the Supervision of ReinsuranceUndertakings, 1999

4.4.3 Alternative risk transfer (ART) products

Boundaries between traditional and alternative risk financing tend to blur. This, together withthe frequent invisibility of ART products in financial statements, makes it extremely difficult tomake quantitative statements about the market volume of the ART products. Also, a commonbasis for the business volume of ART products seems to be difficult to identify. However, astudy produced by Swiss Re estimates the premium volume of ART products to be around US$30 billion, of which captives account for approximately two-thirds. Integrated multi-year/multi-line products, multi-trigger cover, contingent capital as well as insurance bonds and derivativesare still insignificant in terms of volume. (Source: Sigma 2/1999).

The reinsurance industry tends to offer ART products, multi-line or multi-year contracts directlyto the company that demands the insurance protection. The construction works legally either viafronting through the books of a direct insurer, or if possible directly with the demandingcompany.

The size of the ART market by different product categories in 1998 has been estimated in astudy prepared by Tillinghast Towers-Perrin. Their findings are summarized below:

Estimated market size

US$ billion

Estimated size of worldwide ART market* 13Estimated size of World Reinsurance Market 125Estimated size of World Insurance Market 2,129Estimated size of European Insurance Market 669

*excludes captives and other self-funded vehicles but including securitisation.Source: Tillinghast Towers-Perrin, European Commission ART Market Study, Final report October 2000

The major markets for ART business are based in New York (estimated at more than 50% of thebusiness written), Bermuda, London, Zurich, Dublin and Luxembourg. However specialistcompanies in this market also operate in other countries, such as Hannover Re in Germany.

34

The success of ART products has continued to attract further entrants to the ART market. In thelast five or six years, many new operations have been established and there are continuing signsof increasing competition in this area.

A sub-segment of the ART market is risk transfer using capital markets. Risk transferencethrough capital markets is still a narrow segment compared with traditional reinsurance orinsurance. That is mainly due to the costs and inefficiencies of the transactions for the issuer.Capital market solutions are focused on natural catastrophe risks. Insurance derivatives andsecuritisation have been the major mechanisms for insurance risk transfer using capital markets.

Trading of insurance derivatives on commodities exchanges has only been modest, even thoughthe instruments have been adapted and refined to meet client needs many times since they werefirst introduced. The use of insurance derivatives as protection against previously uninsuredthreats to the earnings of an industrial or service company offers a lot of potential. Weather isonly one example.

4.4.4 The Internet as a distribution channel

In 1999 and 2000 reinsurers’ margins were under pressure. The reinsurance industry consideredtwo ways of tackling the problem: higher rates and lower transaction costs. Internet basedreinsurance trading systems are promising lower transaction costs and faster and easier access tobusiness than the traditional distribution channels. However, internet business is likely to putpressure on margins as well12.

Based on internet technology there are currently two major systems used by reinsurancemarkets: “Reway” and “Inreon”. Reway was set up by Gothaer Re of Germany. Inreon isbacked by the world’s two biggest reinsurers, Swiss Re and Munich Re together with InternetCapital Group (US based internet holding company and Accenture)13.

Inreon provides insurance companies, brokers and professional reinsurers with transactioncapabilities for standardised reinsurance covers. Inreon´s standardised reinsurance trading isinitially on facultative non-proportional property business in the USA, UK, France, Germany,the Netherlands, Italy, Belgium and Spain. In the near future products will include facultativeproportional property cover and both non-proportional and proportional covers for casualty andother lines of business.14

Reway as well as Inreon offer insurance companies, brokers and professional reinsurers anopportunity to use the internet platform to enter into reinsurance treaties online. Reway isfocusing initially on the European market.

12 Reinsurance, October 200013 Bloomberg, L.P.: Munich Re, Swiss Re ; Accenture set up internet site, 18.12.200014 Lloyd’s of London Press Limited: Two top reinsurers team up to form web-based exchange,

19.12.2000

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4.5 The role of offshore locations

Offshore insurance and reinsurance is often, but not always, driven by taxation and regulatoryconsiderations. Whilst early offshore insurance and reinsurance companies faced fewregulations, more recently most locations have adopted relatively comprehensive systems ofinsurance supervision and regulation. As the international significance of off-shore insuranceand reinsurance has grown, it has been necessary to upgrade the quality of insurance regulation.Regulatory co-operation with the main on-shore markets is substantial, including exchange ofinformation.

Nevertheless, the generally simpler offshore legislation makes it easier to evolve new types ofproduct. The favourable regulatory and taxation environment encourages innovation anddevelopment. Almost all of the new insurance and reinsurance approaches that have broadenedthe practical concepts of insurance have been developed offshore. Hence, offshore insuranceand reinsurance markets in the past grew with new approaches to covering risk, such asfinancial insurance and reinsurance and the securitisation of reinsurance risks. However, growthin more traditional areas of insurance and reinsurance, particularly in catastrophe reinsuranceand excess liability insurance, has also been seen in these offshore locations.

Aside from regulatory considerations, other factors may be involved in the formation ofinsurance or reinsurance companies offshore. For example:

§ the use of independent territories to manage global insurance and reinsurance programmesneutrally;

§ cost effective insurance and reinsurance management by specialist companies; and

§ reducing taxation costs.

Reasons for using an offshore location include:

§ the capability to co-ordinate global insurance programmes between reinsurance companiesfrom a number of countries, often in conjunction with an overall umbrella or similar cover;

§ the ability to access other insurance and reinsurance markets without any domesticregulatory limitations; and

§ involvement in the reinsurance or coinsurance of captive and other offshore insurers throughlocal presence.

Recently the distinction between onshore and offshore domiciles has become somewhat blurred,because onshore captive locations continue to introduce legislation aimed at attracting newbusiness. Various actions by the OECD have reduced the taxation benefits of offshore locations.However, in the case of captives the offshore market is growing faster than the onshore market.In 1998, two thirds of new captives formed were offshore, and the trend is continuing.

A major attraction of offshore captive domiciles is the low level of regulation. However, manydomiciles have recently tightened up their insurance (and reinsurance) regulations in the face ofaccusations that their regulation is somewhat lax. Nevertheless, compared with setting up in theparent territory of the captive, the regulatory environment can still be favourable.

36

The electronic revolution removes most of the remaining barriers between the onshore andoffshore markets. Reinsurance/insurance can therefore be transacted anywhere that has physicalcapabilities (digital communications etc) and where insurance expertise exists. This in turncreates a threat to traditional geographical centres of the reinsurance market15.

Perhaps the most significant development in offshore locations was the development ofBermuda as a location for reinsurance companies. Whilst the Bermudian companies havecontinued to remain strong, and have themselves seen significant consolidation, they have alsoseen the attraction of location in major onshore centres, such as the US and Europe. Forexample, ACE, XL Capital and Terra Nova have become major investors in Lloyd's.

4.6 Captives

A captive is an insurance company that belongs to a major corporation or group and underwritesor reinsures primarily or exclusively the risks of firms belonging to the respective group. In1998, there were about 3,800 captives worldwide, creating a premium volume of approximatelyUSD 21 billion16, equivalent to a share of roughly 6% of all premiums written in commerciallines of business. One-third of the captives were domiciled in Bermuda. More than half of allcaptives worldwide belong to industrial and service companies in the US.

The captive market is highly competitive in terms of captive domiciles and the competition isset to continue to be fierce in the future. More than 80% of the estimated total number ofcaptives worldwide are located in eight major domiciles.17:

1. Bermuda

2. The Cayman Islands

3. Guernsey

4. Vermont

5. Luxembourg

6. Barbados

7. The Isle of Man

8. Dublin

(for details of numbers of captives see Appendix 2)

Whilst the captive market has been growing steadily over the last two or three decades, with netgrowth of around 200 captives each year, this growth has slowed slightly in recent years.

15 The Role of offshore insurance, Jim Bannister Developments Limited 200016 Source: Tillinghast Towers-Perrin, Swiss Re Economic Research17 The Role of offshore insurance, Jim Bannister Developments Limited 2000

37

4.7 The future evolution of the market and developments in products

4.7.1 Trend from proportional to non-proportional business

It is difficult to substantiate the generally perceived trend from proportional to non-proportionalbusiness with quantitative data covering the whole industry. Industry wide statistics do notgenerally provide analysis of treaty business in this way. However, the trend is reasonably welldocumented. The advent of Bermudan capacity, for example, was principally in the area ofexcess of loss reinsurance.

The following quote comes from Global Reinsurance18:

“Coupled with the shrinkage in the population, market leadership also took over, where itbecame more important for cedants to focus on doing business with a small number of large andwell-capitalised reinsurers, rather than the other way around as it had been pre-1984. Because ofthis, reinsurance underwriters were able to have their way, imposing a risk-excess model on themarket more broadly, in place of the proportional form that had been prevalent, thereby gainingmore direct control over their own underwriting and pricing.”

4.7.2 The evolution of ART and securitisation

In the early 1990’s, potential losses from catastrophe risks exceeded the capacity available inthe worldwide reinsurance markets. One result of this gap in the global market, especially inrelation to high level catastrophe cover, was the formation, backed by major financialinstitutions, of the highly capitalised Bermudian catastrophe excess of loss reinsurers, such asXL, and Mid Ocean, among others. With rising rates for catastrophe cover and the increasingtendency for reinsurers to monitor aggregate exposures, another result was that investmentbanks began to develop alternative solutions to provide ways for reinsurers to offset theirresidual catastrophe exposures, using the large cash reserves of the capital markets as a meansof raising additional capital in case of major losses.

Various ART solutions have been developed, including catastrophe options and bonds, and thelaunching in 1995 by the Chicago Board of Trade of an insurance derivative option based onindexed case estimates. The latter met with limited success, and some bonds have not reachedthe market (such as the California Earthquake Authority deal of 1996). However, a number ofsignificant transactions were successfully completed in the late 1990s, including a ten yearsecuritisation by St Paul Re, using a special purpose vehicle in the Cayman Islands to enable itto underwrite catastrophe business in the USA and the Caribbean.

Such deals involve a high amount of investment in time and transaction costs. They also involvesignificant modelling input. A number of investment banks are actively marketing the conceptof catastrophe bonds to reinsurers, and more of these products are likely to appear in future.

The involvement of capital markets is increasingly blurring the division between banking andreinsurance. Transactions are often complex and this presents an issue for regulators. They needto understand the underlying motivation for such transactions, their effects and regulatoryimpact, in order to assess whether their regulatory approach is appropriate.

18 Global reinsurance – September 2000 “Look! They’ve killed reinsurance”

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4.8 Competitive position of EU reinsurers from a global perspective

Despite the international nature of the reinsurance market, obstacles to cross-border businessstill exist. In terms of regulatory barriers, there are several areas where regulatory issues couldhave an impact on competition between EU and non-EU reinsurers.

First, there is a possibility that capital requirements could influence decisions regarding where areinsurer is located. However, in practice the capital required in order to meet the requirementsof rating agencies and the market generally exceed regulatory requirements to a great extent.The EU solvency margin, for example, designed for primary insurance companies, is oftenirrelevant in the case of reinsurance companies, as the requirement imposed by the market is fargreater. Moreover, the question of location is arguably less important, given the internationalnature of reinsurance.

Second, the regulatory approach in different territories may exert competitive pressures.Compliance costs may be higher where there is a greater regulatory reporting burden, and wheremore regulatory costs are passed on to the reinsurance industry in one territory compared toanother, there may be competition implications.

The OECD and the CEA have identified administrative impediments in the EU. These include,for example, the obligation for branches of non-EU reinsurers to issue financial statementsaccording to local GAAP (generally accepted accounted principles) for the whole group. CertainEU countries also make use of systems where assets of the reinsurer must be pledged in order tocover outstanding claims provisions.

According to the OECD and the CEA other obstacles exist. In some countries there is still amonopolistic situation in reinsurance through one privileged company, which is usually state-owned. In turn, some countries require compulsory cessions in certain lines of business to astate company or to identified national reinsurers. Supervisory restrictions, such as requirementsto register in the host country or limits to cessions, can also exist. Furthermore excise taxes canbe required19.

As an answer to this, the CEA proposes the introduction of a “Single Passport”, which does notnecessarily mean a harmonisation of the supervision of reinsurers.

19 Source: EU Commission, Discussion Paper to the IC reinsurance Subgroup “Approaches to

Reinsurance Supervision”, 2000

39

5 Description of the different types of supervision approachescurrently used in the EU as well as other major Non-EUcountries

5.1 Scope

In accordance with the Terms of Reference, this chapter provides “a description of the differenttypes of supervision approaches currently used in the EU as well as in major non-EU countries.This should include a comparison of the principal characteristics and differences of major orleading jurisdictions, with the aim of clarifying the rationale underlying the adoptedsupervisory approach. It should indicate whether the same supervision regimes are used forinsurance and reinsurance”.

5.2 Approach

In reporting on the above objective, we undertook the following approach:

§ Use of questionnaires to local KPMG insurance regulatory specialists in each country;

§ Discussions with regulators and use of public information where necessary, to supplementinformation gathered from local offices.

5.3 Introduction: reasons for supervision

The major common objective of prudential supervision of reinsurance, in those jurisdictionswhere it is supervised, is the need for protection of the interests of the policyholders. Prudentialsupervision aims to minimise the instances of insolvencies of reinsurers.

Whilst this overall objective is generally valid for the supervision of both insurance andreinsurance business, in some jurisdictions reinsurance supervision is organised with a ‘lightertouch’ than insurance supervision because reinsurance companies conduct their businesspredominantly in an inter-professional marketplace. A further consideration is the perception inother territories that, due to the special characteristics of the reinsurance market, withoutsupervision the market in the long term would not work properly (for example in soft marketsreinsurance companies offer reinsurance cover at uneconomic prices). Thus supervision may bein the best interests of economic policy objectives.

40

Types of supervision can be classified in a number of ways. The IAIS identifies five mainapproaches20:

(i) no supervision at all;

(ii) supervision of reinsurance is restricted to ceded reinsurance of primary insurers only;

(iii) the supervisor is authorised to request non-public information about a domesticreinsurer;

(iv) every reinsurer doing business with a domestic reinsurer is licensed;

(v) uniform licensing being extended with additional requirements for the insurer or thereinsurer.

5.4 Supervising authority

Supervision of reinsurance can be provided by general public authorities or a special insurancedepartment. A further possible form of reinsurance supervision is self-regulation through themarket, and this is mainly achieved by rating agencies or by cedants’ assessments of reinsurers’financial position in deciding whether to place cover. Due to the fact that reinsurance companiesdo business with professionals as described above, self-regulation (principally by the use ofmarket mechanisms) might be a viable alternative to other forms of supervision.

The role of the rating agencies has become more significant in recent years. Rating agencies arenot only relevant for potential shareholders of the reinsurance companies, but also for otherstakeholders (such as policyholders). The information provided by the rating agencies can beuseful in assessing the security of reinsurers, especially their claims paying abilities.

Rating and regulation are becoming closely connected. They have different agendas, but incertain areas they can be complementary to each other. Reinsurance Magazine (August 2000)notes that increasing co-operation between the world’s regulatory authorities and the majorrating agencies is a likely future trend.

Reinsurance companies are regulated in different ways in terms of which legislation is appliedto regulating the business. A reinsurance company can be subject to legislation either of thecountry where business is written or of the country of origin.

A licence in the country of origin is, according to the European Directives, a precondition forstarting direct insurance activities in a Member State. If the licence is withdrawn, the insuranceundertaking must stop writing new business. Many EU states also require a licence forreinsurance business. The licence has to be obtained in every single country where the companywants to write reinsurance business, and where there is a requirement to obtain a licence.However, not all countries require a licence from a non-domestic reinsurer.

20 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles, standards

and practices, February 2000

41

Within the EU there is an attempt to provide European reinsurers with a common form ofcertification, taking the form of a statement from the supervisor (Single Passport). In a singlepassport solution the reinsurer, providing it complies with certain criteria and requirements,receives an official recognition (passport) to undertake reinsurance business in the EEA, withoutfurther approval or registration procedures. If at any time a reinsurer fails to meet theserequirements, the passport can be withdrawn.

5.5 Forms of supervision

The key features of the supervisory approaches are:

§ licensing requirements;

§ solvency requirements (or an equivalent measure);

§ monitoring (including scrutiny of various aspects of the business, site visits, etc).

5.5.1 Licensing criteria

Licensing allows supervisors to impose minimum capital and management requirements.Additionally, supervisors obtain direct and established access to any information concerning thereinsurance business. Licensing criteria vary from country to country. The core requirementsproposed by the CEA are: acceptable legal form, fit and proper requirements for management,prudential solvency requirements, adequacy of technical provisions, approval of controllers(shareholders) and at least annual reporting to the regulator.

As a by-product of the licensing requirement, supervisors can obtain crucial information aboutthe reinsurance market in the country.

5.5.2 Financial Supervision

Financial supervision can include the review of a company’s financial statements and/oradditional information, the review of technical provisions for their adequacy and solvencyrequirements. Financial supervision can also include investment regulations. The question ofwhether the special character of reinsurance business (for example, reinsurance business beingmore international than insurance business) warrants differences between investmentregulations for insurance and reinsurance business will need to be addressed.

5.5.2.1 Direct versus indirect supervision

The current situation in reinsurance supervision demonstrates that there is no commonlyaccepted single method of reinsurance supervision. A European Commission questionnaire onthe supervision of reinsurance undertakings showed that almost all Member States supervisereinsurers either directly or indirectly or they have a mixture of both direct and indirectsupervision.

Direct supervision means that any reinsurer conducting business within an EU member state isrequired to be authorised in some way by the supervisor. Direct supervision includes otherrequirements, for example, managers must be fit and proper, adequacy of technical provisions,minimum solvency margins, and submission of financial statements.

42

Indirect supervision is conducted via the full supervision of direct insurers. A reinsurer isexamined as a result of the supervisor’s scrutiny of the primary insurer’s outward reinsuranceprogramme.

5.6 Supervision of reinsurance in the EU

Direct insurance activities in the EU are regulated and supervised in accordance with EUdirectives. There are currently no prudential directives dealing with reinsurance. The onlydirective which does deal with reinsurance is 64/225/EEC on the abolition of restrictions onfreedom of establishment and freedom to provide services in respect of reinsurance andretrocession.

The actual supervision of reinsurers is based on national legislation. This has led to aconsiderable variety in terms of regulation and levels of reinsurance supervision, whicharguably hinders the further development of the internal reinsurance market.

Domestic professional reinsurers are not subject to any reinsurance supervision in Belgium,Ireland and Greece. Germany, France and the Netherlands apply elements of their directinsurance supervisory regime to reinsurers while a reduced licensing regime exists in Austria,Italy, Spain and Sweden where only the latter two impose solvency margin requirements.

Only in the UK, Denmark, Finland and Portugal are reinsurers subject to the comprehensiveregulation and supervision applied to direct insurers under the single market regime, includinglicensing and thorough on-going financial supervision.

The following sections highlight areas of differences in the approach towards reinsurance,compared to insurance, in various European member states while the table below summarisesthe approaches in the main EU member states.

43

Supervision Germany France UK Netherlands Italy Denmark Sweden Spain LuxembourgLicence is required in order to practice reinsurance* domestic reinsurers* non-domestic reinsurers

XX

XX

üü

XX

üü

üü

üX

üX

üX

Reinsurers are subject to supervision ü ü ü ü ü ü ü ü üReinsurers are supervised directly ü X ü X ü ü ü ü üReinsurers are supervised indirectly ü ü ü ü X ü X ü üReinsurers are a subject to on-site inspections* domestic* non-domestic

üX

üX

üü

üX

üü

üX

üX

üX

üX

Management must be “fit and proper”* domestic* non-domestic

XX

üX

üü

XX

üü

üX

üX

üX

üX

Changes in management must be reported*domestic* non-domestic

XX

XX

üü

XX

üü

üX

üX

üX

üX

Sufficiency of technical provisions is examined* domestic*non-domestic

üX

üX

üü

XX

üü

üX

üX

üX

üX

Solvency margin requirement exists X X ü X X ü ü ü ü

44

Supervision Germany France UK Netherlands Italy Denmark Sweden Spain Luxembourg

Financial statements must be submitted* domestic* non-domestic

üX

üX

üü

üX

üü

üX

üX

üX

üX

Annual Submission* domestic*non-domestic

üX

üX

üü

üX

üü

üX

üX

üX

üX

Quarterly Submission* domestic* non-domestic

ü (a)

XXX

üü

XX

XX

XX

XX

XX

XX

Assets are examined* domestic* non-domestic

XX

XX

üü

XX

üü

üX

üX

üX

üX

Sanctions: licence can be withdrawn* domestic* non-domestic

XX

XX

üü

XX

üü

üX

üX

üX

üX

Sanctions: fines may be imposed* domestic* non-domestic

üX

üX

üü

XX

üü

üX

üX

üX

üX

a) only report on development of investments

mk/nb/552 45

5.6.1 Denmark

Reinsurance business is regulated in Denmark in the same way as direct insurancebusiness and based mainly on rules implementing EU directives. This includesaccounting, investment, solvency, and fit and proper rules.

The main objectives of the regulation of reinsurance business are, we understand, tominimise the possibility of credit loss on reinsurance for the ceding direct insurers. This isdirectly related to the protection of the financial position of the primary insurers andtherefore to the protection of policyholders.

Licensing requirements

A licence is required by incorporated Danish companies to practise reinsurance inDenmark. As of 1 April 2000 branches of foreign reinsurance companies (permanentestablishments) also need a licence. Having a permanent representative will constitute apermanent residence. Foreign reinsurance companies, without having a permanentresidence or a permanent representative in Denmark, can sell reinsurance to Danish directinsurers without having a licence in Denmark.

The rules regarding licensing are the same as for direct insurers. To obtain and maintain alicence in Denmark, a reinsurer has to make a standard application to the supervisoryauthority, make the required statutory filings and maintain a level of assets sufficient toservice the level of liabilities it reinsures. The Board of Directors in Danish insurancecompanies has to determine the sufficiency of the security of the used reinsurers andtherefore normally only uses reinsurers with good security. The requirements are checkedregularly by the regulator. The regulator can withdraw the licence if the regulations arebroken.

Reinsurers are subject to regular on-site inspection visits by the regulator in the same wayas direct insurers.

The board of management and members of the board of directors are required to meet thefit and proper criteria, based on EU rules. Changes in management have to be reported tothe regulator who can withdraw the licence if the management does not meet the fit andproper criteria. These criteria are checked at the time of the original submission by thecompany and are normally not checked on an ongoing basis. Normally the regulator willnot check the criteria if a member of management has already been approved by theregulator in another EU or EEU member country.

Reporting requirements

The financial reporting requirements are the same as for direct insurers. Audited annualfinancial statements (based on the EU Insurance Accounts Directive) and regulatoryreturns are required. The regulatory returns are in the same form and level of detail as fordirect insurers.

Direct insurers as well as reinsurers have to prepare and file audited annual financialstatements and regulatory returns within 5 months after the year-end. In the near futurethis time limit will be changed to 4 months.

mk/nb/552 46

Once a year the non-domestic reinsurers (branches) submit a report on their activities tothe regulator. The report contains information about capacity utilisation and aboutbusiness in general. The branch report has to be certified by a state authorised orregistered public accountant. A branch of a foreign reinsurer must each year file with theregulator a specification of the contracts entered into, analysed by country, and aspecification of the ten largest ceding companies. General agents have to file two copiesof the annual accounts for the company with the Danish regulators. A non-domesticreinsurance subsidiary must comply with the rules of the domestic reinsurers, i.e. directinsurers.

There are no written rules regarding probable maximum losses and maximum exposuresbut the supervisor is very focused on how direct insurers and reinsurers manage theircapacity.

Solvency requirements

As for direct insurers a solvency requirement calculation has to be prepared. The non-lifesolvency provision is largely derived from amounts in the audited financial statements.The life solvency calculations are prepared by and signed off by the appointed actuary. Areinsurance company that conducts life reinsurance needs to have an appointed actuary.

Use of rating agencies

The Danish Supervisory Authority has implemented a rating model (called REMOS-reinsurance monitoring system) to determine the risk profile of the reinsurance cover ofthe insurance companies. The reinsurance programmes of all larger direct insurers areregistered in REMOS including treaties, cover and security. This system rates companiesby reference to a number of financial ratios, but also takes into account the level ofexposure that companies assume when rating the security of a buyer’s entire reinsuranceprogramme. However, the information is not available to the public.

5.6.2 Germany

Reinsurance companies are subject to limited supervision compared to direct insurancecompanies. The rationale for the difference between insurance and reinsurance companieswith respect to supervision is that insurance companies are business professionals that donot need the same level of protection as individuals. Another argument for the differenttreatment mentioned in the literature is that the models for supervision which areappropriate for insurance companies do not fit the special character of reinsurancebusiness, especially as reinsurance business is more international than insurance business.

Consideration is being given to revising the existing regulation for professional reinsurersin Germany.

Reporting requirements

Although reinsurance companies are subject to limited supervision compared to directinsurance companies, they have to comply with requirements regarding accounting andreporting to the supervisory authority similar to direct insurance supervision.Furthermore, reinsurance companies are obliged to submit a quarterly report on thedevelopment of investments.

mk/nb/552 47

Solvency requirements

The German solvency requirements are based on the European Directives. There is nostatutory solvency margin requirement for reinsurers. However, the supervisor tries toensure that reinsurers have a minimum capital at the level required for direct insurers.

Insurer’s procedures for monitoring reinsurer security

The German supervisory authority has published guidance for direct insurers on how toassess the performance and capacity of reinsurers on the basis of data from financialstatements and other available information. Following this guidance, it is necessary fordirect insurers to review the annual results of the reinsurer in comparison to the previousyear. Other available information has to be taken into account such as information frombrokers or rating agencies. If the assessment by rating agencies is considered, it isnecessary to obtain comparative ratings from different rating agencies. Assessments ofthird parties have to be closely checked before being taken into consideration.

The following information, concerning the company’s outwards reinsurance programme,must be submitted by direct insurers to the supervisory authority:

§ The name of the reinsurance and insurance company or the name of the reinsurancebroker;

§ The ceded premiums have to be analysed between direct insurance business and theassumed reinsurance business. The amount of the ceded premiums has to include thepremiums paid to the reinsurer as well as portfolio entries;

§ The reinsurer’s share of the gross technical provisions has to be analysed betweendirect insurance business and the assumed insurance business;

§ The liabilities from deposits of reinsurers.

In addition, the supervisory authority obtains the audit report through indirect submissionwhich must contain information about results from reinsurance contracts (inwards andoutwards) overall and separately for certain lines of business. Also, the auditor has tocomment on the creditworthiness of reinsurance receivables.

On the basis of the submitted information mentioned above the supervisory authority hasthe ability to directly assess the reinsurance programme of direct insurers.

The supervisor does not consider the solvency position of a particular reinsurer whenassessing the quality of a company’s reinsurance recoverables since in Germany there areno solvency requirements for professional reinsurers.

The supervisor takes into account the fact that insurance groups often manage theirreinsurance programme on a group basis in order to manage it more efficiently and toprevent over exposure to particular reinsurers.

mk/nb/552 48

Adequacy of assets

Reinsurance is not subject to the investment regulations in force for direct insurers.

For investments valued in accordance with the historical cost principle, the market valuemust be disclosed in the notes.

There are no restrictions placed on the recognition of assets arising from outwardsreinsurance contracts.

Many insurance companies use stress tests in order to quantify their investment risks.Reinsurers tend to have more professional knowledge and therefore more sophisticatedsystems. Asset/liability management techniques are still at an early stage of practical use.Some insurance companies already use a stochastic model concerning investments.

Use of rating agencies

In Germany, the largest insurance companies are usually rated by one of the leadingrating agencies. Rating is not obligatory. Insurers use ratings for marketing and toimprove their credit standing. Market trust in ratings is high. More than 700 directinsurers and over 40 reinsurers exist, of which 169 are rated by Standard & Poor’s, 12 byMoody’s and 17 by Assekurata a German rating agency. The use by the regulator of theseratings is very limited and consists merely in suggesting their use to direct insurers whenassessing the performance capacity of reinsurers.

5.6.3 Ireland

Traditionally the Irish reinsurance industry has not received the same degree of scrutinyas the direct insurance sector. This area is now in the process of being tightened with thefoundations for further regulation having been laid recently by the Insurance Act 2000.

The Irish regulator does not operate a formal authorisation process but is able to exertcontrol over the establishment of new entrants through an arrangement with the Irishcompanies registry. Under the new Act there will be further requirements in relation toauthorisation.

There is currently no formal supervision of reinsurance companies but the reinsurancemarket is relatively young, and a supervisory approach is expected to be introducedwithin the next five years.

5.6.4 Italy

According to a 1959 Act, Italian undertakings and branches of foreign (EU and non-EU)undertakings operating exclusively as professional reinsurers are subject to Isvap´s directsupervision.

Undertakings which intend to pursue only reinsurance business in Italy must be grantedauthorisation by Isvap. In this case, as in the case of transfer of controlling interests in areinsurance undertaking, the same regulations in force in direct insurance apply as regardsthe requirements of good repute and financial soundness of shareholders.

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Isvap tends to substantially extend the more complex regulations applying to directinsurance; this is why it has introduced a routine procedure under which an ad-hocscheme of operations is required in order to verify, apart from the good repute andprofessional qualifications of administrators and internal auditors, if an undertaking hassufficient technical and financial resources to ensure its technical, economic and financialstability during its first three years of existence. More specifically, Isvap requiresestimates of the balance sheet, and the qualitative and quantitative composition of assetsand liabilities, as well as the profit and loss accounts with the expected amounts ofpremiums, loss burden and production and administration costs.

The 1959 Act envisages minimum capital requirements that are nowadays insufficient:this is why they are calculated on the basis of the needs shown in the scheme ofoperations, with special reference to the nature of the risks that the undertaking intends tocover, the financial balance and the need to represent technical commitments.

No quantitative or qualitative limits are envisaged for assets representing technicalprovisions in reinsurance business (done by a professional reinsurer or by an undertakingwhich also pursues direct insurance); however, undertakings’ balance sheets must “showreal or easily realisable financial resources for an amount not lower than the existingtechnical provisions”.

Professional reinsurers are not subject to present regulations on direct insurance asregards the solvency margin; nonetheless composites must take reinsurance business intoaccount when calculating the solvency margin.

Like direct insurers, reinsurers must submit a report on the first half year, annual accountsand supervisory forms, except for a number of attachments and supervisory forms whichare not technically applicable. In this regard these undertakings – although they are notobliged to do so – have the report and the balance sheet audited on a voluntary basis.

The balance sheet must be approved before 30 June of the year following the financialyear to which it refers, and can be postponed until 30 September, but in this case therelevant reasons must be explained in the notes on the accounts.

The chart of accounts that companies must adopt applies to both insurance andreinsurance undertakings.

The said 1959 Act establishes that reinsurance undertakings must keep, apart from thebooks envisaged by the Italian civil code according to the type of company, the register ofcontracts, the list of claims reported and the register of premiums, although reinsurancepremiums are exempted from taxes if the latter have already been paid on the directpremium. According to the same code reinsurance contracts must be proved in writing.

Isvap has the same supervisory and sanctionary powers as those envisaged for insuranceundertakings and – based on the examination of the yearly balance sheet of reinsuranceundertakings or on any other evidence – may require information and documents, expresscriticism, raise objections and conduct inspections on the reinsurance premises and on allaspects of their activity.

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In case of business crisis, Isvap also has the same powers as those envisaged forundertakings pursuing direct insurance business even as regards the appointment of thead acta manager, the special management and the company`s compulsory liquidation.

Finally, on the basis of the valuation of the solvency of a reinsurer not based in a EUcountry, Isvap may not allow any technical provisions of a direct insurer to be covered byclaims against him.

5.6.5 The Netherlands

Licensing requirements

Few reinsurance companies are based in the Netherlands and overseas reinsurers play animportant role in the Dutch market. Pure reinsurance companies wishing to operate in theNetherlands do not require a licence. However, if a company also offers direct insuranceit is considered to be an insurance company and as a result, all business written by it(including the inward reinsurance) falls under the supervision of the Dutch regulator,according to EU rules.

Contrary to the practice with insurance companies, reinsurers do not need regulatoryapproval for their (non-)executive directors. However, when establishing a N.V. thecompany will need ministerial approval. The approval process includes the assessment offuture directors, although this is generally a formality.

Reinsurance companies cannot (directly or indirectly) obtain an ownership interest of 5%or more in a bank or insurance company without the consent of the regulator. Other thanthis, there are no compulsory guidelines on the investment policy of reinsurers.

Reporting requirements

Reinsurance companies are obliged to file two copies of their annual accounts anddirectors’ report with the insurance regulator. The accounts must comply with DutchGAAP. The accounting principles (including the valuation principles relating to technicalprovisions) are consistent with those for insurance companies. Reinsurance companies arenot required to file returns with the insurance regulator.

In addition to being required to file their annual financial statements, reinsurancecompanies must provide any information the regulator may need to fulfil its supervisoryobligations. The regulator has the power to approach the management and supervisoryboard of the reinsurance company when required.

Solvency requirements

There are no specific solvency requirements for reinsurance companies. However,reinsurance companies founded as a public limited liability company have to adhere togeneral requirements. Reinsurance companies belonging to an insurance conglomeratemust adhere to the EU directive on solvency requirements for insurance groups that hasbeen implemented under Dutch law as of calendar year 2001.

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Insurer’s procedures for monitoring reinsurer security

According to a study published by Pension and Insurance Supervision Board (PVK) thefollowing instruments are used to monitor the reinsurance practice of Dutch insurancecompanies:

§ Analysis of annual financial statements of Dutch reinsurance companies. All availableinformation is stored in a database and used as reference when reviewing the returnsof Dutch insurers and assessing the credit risk of the companies’ reinsurancerecoverables;

§ Review of annual returns;

§ On-site investigations, which include interviews with management and a review of asample of reinsurance contract and transactions. During the interview, the supervisoryauthority discusses the nature and magnitude of the risks ceded, the policy on netretention, measures taken concerning catastrophe risks and accumulation of risks, thechosen types of reinsurance, the exposure to individual reinsurers, and the selectioncriteria used to identify appropriate reinsurers. During the sample testing, theconditions of the reinsurance contracts are reviewed and the internal controlprocedures are tested;

§ Reinsurance is one of the topics addressed during the annual meeting that the PVK haswith management.

The reinsurance review in the annual returns of a non-life insurance company includes:

§ A description of the reinsurance strategy by line of business (cover obtained, netretention, type of reinsurance, measures taken regarding catastrophe risks);

§ A list of all reinsurers with whom the insurer has signed a non-proportionalreinsurance contract (excess of loss, stop loss);

§ A list of all reinsurers with whom a proportional reinsurance contract has been signedthat transfers more than 10% of the gross premium (quota share, surplus);

§ For each reinsurer an overview is provided of any outstanding balances, thereinsurance premiums ceded, the reinsurer’s share in claims incurred and in thetechnical provisions;

§ Collateral or deposits placed with the company are disclosed if they exceed 10% of thereinsurer’s share in the technical provisions.

The reinsurance review in the annual returns of a life insurance company include:

§ A description of the reinsurance strategy by type of reinsurance;

§ Information on the net retention (per incident);

§ A list of all reinsurers including the reinsurer’s share in the technical provisions andthe amount reinsured by type of reinsurance;

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§ Collateral or deposits placed with the company are disclosed if they exceed 10% of thereinsurer’s share in the technical provisions.

Insurance companies are concentrating the management of their reinsurance programmesat a group level. Generally speaking, the net retention is maximised for the group as awhole. Off-shore captives can be established.

In 2000, the PVK drafted new actuarial principles which proposed to link the safetymargins that an individual insurer should apply to the effectiveness of its riskmanagement policies. Indirectly this would also affect the way that the PVK monitorsoutwards reinsurance arrangements. The draft was revised based on comments receivedfrom local insurance companies and other parties involved. The final report was deliveredin September 2001. This report is referred to as the “basic principles for a financialassessment framework”. On the basis of these principles, the PVK has started to elaboratepractical policy rules for financial testing. However, it will take a few years before thenew policy rules become effective.

Adequacy of assets

Both in shareholders accounts and in the annual returns, investments (financialinstruments and real estate) may be valued at historical cost or market value. Fixedinterest investments may be valued at redemption price.

In May 2001 a specialist group appointed to review the accounting principles applied byinsurance companies issued a report with recommendations to improve the comparabilityof the financial statements of insurers. The report will result in new directives that areintended as an interim standard, awaiting the IASB standard on the accounting forinsurance contracts among others. The recommendations include:

§ valuation of equities at market value and fixed interest securities at amortised costs ormarket value;

§ the immediate inclusion of realised gains and losses on investments in net profit orinclusion of realised and unrealised gains and losses on investments in net profit;spreading these over time is not allowed;

§ life insurance provision: disclosure of the quantitative result of a statisticallyaccentuated adequacy test of the technical provision for life insurance, based onmodern, realistic principles.

§ non-life insurance provisions: disclosure of the run-off of the claims provision forunderwriting years already closed. A breakdown of the nature and value ofdevelopments of the provisions for catastrophes.

Dutch insurance companies disagree strongly with the immediate inclusion of realisedgains and losses in net profit. The outcome of the political debate on the new directives isas yet unclear.

The annual returns include an overview in which the insurance company must specify itsassets and liabilities that are held in foreign currencies.

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The regulator can challenge the valuation of an asset arising from an outwardsreinsurance contract.

In the light of IAS 32 that has been implemented in the Netherlands, companies arerequired to provide disclosure in the financial statements on the risks related to theirfinancial instruments.

In life-insurance business, models based on the calculation of the embedded value areused for asset-liability management and scenario analysis. The models applied focus onasset-liability mismatches.

Use of rating agencies

In the Netherlands, insurance companies can apply for a rating by one of theinternationally acknowledged rating companies, who typically publish the ratings on theirwebsites. There is no publicly available rating system designed specifically for the Dutchinsurance market. The regulator does not disclose any regulatory rating that could be usedas an indication of the companies’ risks. However, some information in the annual returnsmust be made publicly available. Several parties analyse this information to identifydevelopments in the Dutch market and publish “top-10” lists of insurance companies.

5.6.6 Spain

In general, reinsurance is regulated in the same way as direct insurance, although thereare minor differences. There is no legal requirement for reinsurance companies tomaintain a solvency margin.

Licensing requirements

Spanish reinsurers and foreign reinsurance entities or business associations which set upbranches in Spain require authorisation from the “Ministry of Economy”. If a companywhich is registered in an EEA country wishes to establish a branch in Spain a proceduresimilar to that applicable to direct insurers (European passport) is followed.

Foreign insurance or reinsurance companies or business associations operating in theirown countries, with or without Spanish branches, may also accept reinsurance operationsthrough their registered offices. In the case of entities registered in the EEA, suchoperations may be accepted through branches established in any member state. Theseentities do not require an authorisation.

Requirements for obtaining an authorisation are the same as those established for directinsurance companies and include restriction of statutory activity, submission of aprogramme of activities, forecasts for the first three years, minimum share capital,shareholders requirements and effectiveness of management. Ongoing compliance withrequirements is mandatory for obtaining and maintaining the State authorisation, whichwill be revoked if any non-compliance is detected. Any breaches of the regulation mayresult in the authorisation to underwrite new or to renew reinsurance contracts beingrevoked or suspended, depending on the degree of the breaches.

Reinsurance companies, like direct insurance companies, are subject to a regular on-siteinspection visit by the regulator.

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All members of the executive management must be individuals of proven integrity andwith appropriate qualifications, as established for direct insurance. These individualsshould figure in the administrative register of senior management. They must satisfycertain requirements before assuming such positions. The regulator monitors therequirement generally through inspection of new and existing companies.

Reporting requirements

There are certain differences between the documentation to be presented by insurers andreinsurers, as follows.

§ In the statistical documentation of balance sheet items, reinsurers should distinguishbetween group, associated and other companies with regard to creditors and debtorsfor accepted reinsurance. Details should also be given to the amount provided for baddebts on reinsurance accepted;

§ Model 12 requires a breakdown of technical provisions and deposits (actuarialprovisions, provisions for outstanding claims and other technical provisions), givingdetails of the amounts for the single line of business;

§ Model 19 requires details of premiums and claims settled by country, analysedbetween EEA member states, Switzerland, the USA and other countries.

The Spanish supervisory board requires annual accounts, director’s report, statisticalinformation and, where applicable, general and supplementary audit reports. The deadlinefor insurance companies is the 10 July of the following year. Reinsurance companieshave to deliver by the 10 October.

The regulator considers probable maximum losses and maximum exposures to the extentnecessary to grant operating licences.

Solvency requirements

Entities carrying out reinsurance operations are required to create, calculate, record andinvest provisions in the same way as direct insurance companies. There are no differencesbetween reinsurance and direct insurance in regard to the calculation of solvency marginsor the items covered thereby.

Legislation regulating reinsurance tends to favour specialisation, requiring that newlycreated entities carry out reinsurance activities exclusively. Additionally, and here thereare no differences with direct insurance, the controlling body favours specialisation byline of business and risk concentration policies.

We understand that the regulator is principally concerned with the following areas:

§ complexity of the reinsurance business;

§ the risk of insolvency of reinsurance entities which affects both the cedant and itsinsured parties (the protection of the primary insurer’s policyholders);

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§ the principle of diversifying risk culminates in the reinsurance business and,consequently, the concentration of risks on these should be avoided, given theincreased impact this could have on direct insurance;

§ a perceived need to regulate the continuous innovations in the sector, especially giventhe international scope involved. (It should be borne in mind that almost half of theinsurance companies operating in Spain are foreign-based).

Insurer’s procedures for monitoring reinsurer security

Spanish legislation only refers to the retention programme as follows: insurance andreinsurance companies must arrange their reinsurance programmes so that their netretention is appropriate, given their economic capacity, to maintain the company’sfinancial and technical stability.

Information on reinsurance has to be submitted to the regulator. Life insurance companies(when accepted reinsurance premiums represent more than 10% of total premiums) mustsubmit details of premiums analysed by individual and group policies, and by periodicand single premiums, by with and without profit participation, and where the investmentrisk is borne by the policyholder. Non-life insurance companies are required to submit abreakdown of technical income and expenses between direct insurance and assumedreinsurance (where premiums accepted exceed 10% of total premiums).

The following details must be submitted by insurers to the insurance authorities aboutceded business: type of reinsurance contracts, retention/priority and limit of the contracts(for each class of business representing more than 20% of direct business); listing ofreinsurers representing more than 5% of the ceded business and details of year endbalances with these reinsurers.

In addition, insurance companies must keep, inter alia, a register of accepted andoutwards reinsurance contracts with identification data for each individual reinsurancecontract. The information has to be distinguished between treaties and facultativecontracts. The information for each contract should include characteristics of the risksreinsured, conditions of reinsurance coverage and all other matters with an economicimpact.

The documentation to be submitted annually to the regulator requires a breakdown ofreinsurance by country.

No specific programmes have been set up by the Spanish regulator to monitor insurancecompanies’ risk management procedures, either generally or in particular in relation tothe reinsurance programme.

Adequacy of assets

Historical cost accounting rules are applied in accounting. However, for solvencypurposes, hidden reserves arising from the difference between the cost and market valueof investments are taken into account.

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The currency in which the investments are realisable must be matched with the currencyin which the insurance liability will be settled, when the assets in other currencies exceed7% of the total and when they exceed 20% of liabilities in the currency. There is anexception when the liabilities are payable in non EEA currencies. As a rule, financialinvestments must be issued in or subject to the control mechanisms of the OECD or theEEA, and deposited in the EEA. Similarly, real estate investments must be located withinthe EEA. Exceptions must be approved by the regulator.

The use of asset-liability management techniques for the management of expectedpayments for life insurance has increased. This enables insurance companies to guaranteetechnical interest rates on the basis of allocated investments, provided that they complywith certain requirements regarding maturities, financial duration and sensitivity of thecurrent value to variations in interest rates at specified future dates.

Use of rating agencies

In Spain, only a few insurance entities have been rated by an external agency (generallyStandard & Poor’s, Moody’s and Fitch IBCA) as there is no significant market pressureto obtain a rating. The regulations assume the use of credit rating in the following cases:use of appropriate assets for the coverage of life insurance provisions ; in the case of useof derivatives traded in OTC markets, both parties must have received a favourable creditrating; accounting legislation also takes into consideration the credit rating of the issuerwhen valuing fixed income securities.

5.6.7 Sweden

Reinsurance is in most aspects regulated in the same way as direct insurance. Somedifferences however exist, but not concerning solvency requirements.

Licensing requirements

A licence is required in order to practise reinsurance. However, this only concernsSwedish companies. Non-Swedish reinsurers can practise their business in Sweden on across-border or establishment basis without a licence. Branches from other countries thanEEA or Switzerland have to apply for a licence. The same rules apply for direct insuranceand reinsurance.

It is necessary to file an operating/business plan before obtaining a licence. Licensedentities are checked on a regular basis. If the requirements are not met the licence may bewithdrawn.

Reinsurers (companies and foreign branches) can be subject to on-site visits by theregulator in the same way as for direct insurers.

The same fit and proper requirements for controllers, directors and managers apply forreinsurers as for direct insurers, including a need to report changes in the management.An approval is not required when there are changes in management.

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Reporting requirements

Reporting requirements are almost the same as those established for direct insurancecompanies and the same deadlines are imposed depending on the size of the business.

Branches from EEA companies have to prepare a balance sheet and profit and lossaccounts. The requirements are the same as for direct insurance. Subsidiaries have topresent an annual report.

Regarding probable maximum losses and maximum exposures, the supervisor usuallydoes not monitor this area.

Solvency requirements

Reinsurance companies have to file an annual solvency declaration to the supervisoryauthority, and also report the level of technical provisions.

The solvency calculations are based on the EU directives. No major changes have beenmade.

Use of rating agencies

Most of the largest Swedish companies are rated by Standard and Poor’s based on publicinformation. At present there is no mechanism that gives an insurance company aregulatory rating or grading. However, the regulators are currently working on aninternational grading system to ensure stability within financial institutes includinginsurance companies.

5.6.8 France

5.6.8.1 Future revised regulations

A new law was adopted by parliament in May 2001 imposing specific regulation onreinsurers which is more extensive compared to existing regulation. This new law willsoon be complemented by detailed regulatory rules. The new rules would subjectreinsurers to an authorisation procedure similar to that for direct insurance companies. Itwould include adequate financial and technical means for the business to be written,quality of shareholders, procedures for financial recovery, and comparable sanctions(including withdrawal of the authorisation). Solvency requirements (including technicalprovisions, their coverage by admitted assets, and the solvency margin) will beimplemented in the future, and will differ from those applied to direct insurancecompanies to take account of the special features of reinsurance business.

5.6.8.2 Regulations currently in place

Licensing requirements

There is no need for a license for assumed reinsurance. There are no specific rules forreinsurance companies, but French reinsurers have to file some of the direct insurerinformation with the French supervisor, the “Commission de Contrôle des Assurances”,who also has the right to control French reinsurers.

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French reinsurers can be subject to on-site inspections like direct insurance companies.The same fit and proper requirements apply to reinsurers as to direct insurers.

Reporting requirements

French reinsurers have to file with the supervisor in a format derived from the directinsurer’s format. Financial statements must be approved by the shareholders no later than6 months after the year-end.

Reinsurance subsidiaries are treated as a special category of domestic reinsurers. Thereare no supervisory requirements for branches of foreign reinsurers. Only reinsurersincorporated in France are supervised and considered supervisable.

Newly established reinsurers must send specified details to the supervisor including thestatutes of the company and names of the directors. Financial statements required by thesupervisor are the same as for direct insurers.

Solvency requirements

French reinsurers are not required to cover their technical provisions by admitted assets orto comply with a solvency margin.

Insurer’s procedures for monitoring reinsurer security

As stated in the framework of the mission of permanent supervision of insurancecompanies, it is the French supervisor’s responsibility to assess the adequacy ofreinsurance programmes of direct insurers on a case by case basis.

In meeting this responsibility, the supervisor may examine in detail the reinsuranceprogramme during on-site audits to insurance companies.

Regarding information required to be submitted to the supervisor, property and casualtyinsurance companies need to file two schedules every year that give summarizedinformation on assumptions and cessions:

§ Schedule C3 which provides a breakdown of assumed and ceded reinsurancepremiums, insurance liabilities, technical balance (premiums less loss expenses lessacquisition expenses), and interest expense on cash deposits from reinsurers. Thisinformation is further analysed for group companies and non group companies, andfor French and foreign reinsurers;

§ Schedule C13 which analyses operations by accident year for ceded paid losses,reinsurers’ share of loss reserves at the beginning and at the end of the financial year,and for some categories, increase in reinsurers’ share of earned premiums.

The technical provisions are assessed before reinsurance.

A company’s reinsurance recoverables are admitted in coverage of these gross technicalprovisions only up to the amounts secured by collateral from the corresponding reinsurers(or cash deposits or letters of credit from banks under specific conditions). Insurancecompanies also have to check the financial heath of their reinsurers, as recommended bythe OECD.

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The French insurance law provides prudential rules on the quality of collaterals.

The supervisor has two prospective tools in order to monitor risk management proceduresin relation to the reinsurance programmes. He can examine the annual solvency report,which analyses the sufficiency of assets as regard liabilities and possible future solvencymargin requirements; and the quarterly schedule called T3, which aims at assessing theeffect of stress-testing on asset-liability management. Moreover, the supervisor can askthe company to provide any information deemed necessary and carry out on-siteinspections.

So far the supervisor has controlled individual companies. The implementation of the1998 insurance groups directive will change this by introducing a group approach.

Adequacy of assets

Assets are usually carried at cost except fixed income securities which are carried atamortised cost. Investments are to be individually written down if a decrease in marketvalue is considered permanent. If the market value of the overall investment portfolioother than bonds is lower than the carrying value, then the value is written down to themarket value.

Insurance liabilities have to be covered by assets in a currency which matches thecurrency of the insurance liability. Pending the entering into force of the new regulation,this requirement does not apply to reinsurers.

Regarding assets arising from outwards reinsurance contracts, cash deposits by reinsurersenable the insurance company, in principle, to have adequate assets in coverage of grosstechnical provisions. Reinsurance recoverables are admitted in coverage of grosstechnical provisions up to the amounts secured by collateral.

The supervisor has recently developed some schedules (quarterly report) to assessexposure to interest rates and capital market changes on the assets and liabilities of thecompanies.

Use of rating agencies

In France, only the major insurance groups have a rating provided by a rating agency(Standard & Poor’s, Moody’s or Fitch IBCA). They are automatically rated when listedon a US stock exchange, otherwise French insurance companies have to request ratingagencies for a rating. No use of ratings is made by the supervisor.

5.6.9 United Kingdom

5.6.9.1 The company market

In the UK, the legislative framework for supervision makes little distinction betweeninsurance business and reinsurance. The main objective of the regulation of reinsurancebusiness is the same as that for direct business, i.e. confirmation of the company’songoing ability to meet its obligations to policyholders (in this case other insurers).

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Licensing requirements

Reinsurance business is regulated in exactly the same way as direct insurance business,for which the requirements are derived from the appropriate EU Directives. In order tobecome authorised, an applicant is required to submit financial forecasts and otherinformation required by the relevant legislation.

Reinsurers are subject to on-site inspections in the same way as direct insurers. Fit andproper requirements apply exactly as for direct business, as does the need for theregulator’s approval of changes in management.

Reporting requirements

The reporting required by the regulator is the same as for that for direct business. A returnis to be submitted normally annually, but in certain cases (e.g. new companies) quarterly.This is a standard form and includes calculation of the required solvency margin, balancesheet, revenue account, reinsurance arrangements and detailed analysis of revenueheadings. All annual returns require a report by the auditor and in the case of life businessan actuarial report on the adequacy of technical provisions is required also.

The UK branches of non EU-companies are supervised in the same way as UKcompanies. In addition returns with their global figures have to be submitted.

Solvency requirements

Reinsurers in the company market are subject to the same solvency requirements as directinsurers. However, there are differences in the approach taken by the regulator,recognising the different nature of reinsurance business.

In addition to the standard regulatory reporting and solvency tests to which all UKauthorised insurance companies are subjected, the regulator carries out certain additionalchecks on insurance companies operating in the London Market. These involveprincipally looking at the reinsurer’s solvency position under a number of different lossscenarios and estimating probable maximum losses, in order to assess the degree of riskinherent in the liability side of the balance sheet. Also, an attempt is made to rankreinsurers according to risk assessments made by the regulator based on its loss scenariotesting.

This type of approach represents an attempt to recognise the additional risks posed by areinsurer, as a result of the complexity of its business and the volatility inherent in itsreinsurance liabilities. With regard to the solvency position, there are two principal risksposed by claims provisions: first, the possibility that future claims events in respect ofcontracts already entered into may exceed expected levels, and second, that claimsalready incurred but not settled may exceed amounts provided within liabilities.Interestingly, neither of these possibilities are explicitly dealt with by the current solvencymargin methodology.

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For professional reinsurers writing life business, the solvency margin calculation appliesa different rate (0.1% rather than 0.3%) to capital at risk. Other differences apply toreinsurance business rather than to reinsurance companies. The matching and localisationrequirements do not apply to reinsurance business. Non-life reinsurance business isanalysed separately in the regulatory returns and is accounted for on an underwriting yearbasis rather than an accident year basis. Most fundamentally, the authorisation of non-UKreinsurers applies to their worldwide operations, not just to business carried on in the UK.

5.6.9.2 The Lloyd’s market

The supervisory approach within the Lloyd’s market is somewhat different to thecompany market in the UK. In particular, Lloyd’s operates a risk based system andfocuses its regulatory efforts on perceived high risk areas. Whilst the approachencompasses both insurance and reinsurance business, the emphasis on risk means thatreinsurance business may be monitored more closely; syndicates are required, forexample, to produce Realistic Disaster Scenarios, identifying their potential exposure tomajor losses.

In addition, Lloyd’s has on occasion undertaken reviews into the market-wide use ofspecific reinsurers, in attempts to identify potential problems.

Further details of the regulatory approach adopted by Lloyd’s is included in Appendix 3.

5.7 Supervision of reinsurance in major non-EU countries

The varied approach to supervision of reinsurance across the EU is reflected elsewhere inthe world. However, where reinsurance is regulated, the approach usually differs littlefrom the approach to regulation of insurance business. Solvency or equivalentrequirements are usually based on the same rationale, and although there may be higherrequirements for reinsurers writing significant amounts of catastrophe business, theoverall approach to supervision is usually similar.

5.7.1 Canada

Reinsurance is explicitly defined and included within the overall business of insurance.The main objective of the regulation of reinsurance business is to minimize the possibilityof credit loss on reinsurance for the ceding direct insurers.

Licensing requirements

Whilst reinsurance can be bought from unlicensed reinsurers, the ceding company, inorder to obtain reinsurance credit for its own statutory reporting purposes, would typicallyrequire the reinsurer to post a letter of credit.

To obtain and maintain a licence in Canada, a reinsurer would make a standardapplication to the federal regulator, make the required statutory filings and maintain alevel of assets in Canada sufficient to service the level of liabilities it reinsures, asprescribed in the regulator’s rules.

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The Canadian regulator operates a licensing system, and supervises reinsurance businessin essentially the same way as direct insurance business, except that reinsurers do not dealwith the public and accordingly do not have market conduct regulation to comply with.

There are a number of subjective matters to be considered by regulators in decidingwhether to grant a licence including, adequate financial resources to provide minimumcapital; providing a sound written business plan for the review of the regulator; a recordof successful business operations by the owners of at least five years; management teamwith proven experience; compatibility of the proposal with the best interests of theCanadian financial system; equally favourable treatment accorded to Canadian companiesin the countries in which the foreign insurer principally conducts business; ability tocomply with all relevant Canadian legal requirements.

Minimum initial capital requirements are higher for reinsurers than for direct writers,reflecting the perceived greater inherent risks in reinsurance. Ongoing capitalrequirements are also calculated based on the actual risks undertaken by the insurer, onthe same basis for both direct insurers and reinsurers.

Initial and ongoing governance requirements are the same for reinsurers as for otherinsurers, appropriate books and records must be maintained in accordance with GAAP;generally accepted actuarial standards must be used; appropriate systems of internalcontrol must be maintained; directors and officers, as well as the auditor and appointedactuary, have duties to remedy breaches of law and regulation, and to report to theregulator any breach that is not remedied on a timely basis, as well as any conditionthreatening the “well being” of the insurer.

Once an insurer (whether a direct insurer or a reinsurer) is initially licensed, it is subjectto ongoing supervision. This monitoring is done by the regulator through review ofannual audited financial returns and actuarial opinions, unaudited quarterly financialreturns, and an annual contact or visit from regulatory staff.

The regulator can place restrictions on a licence (e.g. limiting or prohibiting newbusiness, limiting renewals) unless conditions such as inadequate capitalisation areremedied. Withdrawal of a licence would prevent an insurer from carrying on business.These sanctions, together with monetary fines, can be used to compel insurers to remedya wide range of problems, such as poor market conduct, poor governance procedures orother breaches of the legislation or regulation. In extreme cases, the regulator can takecontrol of an insurer and place it in liquidation, ordinarily to protect policyholders andclaimants when an insurer is insolvent.

Reinsurance companies can be subject to regular on-site inspection visits by the regulatoras for direct insurance companies.

Directors and certain officers, including the chief executive officer, secretary, treasurer,controller, actuary and any other officer reporting to the board of the CEO, are required tomeet the fit and proper criteria. Changes in senior management are ordinarily reported tothe regulator as a courtesy. There are no requirements for management and no regulatoryapproval is required.

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Reporting requirements

The financial reporting requirements are essentially the same as for direct insurers,audited financial statements and regulatory returns are required, together with anappointed actuary’s report on the technical provisions for policy liabilities. The regulatoryreturns are in the same form and level of details as for direct insurers.

All reinsurers are required to report on a GAAP basis, regardless of whether they areforeign-owned or domestic, and regardless of whether they are organised as a company ora branch.

Reinsurers have adapted to shorter reporting deadlines by the use of estimates and moreactuarial analysis. This has been made necessary both by earlier deadlines for regulatoryreporting, and also by accelerating reporting deadlines of their parent companies, some ofwhich are publicly listed.

Solvency requirements

Technical provisions are based on accepted actuarial standards. Equalisation provisionsare forbidden as they are contrary to both GAAP and actuarial standards. An appointedactuary’s report is required on the technical provisions for policy liabilities. The non-lifesolvency provision is largely derived from amounts in the audited financial statements,while the life solvency provision is subject to annual audit by the external auditors.

Reinsurers are subject to risk-based minimum solvency requirements – a minimum assettest (MAT) for non-life, and minimum continuing capital and surplus requirement(MCCSR) for life. These requirements are the same as those that apply to insurers.

Insurer’s procedure for monitoring reinsurers security

The regulator reviews the general details of the reinsurance programme. An outline of thereinsurance programme of a non-life insurer is typically included in the annual appointedactuary’s report. In addition, the regulator has specified more detailed requirements forearthquake exposures, including studies estimating the insurer’s probable maximum lossin a given geographic area. These are used to monitor the preparedness of an insurer,including its reinsurance arrangements, to survive such a loss.

The annual statutory return schedules referred to above requires a list of reinsurers(identifying which are affiliates) and the premiums and claims ceded to each company.Separate schedules provide details of reinsurance ceded to unregistered reinsurers, so thatthe impact on the solvency margin can be calculated. Schedules in the statutory returnrequire details of any collateral or deposits placed by the reinsurer.

The regulator places emphasis on the assets maintained in Canada, and the solvencyratios of the Canadian operation of the reinsurer.

Regarding the monitoring of risk management procedures in relation to the reinsuranceprogramme, the regulator is beginning to see the results of life insurer companies’ riskself-assessments, and the review of those self-assessments in the course of annualinspection visits. All insurers are expected to monitor the credit worthiness of theirreinsurers.

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Larger multinational insurers have increasingly coordinated reinsurance within theirgroups, with the result that the coordination often occurs outside the country, andfrequently involves affiliated company reinsurers. The regulator must usually deal withthe information available within Canada.

The regulator is not currently reviewing the treatment of reinsurance ceded for regulatorypurposes.

Adequacy of assets

In non-life business, a cost basis is used in both the shareholder accounts and regulatoryreturns. Investments are set at market value for solvency testing purposes.

In life business, cost basis is used in both the shareholder accounts and regulatory returns,except for investments in equities and real estate, which are marked to market at 15% and10% per year respectively. Similarly, realised gains on equities and real estate aredeferred and amortised to income at 15% and 10% per year respectively.

There are no specific foreign exchange regulatory requirements. However, mismatchedcurrency risks could give rise to higher actuarial liabilities and higher risk-based capitalrequirements.

Explicit asset-liability matching techniques are used in life business. Future cash flowsare modelled to develop life insurance actuarial liabilities, and specifically to develop aprovision for asset-liability mismatches. Portfolio management practices are reasonablysophisticated for life insurers. Non-life insurers commonly manage liquidity in morebasic ways, and are most likely to deal with diversification in terms of concentrationlimits or similar approaches.

Use of rating agencies

In Canada, the publicly quoted stock companies for the most part have a rating providedby a rating agency. Most smaller companies do not engage a rating agency. Where theinsurer does not request a rating, one rating agency (AM Best) may publish a“provisional” rating based on published financial information. Standard & Poor’s, AMBest and Canadian Bond Rating Service are the main rating agencies. Ratings generallyinclude both capital instruments and claims paying ability. There is no explicit use by theregulator.

5.7.2 The USA

The regulation of reinsurance in the USA closely follows that of direct insurancebusiness. Licensing follows the same structure and solvency requirements follow a riskbased capital approach as required for insurers.

Reinsurance is generally covered by the broad definition of insurance in most states, butall states have specific reinsurance statutes under their insurance law.

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Licensing requirements

Foreign companies can establish themselves as either an Authorised (licensed) orAccredited reinsurer. Each state has unique licensing requirements. The requirements tobecome an Accredited Reinsurer is mandated by the NAIC’s “Model Law on Credit forReinsurance”. Certain provisions of the Accredited Reinsurer provision are unique toreinsurers.

To be accredited there are accounting/financial reporting and requests for information andon site inspection criteria. Sanctions which may be imposed are withdrawing the licenceor accreditation or possibly requiring more stringent reporting.

Generally, key management and financial reporting personnel and members of the boardof directors are required to meet the criteria of “integrity and competence ofmanagement”.

Reporting requirements

For reporting purposes, reinsurance is generally subject to less detailed reporting inregulatory filings. Statutory filing requirements are guided by the filing company’s stateof domicile. For authorised reinsurers, annual statements are due to the NAIC. Non-domestic companies have the same filing requirements as domestic companies.

For regulatory filings, non-life insurance companies include the following based onrelevance:

§ A description of the reinsurance strategy (cover obtained, net retention, type ofreinsurance, measures taken regarding catastrophic risks);

§ A list of reinsurers with whom the insurer has amounts due;

§ Collateral or deposits placed with the company are disclosed if they exceed 10% of thereinsurer’s share in the technical provisions.

Solvency requirements

Solvency requirements follow a risk based capital approach, as for direct insurers. Thisapproach, based on a model established by the NAIC, measures the various risks in thebusiness, including investment risks, and calculates a score relative to the insurer’s statedcapital. In the event of deficiencies, certain actions are taken. The models are relativelycomplex and cover a broad range of risks. Since the underlying accounting model haschanged with effect from 1 January 2001, these models will need to be revisited to ensureproper calculations. In addition, an older more traditional model still exists but generallyhas little impact.

Supervision is subject to the rules and regulations of individual states. Most states haveadopted the NAIC’s capital models, but in some cases the local rules are more or lessrestrictive, by requiring a minimum or larger capital requirement.

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Insurer’s procedure for monitoring reinsurers security

One interesting feature of the US approach is the extensive information required byregulators in respect of a cedant’s outwards reinsurance programme:

§ The review of outwards reinsurance is based on periodic state regulatory examinationsof cedants. Furthermore, significant contracts are likely to be discussed and agreedwith regulators in advance. There are a number of credit related requirements to helpminimise potential losses on outwards reinsurance. For example, the reinsurer mayhave to post letters of credit or trust accounts in order for receivables to be allowed tobe counted for regulatory capital requirements.

§ Cedants are required to continually monitor the credit worthiness of their reinsurers.Statutory requirements stipulate such monitoring, as well as accounting and auditingliterature.

§ In connection with the quarterly and annual reporting of financial results, insurers arerequired to provide comprehensive information, showing the reinsurers and theirrelated balances. This information is fairly well scrutinized to monitor troublesituations. In addition, limited additional information is contained in notes to thefinancial statements filed by the company in February following the year-end.

Adequacy of assets

Invested assets are valued at amortised cost for fixed maturity investments and marketvalue for equities.

Financial statements typically contain a number of disclosures relating to riskmanagement and financial instruments used to manage risks. In addition, the SECimposes a significant amount of disclosures on market risks relating to derivatives andfinancial instruments in the annual form 10-K.

Regulators impose significant financial and modelling requirements on companies, suchas cash flow testing. The financial statements include many disclosures, but the filingswith regulators contain much more detail.

Use of rating agencies

Several rating agencies exist in the US. AM Best is the most widely recognised ratingagency for the insurance industry. While the rating agency information is important,insurance regulators generally do not rely significantly on this information, but preparetheir own analysis and information to monitor companies. There are several types ofratings including, claims paying ability or capital instruments. The regulator does not useany internal ratings or market mechanisms in its regulatory process.

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5.7.3 Bermuda

The approach to the regulation of reinsurance broadly follows direct insurance, and thereis no difference in methodology in calculating solvency margins for insurance andreinsurance companies.

Licensing requirements

A licence is required in order to practise reinsurance in Bermuda. To obtain it a reinsurerwould make an application to the regulator and be required to maintain the requiredamount of capital to support its licence application. The applicant must submit a businessplan including information on its products, investments, capital, reinsurance, managementand shareholders. The company must appoint a principal representative, a statutoryauditor and a loss reserve specialist, all of which have statutory duties under theregulation.

The Bermuda regulator does not generally conduct site visits to reinsurance or insurancecompanies, although he has the power to perform them. All new applications of reinsurersare reviewed for fit and proper persons. Additional requirements for this criteria androutine on site inspections are scheduled to be introduced in the current year.

Reporting requirements

All reinsurers are required to have an annual audit and must file an annual statutoryreturn, which includes an audit opinion, a solvency certificate, and analysis of premiums,key operating ratios and an opinion from a loss reserve specialist (actuary).

Solvency requirements

Although the formula and principles are the same, different parameters are used incalculating the solvency margin, depending on the classification of the business. Theclassification could be one of four types:

§ Class 1 – Single parent captive insurer

§ Class 2 – Multi-owner captives

§ Class 3 – Insurers and reinsurers not included in Class 1,2 or 4 and normally includingreinsurers writing third party business, insurers writing direct policies with third partyinsurers and finite risk insurers.

§ Class 4 – Insurers and reinsurers having the intention of underwriting direct excessliability and/or property catastrophe reinsurance risk.

As seen above, insurers and reinsurers are generally class 3. However, if there is excessliability or property catastrophe reinsurance risk i.e. the higher risk categories, then theyare classified as Class 4.

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Based on the above Classes, the solvency calculation is as follows:

Class of insurer Class 1 Class 2 Class 3 Class 4Minimum Capital &Surplus

$120,000 $250,000 $1,000,000 $100,000,000

Premium TestFirst $6 million of NPW(net premium written)NPW excess of $6 million

20%10%

20%10%

20%15%

50% (Note 1)50% (Note 1)

Loss and Loss Expensereserve

10% 10% 15% 15%

Note 1: For Class 4 insurers, the test is 50% of net written premium with maximumdeduction for reinsurance of 25% of GPW (Gross Premium Written).

The main objective of the regulation of the reinsurance business is to ensure that thereinsurer has sufficient solvency and liquidity to meet claim obligations.

5.7.4 Switzerland

Reinsurance business is covered in insurance regulation but most requirements for directinsurance companies do not apply to reinsurance companies.

The Swiss reinsurance market is of course unique, being home to some of the world’slargest reinsurers. The concept of self-regulation by market forces is evident in theregulatory approach.

Licensing requirements

The supervisory legislation provides that all insurance companies constituted under civillaw and carrying on business in Switzerland are subject to supervision unless exemptedby it. Exemption from supervision applies to foreign insurance companies operating inSwitzerland which write reinsurance business only.

Therefore foreign insurance companies which intend to carry on reinsurance business inSwitzerland require no authorisation and are exempted from federal supervision.Authorisation and supervision is required for Swiss reinsurers.

In order to obtain a licence a company must submit a business plan. The business planmust contain information concerning business purpose and internal organisation; theplanned business areas and geographic areas of activity; information necessary to assesssolvency; the by-laws; the balance sheet and annual financial statements or, if applicable,the opening balance sheet and the budget; the tariffs requiring approval and otherinsurance materials to be used in Switzerland; details as to the technical reserves,reinsurance and, if applicable, amounts payable on settlement as well as participation insurpluses. Breaches of the regulations may lead to the withdrawal of the licence.

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Reporting requirements

Reinsurers must complete an annual reporting package to the regulator. Disclosures perline of business are required for direct insurance and reinsurance. Reinsurers often used toreport their underwriting results one year in arrears, but this practice is now uncommon.

Solvency requirements

Whilst there is no solvency requirement set out in legislation, the Swiss regulator doesapply a benchmark of 20% of net premium as a minimum equity requirement. There areno fit and proper requirements and no consideration of probable maximum losses andmaximum exposures by the regulator.

Insurer’s procedures for monitoring reinsurer security

Swiss reinsurance companies report the names of all relevant reinsurance partners to theregulator in the annual reporting package. In general Swiss companies reinsure theirbusiness with highly-rated global reinsurers. Therefore no special focus for the regulatorhas been needed in this area in the past.

The reinsurance programme is not an explicit part of the business plan during thelicensing/authorisation process. It is common practice that the risk assessment is a keytheme in the informal meetings between the regulator and management in the start-upphase.

No additional information on the reinsurance protection programme is collected by theregulator in the annual reporting package. At an interval of about four years, a team fromthe regulator visits the insurance company and discusses such subjects with managementdirectly.

There is no requirement to provide the regulator with details of collateral or deposits.

Most Swiss insurance companies are part of a global group controlled by a foreigncompany or are global players themselves. As a tendency, more and more business isaggregated within the group and reinsurance coverage is placed with third-partyreinsurers with a considerable retention limit. The treatment is supported by the fact thatmost direct insurance companies hold a license for assumed reinsurance as well.

The regulator is not currently reviewing the treatment of reinsurance ceded.

Adequacy of assets

Individual company financial statements and regulatory returns generally use lower ofcost and market value for equities without writing up investments previously writtendown when the market value recovers. Fixed interest securities are normally valued atamortised cost. Market value is often used in consolidated financial statements. Thedifference between market value and cost may be taken into account in assessingsolvency.

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There are requirements to hold “designated assets” to match the insurance liabilities andat most 30% of these assets may be foreign. However, there are no requirements as towhere the securities must be deposited for a Swiss company. The “designated assets”must be held separately from the other assets of the company whether they are held by thecompany itself at its head office or by third parties. For obligations denominated in aforeign currency, the insurance institution has to invest at least 80% of the designatedassets in valuables of the same currency. Foreign insurance institutions must have at theirdisposal in Switzerland assets in the amount of the solvency margin, computed on thebasis of the Swiss business.

There are no restrictions on recognition of assets from outwards reinsurance except forthose inherent in the EU calculation of the solvency margin.

Companies are beginning to calculate measures such as value at risk on their assetportfolio, but linkages between asset and liability risk is a theme being looked at bycompanies rather than something that is already in place.

Use of rating agencies

The major players in the Swiss market are rated by the major international agencies(Standard & Poor’s analyses 36 Swiss insurance and reinsurance companies and AM Bestanalyses 37 companies). The regulator does not make any systematic use of ratings in theregulatory process, in practice little disclosure is given. There is no mechanism inSwitzerland which feeds back to the market any regulatory grading either implicitly orexplicitly.

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6 The rationale with regard to supervisory parameters

6.1 Scope

In accordance with the Terms of Reference, this chapter examines “the rationale withregard to supervisory parameters such as:

- the examination of the adequacy and spread of reinsurance arrangements at the levelof the primary insurer, the admissibility of reinsurance assets for the primary insurer,etc.;

- licensing or registration;

- fit and proper criteria, notification of managers and shareholders at specified levels,adequacy of technical provisions, assets, solvency margin, the importance ofmaximum exposure techniques for risk monitoring by the reinsurer, the possible use ofrating agencies;

- on site inspections.

The study should examine the broad impact and relevance of different accountingpractices, reporting and disclosure requirements (including nature and frequency). Thestudy should comment on the relative importance and feasibility of supervising theparameters in question and its practical implementation with regard to EU and non-EUregistered reinsurers”.

6.2 Approach

In reporting on the above objective, we undertook the following approach:

§ Use of existing specialist knowledge;

§ Use of questionnaires to KPMG offices and a number of interviews with reinsurers;

§ Reviews of existing published sources.

6.3 Extent of supervision

6.3.1 No supervision or self regulation

In a fully liberalised system with free reinsurance trade between domestic insurancecompanies and domestic/foreign reinsurers, insurers are free to choose their reinsurersand are responsible for their business.

A minimal control supplemented by self-regulation, in practice, means that reinsurerscapable of self-regulation are allowed considerable freedom in carrying out theirbusiness, with a minimum of interference from the authorities. In self-regulation, the rulesare drafted by market participants with an intimate knowledge of the market who are bestplaced to maximize the effectiveness of regulation while minimizing the business costs

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Free reinsurance trade between insurers and reinsurers offers the advantage of highflexibility for the spreading of risk among reinsurers and makes it easier for participantsto respond to market needs. Advocates of such a system argue that supervision can createan inequality in the market which may influence effective competition.

The absence of any supervision may lead to the use of low-quality reinsurers, affectingthe solvency of insurance companies and may affect transparency of the market andoverall stability. The majority of EU members support supervision since they do not wantinsurers to obtain poor quality reinsurance. In addition the reinsurance market isbecoming more risky with for example the rising number of captive reinsuranceundertakings or the growing concentration of risks, so greater protection seems to berequired for reinsurers. As the global economy continues to grow, the need for stable andsecure reinsurance will grow with it.

Some in the reinsurance industry state that there is no justification for detailed statesupervision in a wholesale business such as reinsurance. Commercial insurers andreinsurers deal with other professional corporations, business to business. Thesecorporations do not need special protection. The insurance companies are well equippedto distinguish honest and well-capitalised business partners from dubious and financiallyweak reinsurers.

They argue that the objective of reinsurance regulation is unclear. The objective ofinsurance policyholder protection would not be achieved by regulating reinsurance. Thecases of insolvency of reinsurance companies are rare and no insurance company hasbecome insolvent as a result of the insolvency of a reinsurer. Most reinsuranceinsolvencies have occurred in regulated markets. Reinsurance is an economic asset. Itenables a wider spread of risk, which enables direct insurers to write more business. Anydisruptive regulation that hampers the supply of reinsurance capacity would have anegative impact on insurance policyholders, as insurance companies will provide lesscapacity as a consequence. Any heavy-handed reinsurance regulation would beineffective and disruptive. The reinsurance market has become very innovative in recentyears, so that a special difficulty of regulation will be keeping regulators educated on thenew types of products.

In summary, it can be said that opponents of the self regulated reinsurance market aredriven by the fear of insolvencies of reinsurance companies, because of the complexity ofthe business. Unregulated markets have shown in the past that the inherent risk does notseem to be higher than in regulated markets. There is also no evidence that cedants allover the world consider risk in these markets higher. Our analysis did not show that selfregulated companies have an inferior market position or have to accept lower premiums.

6.3.2 Limited or comprehensive supervision

A comprehensive direct supervision system generally involves financial supervision andon-going control.

Limited supervision involves the application of only some elements of the directinsurance supervisory system to reinsurers.

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In a rapidly changing reinsurance world and reinsurance market dynamics, it may becomeincreasingly difficult for a primary insurer to assess the reinsurer’s security. If thereinsurers are directly supervised, the supervisor will be concerned about reinsurance incomparison with other innovative financial arrangements and will monitor the financialposition of the reinsurer21. On the other hand, it may be difficult, if not impossible, forsupervisors to take full responsibility for assessing the reinsurers’ security. However, thesupervisor faces the same difficulties of a rapidly changing market and is not even amarket participant.

It is argued that reinsurance is becoming more prevalent while at the same time the scopeof the risks covered is continuously growing and hence the potential for losses is rapidlyincreasing, and the number of captive reinsurance undertakings is rising. Such evolutionmeans that more prudence is required and that indirect supervision may be insufficient.Others argue that direct supervision is too strict and should be reserved for new marketplayers, for which evaluation is not yet established.

In a direct supervision system, the reinsurer has to submit financial information to thesupervisory authorities. The supervisor may have more information and more capacitythan a ceding insurer (in indirect supervision) to assess a reinsurer’s security.Requirements set by the regulator on capital adequacy or admissibility of investmentsmay be stricter and take into account fuller information than that provided to a cedinginsurer, so that the regulator can make a broader and deeper assessment.

Many countries consider it an advantage that reinsurance supervision is done in the sameform and detail as for direct insurers. Generally, at least some of the elements ofinsurance supervision are used for reinsurance companies. Another advantage is that it isrelatively easy to implement a system based on the rules already applied to directinsurance.

However, some state that the current regulatory regime for direct insurers cannot simplybe applied in its entirety to the reinsurance sector. There are key differences between theregulation of retail and wholesale markets.

Reinsurance is a business conducted between sophisticated parties of essentially equalbargaining power. Companies buying reinsurance policies do not need the same kind ofprotection as private policyholders. Models for supervision which are appropriate forinsurance companies do not fit the special character of reinsurance business, especially asreinsurance business is more international than insurance business.

Some aspects require special consideration such as the correct level of technical reservesfor a reinsurer and its calculation and accounting or the necessity of different solvencymargins and separation of funds for entities carrying on both direct and reinsurancebusiness.

Such an approach requires extra resources to enforce the rules which means thesupervisory costs are higher than under a system of indirect supervision.

21 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles,

standard and practices, February 2000

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The IAIS notes that an insurance supervisor may encounter problems in exercising thesupervision of both the insurer and the reinsurer in that it may have a conflict of interestconcerning the confidentiality of information received.

In the United Kingdom, some associations, like the International UnderwritingAssociation of London (IUA), argue that the information currently required is not asappropriate to the supervision of reinsurers as it is to the supervision of primary insurers.Less information could be demanded in terms of quantity than is required of the primarysector insurers. More appropriate key data could be provided by reinsurers earlier in theprocess than at the present time. The regulator could also aim to promote high standardsand best practice by establishing benchmarks and issuing guidance notes on issues suchas off-balance sheet items or reinsurance credit risk.

To conclude, advocates of regulation are motivated solely by the need to preventinsolvencies. If direct supervision is chosen as a general system, it can fulfil its objectiveonly if the regulating authority has knowledge and capacity to follow the rapidlychanging variety of products and can cover the whole (global) business of a professionalreinsurer. The experience of the past has shown that insolvencies of reinsurancecompanies occurred infrequently and have been more common in regulated markets.Reliance on regulation can stop direct insurers from taking full responsibility forchoosing the right partner for retrocession.

6.4 Overview of supervisory parameters

6.4.1 Direct and indirect supervision

There are two levels at which supervision can be applied to reinsurance business: directsupervision and indirect supervision. Indirect supervision, which focuses on thereinsurance arrangements of the direct insurer, is aimed at protecting policyholdersagainst the risk of a direct insurer defaulting as a result of a failure in its reinsuranceprotection. The primary purpose of direct supervision of reinsurance companies is tomaintain confidence in a country’s reinsurance market. The fact that those jurisdictionswhich do regulate reinsurers do not prohibit direct insurers from placing cover withunregulated reinsurers indicates that they do not consider direct supervision ofreinsurance to be a pre-requisite for the protection of policyholders, although clearly anyrules which serve to promote the secure operation of reinsurers should in turn enhance thesecurity of direct insurers and thereby indirectly improve the protection of individualpolicyholders.

Direct and indirect supervision therefore have distinct purposes. It follows that it ispossible for a jurisdiction to have either or both direct and indirect supervision. Direct andindirect supervision are not alternatives to each other.

Indirect supervision was recommended by the OECD in 1998 in its “Recommendation ofthe Council on assessment of reinsurance companies”.

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6.4.2 Classification of parameters 22

6.4.2.1 Parameters relating to direct supervision

The principal parameters relating to direct supervision, grouped by the IAIS insurancecore principles, are as follows:

§ licensing:

- fit and proper criteria for management;

- review of business plan;

§ passport systems:

§ changes in control;

§ corporate governance;

§ internal controls and risk management;

§ prudential rules on assets:

- diversification requirements;

- restrictions on asset types;

- asset valuation rules;

- matching rules;

§ prudential rules on liabilities:

- liability valuation rules and restrictions on discounting;

- rules on methods to be used;

- certification by loss reserving specialist;

§ capital adequacy and solvency:

- solvency margins;

- resilience and scenario testing;

- equalisation and catastrophe provisions;

22 This section mainly follows the IAIS Core Principles and the supervisory parameters

associated with each principle. (cf. IAIS Insurance Core Principles, October 2000) Theclassification of the IAIS Core Principles has slightly been modified in some cases, e.g.derivatives have been considered together with assets.

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§ market conduct;

§ financial reporting;

§ on-site inspection:

- inspection by the supervisor;

- inspection by third parties, such as auditors.

6.4.2.2 Parameters relating to indirect supervision

Principle 10 of the IAIS Core Principles relates to reinsurance which requires insurancesupervisors to be “able to review reinsurance arrangements, to assess the degree ofreliance placed on these arrangements and to determine the appropriateness of suchreliance”23. In other words, this principle relates to indirect supervision. The principalparameters relating to indirect supervision are:

§ direct review of reinsurance programme;

§ limits on maximum exposures;

§ admissibility of reinsurance assets for the primary insurer;

§ collateral requirements;

§ diversification requirements;

§ use of rating agencies;

§ restrictions on use of non-regulated reinsurers;

§ restrictions on use of “unapproved reinsurers”.

6.5 Parameters relating to direct supervision

6.5.1 Licensing

6.5.1.1 General features of a licensing system

According to the IAIS Licensing Handbook the term “licence” is understood as theauthority for a company to carry on insurance business, based on contracts betweenpolicyholders and the company, provided the company is subject to supervision by thecompetent authorities. In the Directives “authorisation” is used with the correspondingmeaning.

It is clear that such a definition must be suitably adapted to reinsurance. Certainamendments would have to be made in order to reflect the fact that there is no direct linkbetween the reinsurer and the policyholder.

23 ibid paragraph 21

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By requiring the licensing of reinsurers, according to the IAIS, supervisors would obtain:

§ an overview of the companies engaged in reinsurance in a country (e.g. to controlactivities in money laundering);

§ assurance that minimum capital and management requirements are met;

§ direct access to any information regarding the reinsurance business.

A licensing system would have to be adapted for reinsurance companies wanting to doreinsurance business. Existing entities would need to fulfil licensing requirements inorder to continue carrying on reinsurance business. Traditionally in direct insurance thegranting of a licence means that the supervisor has performed a thorough examination ofthe insurance undertaking. If the licensing is not granted or is revoked the company canno longer carry on reinsurance business.

Licensing in general plays an important role in ensuring efficiency and stability in themarket. Strict conditions governing the formal approval of insurance companies arenecessary to protect insurance users. The licensing process may also help ensure that faircompetition exists among companies in the market.

Requirements are preconditions for granting a licence and must be met at all times duringthe on-going business operations. It is necessary to consider the licensing requirementsapplied to insurance companies to see if they can be adapted to reinsurance companies.They are as follows (according to Supervisory Standard on Licensing from the IAIS):

§ legal form and head office of the company;

§ objective of the company;

§ minimum capital;

§ fit and proper criteria for directors and/or senior management;

§ control of shareholders;

§ affiliation contracts and outsourcing;

§ product control (general policy conditions, technical bases for the calculation ofpremium rates and provisions);

§ articles of incorporation;

§ actuaries and auditors.

The withdrawal of the licence creates a clear legal situation and improves transparency ofthe market. The supervisor needs to have at its disposal the right to withdraw the licence.As a legal consequence of this withdrawal, the reinsurance company is no longerpermitted to carry on reinsurance business. It gives a clear mandate to the supervisor toremove unsuitable companies from the market.

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In this system, cedants are better able to judge their reinsurers, as they are submitted to aminimum level of requirements. But on the other hand, there is the “moral hazard” thatthe cedant may place too much reliance on the fact that the reinsurer is licensed andcontrolled by the supervisor. Supervision of reinsurers by the regulator should not exemptthe direct insurer from establishing its own controls over reinsurer’s security.

It is also argued that licensing is not a standard in itself, but rather a sanction mechanismto enforce the standards. If direct insurers were obliged to do business only withreinsurers that fulfil certain standards, the objectives could also be achieved throughindirect supervision.

Furthermore, introducing a licensing system in a previously non or less regulated sectorcould be difficult to implement. It might be difficult to require existing companies whichdo not meet the regulatory requirements to cease activities. A system of licensing bringsadditional costs of implementation and administration, such as the cost of theauthorisation procedure.

In European countries where a licence is needed for reinsurance companies, generally therules used are the same as for direct insurers. In some countries, in the case of lifebusiness there are minor differences between the solvency requirements for direct andreinsurance business.

The advantage of a licensing system is that it is the maximum protection for the insuranceindustry that regulation can provide. On the other hand, it represents the maximumintervention in the market. The question is, whether the aims of a licensing system can beachieved via a passport system without affecting the market mechanism. The market willprobably punish companies without a passport, so that the effect strived for is reached ineither case.

A licensing system within the EU may affect competition in the global reinsurancemarket and relations with Non-EU countries and off-shore locations have to beconsidered. If the licensing system is implemented this disadvantage will have to becompensated by additional benefits.

6.5.1.2 Fit and proper criteria for management and controllers

The main objective of such criteria is to assess whether reinsurance entities are soundlyand prudently managed and directed and that their key functionaries (directors, managers,shareholders and other who exercise a material or controlling influence over the affairs ofthe reinsurance entity) do not pose a risk to the interests of present and future cedants ofthese entities24.

The criteria could cover the following persons, as proposed by the Australian RegulationAuthority:

- directors, in the case of a locally incorporated reinsurer;

- senior management;

- the approved auditor;

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- the approved valuation actuary, where relevant;

- the agent, in the case of a branch; and

- other key staff, who are responsible for important decisions.

The supervisor must monitor compliance with the standards on an ongoing basis. Aperson is fit and proper if that person has:

- never been convicted of an offence under national or foreign law in respect of conductrelating to a financial institution or conduct relating to dishonesty;

- never been bankrupt, applied to take the benefit of the law for the relief of bankrupt orinsolvency debtors or compounded with the person’s creditors;

- formal qualifications, including membership of professional associations and bodiesand the nature of binding professional codes of conduct and enforcement of thesewithin the professional body;

- no potential conflicts of interest;

- a business track record and appropriate experience;

- demonstrated competence in the conduct of business duties;

- demonstrated integrity in the conduct of business activities;

- a good reputation within the business and financial community.

Each reinsurer should provide the regulator with details of those persons acting in the keypositions and notify immediately if a person to whom this standard applies no longercomplies with the tests of fitness and propriety.

The demonstration of business competencies for management is a complex requirement,especially for reinsurance. The business is heterogeneous so it is necessary that, as aminimum, any head of a department has specialist knowledge of the segment. Theinternational nature of the reinsurance business makes it even more complex. Forexample, the underwriting of life business differs totally from that of a typhoon risk inJapan.

Some of the EU members use these criteria in the supervision of reinsurers. Generally fitand proper requirements apply exactly as for direct business, including the need to reportchanges in the management. The same criteria for insurance companies seem to beappropriate for reinsurers.

24 IAIS Fit and Proper Principles

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Fraud prevention could be supported by developing fit and proper testing instruments.When reinsurers are subjected to direct supervision the same fit and proper requirementswould apply. In the case of a non-licensed reinsurer, fit and proper testing would needspecial attention. It would be helpful to have more structured information available aboutthe fitness and propriety of the management of reinsurers25.

From the IAIS point of view, fit and proper testing is important. The reinsurer’s activity isessential in the comprehensive chain of risk spread and reduction sought by the insurer.Therefore, fit and proper testing should be applicable to all management activities in therisk spreading process beyond the primary insurance sector, including the reinsurancesector.

There is a wide agreement in the insurance industry that members of the board ofdirectors in an insurance company, direct insurer or professional reinsurer, should have anappropriate qualification based on theoretical and practical knowledge and experienceand be personally liable. This is based on recognition that failures of insurance companiescan arise from bad management, criminal activities and lack of resistance to shareholders’pressures.

The first EU Council Directives provide that the home member state shall require everyinsurance company for which authorisation is sought to “be effectively run by persons ofgood repute with the appropriate professional qualifications or experience”. TheseDirectives only relate to direct insurers. However, there is a general acceptance thatprofessional reinsurers should also be expected to meet such requirements.

Regarding the persons who have to meet these requirements, these might be any director,controller manager or main agent of the reinsurer, as provided by the UK InsuranceCompanies Act, or as proposed by the CEA restricted to the members of the board ofmanagement, since they manage the company and have the prime responsibility andpower to do so.

Professional reinsurers cover the whole insurance market which is heterogeneous. It willalways be necessary to have sufficient underwriting expertise in every area covered.

6.5.1.3 Review of business plan

Before granting authorisation, insurance supervisors invariably obtain a business plan, ina specified format, from the entity applying for a licence to undertake insurance business.(This requirement in enshrined in the EU insurance directives and is applied by thosejurisdictions which regulate reinsurance companies.) In the EU, the requirement to submita business plan applies only prior to authorisation. Once authorisation is obtained there isno general requirement for an insurer to submit subsequent business plans althoughsupervisors might require plans if there are special circumstances.

25 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles,

standards and practices, February 2000

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This information may help the regulator to:

§ form an initial assessment of the adequacy of the capital and reinsurance arrangementsof the proposed operations;

§ monitor actual business volumes and profitability against what was envisaged at thepoint of authorisation;

§ identify particular risk areas, such as outsourcing arrangements.

Moreover, in discussing the plans with the applicant, the regulator can form a view of theextent to which management is aware of the company’s regulatory obligations.

If subsequently business volumes are higher than those in the plan, the regulator canintervene to require the company to inject further capital.

It would be relatively easy to introduce such a requirement for reinsurance companiesacross the EU. The costs of complying with such a requirement would not be material.The value to the regulator of such a requirement is however to be questioned, because itcould not assist in assessing the reinsurer’s security.

6.5.2 Passport System

Instead of a licensing system, the CEA proposed in May 2000 a passport system. In thissystem, undertakings may choose to adhere to the system or to remain outside it.

It aims to establish an EU model for reinsurance supervision and to promote moreefficient cross-border trade in the reinsurance sector through increased security andthrough the elimination of statutory trust fund requirements.

A passport system would replace supplementary supervision for reinsurance companies inthe host country, or let their cedants enjoy certain benefits linked to the passported statusof the reinsurer.

The CEA proposed a passport applied to professional reinsurers. The IAIS has produced arecommendation which stated that the passport could be applied to professionalreinsurers, underwriting associations and direct insurers accepting reinsurance.

The existing entity must fulfil certain requirements to receive a single passport or in orderto receive some advantages linked to the system. If the passport is not given or is revokedthe entity can continue to do reinsurance business, but will not enjoy advantages linked tothe system.

The passport could take the form of a standard document which would confirm that thecompany meets the requirements. The respective supervisors would have to be able tocheck these requirements, to pass on the results of the checks to the home market andother markets, and to withdraw the document if the requirements were no longer met.

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The standards set must be adequate. Each country of origin would have to impose similarminimum core requirements before granting approval to companies seeking to dobusiness in other participating countries. Major aspects that could be included in apossible EU framework for reinsurance supervision, which are proposed by the CEA orthe IAIS; are as follows:

§ legal form requirement;

§ corporate governance issues: “fit and proper” requirement;

§ shareholder control;

§ operating/business plan, for authorisation; (IAIS only)

§ financial and supervisory reporting (on at least an annual basis);

§ technical provisions appropriate and adequate;

§ prudent solvency requirements;

§ investment rules; (IAIS only)

§ powers of intervention for supervisors;

§ supervisory intervention in cases of reinsurers in difficulty – withdrawal.

Under a mutual recognition scheme, the regulator in each participating country recognisescompanies approved by the regulators from the other participating countries, which couldenable reinsurers to trade freely in the geographical area of mutual recognition.

As argued by the IUA, the objective for a European passport could be to attain mutualrecognition with the equivalent North-American system. Such a system would leavecompanies the choice of whether they would like to adhere to the system or not. But theposition of the supervisor would be weaker as compared with a licensing system, assupervisors would not have the option of removing unsuitable companies from thereinsurance market. If a company did not fulfil the essential solvency requirements, thesupervisor could revoke the passport but not stop the business. In practice, there would beprobably no insurance company that would cede business to such a reinsurer.

If licensing systems are in place in certain countries, it would be seen illogical to replacethem with a passport system, and some in the industry argue that such system could entailextensive additional requirements which would create additional costs. The system couldalso result in an obligation for foreign reinsurers to make security deposits for reinsurancecompanies which would not have the passport.

Many US reinsurance associations argue that a mutual recognition system between EUcountries and the US is premature. For them the proposal would represent a decrease inthe level of such security within the US, although it could represent an improvement withrespect to the security of reinsurance recoverables as compared to the level where theycurrently exist in certain EU countries. As US reinsurers are not afforded a singlepassport within the US it would place them at a competitive disadvantage as compared tonon-US reinsurers.

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The US reinsurance industry disagrees that current practices such as trust fundrequirements or tax restrictions constitute major obstacles in reinsurance and asserts thatboth requirements do nothing more than contribute to a level playing field among USreinsurers and non US reinsurers. Regarding excise tax, the US has entered into treatieswith a number of countries (such as France, Italy, UK, Germany) waiving the collectionof insurance excise tax. According to the US reinsurance industry, trust fundrequirements are not imposed on a “compulsory basis”. If a non-US reinsurer wants to dobusiness in the US, without subjecting itself to the full scope of US regulatory lawsimposed upon US reinsurers (creation of a licensed affiliate or licensing a branch), thenon-US reinsurer must secure its obligation so that US regulators need not be concernedwith its financial status or the level of regulation of its place of domicile, but remainconfident that it will meet its US obligations while it is solvent or in the event that itbecomes insolvent. This strong position is criticised in the European Union.

Some of the German interviewees mentioned that the US deposit requirements are onlyrelevant for new reinsurers intending to enter into the market; the established reinsurershave already met the US requirements by establishing a US subsidiary which is subject tosupervision in the US.

The major argument against a passport system is that regulation cannot displacecompanies from the market after the withdrawal of the passport. The reinsurance marketis globally considered as a working market mechanism, so that a passport probably willbe established as a standard, like ratings in the past. The withdrawal of a passport willtherefore, even more than not applying for a passport, cause market reactions resulting inthe possibility of reduced business volume.

The idea of the single passport system is already included in the proposal for a Directiveof the European Parliament and the Council on the activities of institutions ofoccupational retirement provisions (COM(2000)507final) of 11 October 2000. Nationalregulations on licensing and supervision remain unaffected by this directive.

6.5.3 Changes in control

In insurance business, as defined by the IAIS, the insurance supervisor should require thepurchaser or the licensed insurance company to provide notification of the change incontrol and/or seek approval of the proposed change; the supervisor should establishcriteria to assess the appropriateness of the change, which could include the assessment ofthe suitability of the new owners as well as any new directors and senior managers, andthe soundness of any new business plan.

For many countries, where a licensing system exists, the rules applied for reinsurers arethe same as for direct insurers. In some countries an approval is required when there arechanges in management in reinsurance companies.

As pointed out by the CEA, there is an agreement within the industry that a reinsurer’sgroup structure should be transparent, which means that major shareholders of thereinsurer should be disclosed. Shareholders who have controlling interests should be ableand sufficiently qualified to promote a sound and prudent management of the reinsurer.The qualification of the shareholders is to be presumed if the managerial team meet therequirements of diligence as well as competence and personal qualification.

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6.5.4 Corporate governance

EU insurers and reinsurers already have to operate within the corporate governanceregimes that apply to the generality of companies and these vary from country to country.For example, some countries (for example Germany and the Netherlands) require two tierboards, one executive, one non-executive. In the UK, it is considered best practice forboards to consist of both executive and non-executive directors, although there is nobinding requirement for companies to adopt such a structure.

In general, EU insurance regulators do not impose explicit corporate governancerequirements although it is implicit in the fit and proper requirements that the board willcontain individuals capable of carrying out all the necessary roles.

The fit and proper requirements could be bolstered by requiring companies to documentthe responsibilities of individual directors and senior managers and to provide theregulator with these details. The rationale for such a requirement is that it makes theindividuals concerned pay greater regard to their regulatory responsibilities.

In addition, if not already a requirement of general corporate law, insurance supervisorscould require boards to adopt explicit policies on the following26:

§ the corporate governance principles of the undertaking;

§ the company’s strategic objectives;

§ the means of attaining those objectives and evaluating progress towards thoseobjectives;

§ board structure and appointment procedures;

§ division of responsibilities;

§ risk management functions;

§ external audit and internal control procedures.

Given the existing variety of corporate governance regimes, it would be difficult tointroduce a set of comprehensive harmonised rules on corporate governance forreinsurance companies. However, a requirement for reinsurers to document seniormanagement responsibilities could be introduced without involving significant effort bycompanies.

6.5.5 Internal controls and risk management

The need for reinsurance companies to operate adequate systems of internal control isself-evident. There are a number of approaches that supervisors can take to monitoringthe adequacy of internal controls systems:

26 These areas are based on the IAIS’s Core Principles Methodology approved in October 2000.

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§ requiring directors to produce a certificate that internal controls are adequate;

§ issuing guidance notes on the adequacy of controls and requiring directors to reportany areas of non-compliance with the guidance notes;

§ requiring external auditors routinely to report on the adequacy of internal controls;

§ using external accountants to carry out specific internal control reviews;

§ carrying out audits of internal controls themselves.

The objective of all these parameters is to ensure that companies have adequate controlsin place and that the controls are properly operated.

A requirement for directors to produce a certificate on control adequacy could readily beapplied to reinsurers and, given that reinsurers should already have adequate controls inplace, should not introduce any additional regulatory burden. However, such certificatesgive only limited comfort to supervisors.

Reinsurance is a complex business with exposure to a wide range of operational andfinancial risks. The reinsurance market is international with a great deal of cross-borderactivity. Risks assumed are more complex due to the diversity of reinsurance contracts.There is rapid product innovation with the growth of more novel form of risk transfer.Reinsurance assumes large exposures to catastrophes. Reinsurance being a globalbusiness, exposures may arise in many jurisdictions increasing the degree of legal risk tothe reinsurer.

In these conditions, it is essential for reinsurance to have appropriate administrativesystems and adequate internal control.

The risk management and internal control systems have to be adequate and appropriatefor monitoring and limiting risk. This includes, in particular, the development,implementation and maintenance of adequate and appropriate policies and procedures formonitoring and managing:

ü Underwriting risk

ü Retrocessions

ü Credit risk

ü Investment risk

ü Globalised risk portfolio

ü Currency risk

ü Timing risk

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New approaches to risk management include stress testing and dynamic financialanalysis. These new approaches take an integrated view of market and reinsurance risks.Alternative risk transfer is also being increasingly used as a risk management tool andshould be taken into account by regulators in understanding the implications andformulating appropriate regulations.

Annual dynamic analysis reports (used in the US) model the impact on future financialcondition of various adverse developments with regard to both assets and liabilities. Themodel takes account of factors such as investment losses or market value decreases, fallsin the level of investment income, and a variety of other factors affecting profitability ofthe business such as claims, lapse rates and expense levels.

The internal model that many insurance and reinsurance companies are developing tomanage risk exposure, to allocate their capital efficiently and to provide managementwith tools for business decisions, could be used by supervisors to analyse relevantinformation (Further developments are given in chapter 8).

If supervision is considered necessary, supervisors need to review the adequacy andappropriateness of reinsurers’ risk management policies and procedures. Riskmeasurement methods, risk management processes and strategic asset allocation shouldbe disclosed to the supervising authority.

Generally there is a trend towards improvement of risk management systems. This affectsthe reinsurance industry as well. We did not recognise any differences between marketswhere the supervisory authority monitors risk management and others.

6.5.6 Prudential rules on assets

6.5.6.1 Diversification requirements

Diversification requirements can operate at two levels. One is to require companies toavoid a concentration in any one type of investment. Thus a company can be prohibitedfrom investing more than a certain percentage of its investments admissible for solvencypurposes in property or equities. The other is to prevent companies from investing morethan a specified percentage of their investments in any one entity.

Reinsurance companies in jurisdictions which regulate reinsurers are already subject tosuch requirements. In general the investment strategies of reinsurance companies are notfundamentally different from those of direct insurers and it seems unlikely thatreinsurance companies would have to change their investment approach to comply withthe introduction of admissibility limits.

On the other hand, it is unclear whether it is necessary to have specific rules enshrined inlegislation to ensure that reinsurance companies appropriately diversify their investments.A general requirement for companies to avoid undue concentrations, backed up byreporting requirements which enabled supervisors to identify high concentrations, wouldbe simpler and could be equally effective.

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6.5.6.2 Restrictions on asset types

The basic objective of restricting companies from investing in certain asset types is toprevent insurance undertakings from investing in illiquid or volatile assets. However, inthe case of derivative instruments, there is the additional objective of preventingcompanies from taking on additional risks which may not be evident to the regulators.

As with admissibility limits, the rules could be extended to reinsurance companies but, aswith diversification requirements, it is unclear whether detailed rules are strictlynecessary. The reinsurance industry argues that reinsurers should have the freedom tomanage their investments in accordance with their business and investment plans.Provided that investments are properly valued and disclosed, it is unclear that it isnecessary to have such restrictions. Such rules can have the adverse consequence ofpreventing reinsurers from entering into innovative investment arrangements which maygive a better return than conventional investments or provide a better matching ofliabilities.

Regarding new risk transfer products, the supervisor should take into account theirgrowing use. Disclosure of these products should be enhanced to achieve sufficienttransparency. The accounting and valuation should properly reflect all possiblecommitments and rights. Solvency requirements should take the characteristics of theseproducts fully into account.

6.5.6.3 Asset valuation rules

Reinsurance companies are, of course, already subject to the general accountingrequirements, whether regulated or not. Basic valuation principles vary between EUcountries, some stipulating the market value principle, others the historic cost principle.Where investments are shown at the lower of historic cost and market value in thefinancial statements, the market value has to be disclosed in the notes.

Supervisors can supplement the basic accounting rules by:

§ specifying more detailed valuation rules for particular asset classes;

§ eliminating optional treatments that are available under general accounting rules.

There are a number of reasons for imposing additional requirements:

§ more specific rules and fewer options mean that the balance sheets of reinsurancecompanies are more readily comparable with each other. This assists both supervisorsand direct insurance companies in assessing the relative financial strength of differentreinsurance companies.

§ it ensures that the assets are valued in a way consistent with the rationale behind anysolvency margin requirements.

§ it reduces the risk that companies will place an inappropriately high valuation onassets where it is not easy to establish a market value.

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There is a strong case for subjecting reinsurance companies to more specific assetvaluation rules regardless of whether reinsurers are subject to regulation. Indeed, ifreinsurers are not regulated it is more important that direct insurers and their supervisorsare able to assess accurately the financial strength of reinsurers.

Where there are harmonised solvency margin requirements, it is illogical to permitdifferent asset valuation rules. For example, if the appropriate minimum solvency marginfor a company which values its assets at historical cost is 20% of premium income, it willclearly be necessary for a company which values its assets at market value to be subjectto a higher percentage of premium income.

Valuation rules are already applied to all direct EU insurers and regulated reinsurers and,since reinsurers’ investment strategies are not different in principle from those of directinsurers, there is no reason why they should not be extended to reinsurance companies.Moreover, such a requirement could be introduced even if reinsurers were not subject tofull regulation.

6.5.6.4 Matching rules

Supervisors can require insurers to reduce their mismatch risk by requiring them to matchassets and liabilities. Examples of such requirements are:

§ requiring companies to match foreign currency liabilities with assets in that currencyand to ensure the holding of sufficient assets of appropriate nature, term and liquidityto enable the company to meet insurance liabilities as they become due;

§ requiring life companies to match linked liabilities with the same assets as are used todetermine the unit price.

Currency matching is a much more difficult issue for reinsurers since in many cases theywill not be certain precisely in which currency a liability might arise and, in addition, willtypically face liabilities in many more different currencies than a direct insurer.

In recent years, insurers and reinsurers have developed increasingly sophisticatedtechniques for matching assets and liabilities to reduce the overall level of risk. Theintroduction of rigid matching rules could adversely affect the development of thesetechniques.

An alternative approach might be to require reinsurers to disclose in their publishedfinancial statements the techniques they use to match their investments to their liabilities.Such an approach would be simple to implement and should not be onerous.

6.5.7 Prudential rules on liabilities

The rationale for prudential rules on liabilities is two-fold. In the first instance, theregulator wishes to ensure that insurers use appropriate techniques to determineaccurately what their true liabilities are; and secondly to ensure that insurers retainsufficient funds to meet these liabilities.

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6.5.7.1 Liability valuation rules and restrictions on discounting

In principle, it is possible for regulators to specify rules on:

§ the discount rate (if any) to be applied to liabilities to allow for the investment returnon technical provisions;

§ the extent to which future expenses need to be taken into account;

§ the extent to which future premiums (or premium margins) can be taken into account;

§ the basis for recognising premium income (i.e. the basis for calculating unearnedpremiums and unexpired risks);

§ the extent to which acquisition costs should be deferred.

For life business the amount of uncertainty related to underwriting risk is relatively smalland the existence of rules on such matters as the discount rate to be used, the extent towhich future premiums can be taken into account, and the allowance to be made forfuture expenses can mean that technical provisions will be broadly comparable fromcompany to company.

The position for non-life business is different in that the uncertainty surrounding theamount and timing of claims will often be significant, with the effect that differences inassumptions on discounting and expenses will have a relatively minor effect on the levelof provisions.

The purpose of many valuation rules, such as the restriction on discounting non-lifeoutstanding claims, is to ensure that the estimate of liabilities is conservative. These rulestherefore act as a supplement to the solvency margin requirements.

Valuation rules could also be used to improve comparability between companies and toensure that the basis of calculating liabilities is consistent with the rationale of thesolvency margin calculation. At present, there are considerable disparities betweencompanies in the strength of their provisions. In particular, there is a wide divergence ofpractice regarding the confidence level that should be aimed for when establishing non-life provisions. One approach is to set the provisions at a “best estimate”, i.e. a provisionwhere the probability that claims will be greater than estimated is the same as theprobability that they will be less than estimated. Another approach is to make a provisionwhich will be adequate in all reasonably foreseeable circumstances. It is unclear how thistest could be quantified as a confidence level, but it might be equated with a 95%probability that the actual claims will be no greater than those estimated.

Although it may be difficult in practice to quantify the confidence level that can beattached to a particular level of provision, there is no reason why regulations should notseek to harmonise the level which reinsurers should aim at.

As with the asset valuation rules, any requirements imposed by the insurance supervisorwill overlay the existing general accounting requirements. Moreover, like asset valuationrules, liability valuation rules could be introduced without necessarily subjectingreinsurers to further regulation.

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6.5.7.2 Rules on methods to be used

An adequate level of technical provisions ensures that the company is able to meet itsobligations at any time. All of the insurance industry agrees that an insurer’s technicalprovisions should be appropriate and adequate. It should be the same for reinsurer’stechnical provisions.

As referred to in the European Directive for insurers, the amount of technical provisionsmust at all times be such that an undertaking can meet all liabilities arising out ofinsurance contracts as far as can reasonably be foreseen. Any assessment of the adequacyof a reinsurer’s technical provisions should have this definition as a basis. In addition, thespecial features of reinsurance business could be taken into account in respect of:

§ underwriting risk;

§ credit risk;

§ currency risk;

§ investment risk;

§ timing risk;

§ globalised risk portfolio.

It should establish methods of control for ensuring the adequacy of technical provisions,based on the best actuarial methods used by reinsurers (see also chapter 9). Usually themethods are similar to those applied to direct insurance business and in some cases areidentical, as in the case of proportional reinsurance.

Monitoring of technical provisions is an important point for supervision of reinsurers asinformation provided to the reinsurer is of lower quality than information available todirect insurers. The reinsurer depends on reports from the direct insurer which usually donot include the historical information related to the reinsurer’s portfolio. For non-proportional business, provisions for IBNR claims might not be reported. Because of theinternational nature of the business, the reinsurer has to take into account the internationaldifferent accounting policies for reserving, for example there are countries where claimsprovisions are discounted. Therefore, it is essential for a professional reinsurer to do areserve analysis based on its own portfolio including a calculation for IBNR reserving.

Some associations, such as the CEA, consider that there should be an additional standardwhereby the respective home supervisory authorities would be obliged to check theglobal adequacy of the technical provisions and would need to have the necessary powersto perform these checks.

Generally, the regulatory returns regarding the level of technical provisions required bysupervision authorities are in the same form and level of detail as for direct insurers.However, in some cases, such as in Switzerland, the rules on calculation and evaluationof technical provisions for direct insurers do not apply to reinsurers.

Property and casualty provisions are in practice calculated using actuarial projectiontechniques using paid and incurred loss development triangles.

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Life provisions are calculated using actuarial analysis under the policy premium method,whereby all anticipated future cash inflows and outflows from a policy are estimated andadjusted to present value, with appropriate margins for adverse deviation, to arrive at theprovision for future policy benefits.

Regarding non-life provisions, in some countries reinsurers are required to providedisclosure of the variability in estimates from prior years claims, which many provide byshowing data on the over and under provision adjustments made in the current year’sincome from prior year’s reserves. In addition, schedules showing run-off by accidentyear are required in the statutory return filed with the regulator only. Reinsurers havetended to provide little or no explanation for run-off results.

The effects of significant changes in actuarial assumptions are required to be quantifiedand disclosed in the accounts. Examples of these include changes in the interest rateenvironment, and changes in the policy lapse rate or similar actuarial assumptions.

A possible approach is to give the supervisor the authority to prescribe standards forestablishing technical provisions and to verify the sufficiency of these provisions and torequire them to be increased if necessary. Another possible approach is for reserving to bechecked by the supervisory authority independently.

Given the differences that exist between the books of business of different reinsurers, itwould be unlikely to be practical or appropriate to set rules on the methods of estimationto be used. Moreover, the stipulation of particular methods might inhibit the developmentof better techniques for estimating liabilities.

However, it would be feasible, and not particularly onerous, to require companies todisclose in their annual reports the types of techniques it uses to determine the liabilitiesof its principal classes of non-life business.

6.5.7.3 Certification by loss reserving specialist

Virtually all countries have a requirement for the life provisions of a direct insurer to becertified by a qualified actuary and in countries where reinsurers are supervised thisrequirement is extended to reinsurers. In practice, life reinsurers will almost certainlyalready be obtaining a report on their provisions from an actuary and the introduction of aregulatory requirement for reinsurers would be a codification of existing practice.

For example, in the UK, USA, Canada and Australia life reserves both for direct andreinsurers have to be certified by an actuary. Non-life reserves and DAC have to becertified by an actuary in Canada at present and in Singapore, Australia and Ireland in thenear future. However, the appointed actuary in Canada is not required to be asindependent as an auditor and commonly is an employee of the insurer or reinsurer, andtherefore the external auditor needs to assess the work of the actuary in forming anopinion on the financial statements. Lloyd’s of London for solvency purposes require anactuarial sign-off which includes a review of reinsurance security based on ratingsproduced by the rating agencies.

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For non-life business, it would in principle be possible for supervisors to requirecompanies to obtain a report from a loss reserving specialist on the adequacy of reserves.The rationale for such a requirement would be, that it could help in reducing the risk thatthe provisions may be understated in the financial statements. However it is questionable,whether the potential benefits would compensate for the additional corresponding costs.

Furthermore, there would be practical difficulties in introducing such a requirement in theEU either for direct insurance or reinsurance. Unlike the USA and Canada, there is not alarge and well established non-life actuarial profession and in the short and medium termthere would not be sufficient people with a recognised loss-reserving qualification tocarry out the certification.

6.5.8 Capital adequacy and solvency

6.5.8.1 Statutory minimum solvency margin requirements

The adequacy of financial resources is one of the most important elements in controllingan insurer’s and reinsurer’s security. It ensures its ability to fulfil its commitments at anytime. The assessment of solvency is a key tool for many regulators. Failure by a companyto meet minimum capital or solvency requirements is a primary warning indicator formost regulators.

Elements of the current solvency system in the EU Directives could be used forreinsurers. However, it should be borne in mind that some of the actual methods usedmay not be efficient due to the complexity and international nature of reinsurancebusiness.

Solvency requirements focus on the financial statements and even for direct insurers maylead to stronger requirements for prudent companies. Generally companies with a prudentreserving policy will need more investments to meet solvency rules although the risksthey have assumed may not differ from those assumed by a company which has lessprudent reserves. The technical provision for life business, for example has to be coveredwith investments. As this provision is discounted the amount decreases with any increasein the interest rate used. The economic risk for the company increases with the increase ofthe interest rate so that the solvency requirements develop reciprocally to the risk of thecompany.

In many EU countries the solvency system is considered inadequate. A far reachingfinancial risk model which is based on a general solvency theory and which couldguarantee the financial position of insurers is not yet available. Due to the fact that thefinancial indicators are calculated from financial statements the judgement about thepresent solvency system is based on past, not forward-looking, information. Furthermore,the present solvency system does not take into account the asset management risk of non-life insurers. For life insurers the asset management risk is only addressed through theamount of the total investments and without examination of the different types of risksassociated with the assets.

Part of the industry argues that standardised solvency requirements are easy to implementand monitor, but ignore the individual risk profile and risk management approach, areretrospectively oriented and exaggerate capital requirements and are only for companiesunable or unwilling to develop an internal risk model.

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Additional solvency requirements may be proposed, such as those which would relate tothe investments to compensate for the assets risks. In non-life business special attentionwould have to be given to the possible inadequacy of long-tail business provisions. Toassess the real risk volatility of a business some model, such as a risk-based capital modelmay be used.

The solvency calculations in many countries are based on the EU directives. Oneapproach would be for the reinsurer to perform the same solvency calculation as a directinsurer.

The following methods are used to calculate the solvency margin:

First the amount of equity required as a safety margin is calculated based on defined, risk-weighted margin factors set by the regulator for each asset and liability, including off-balance sheet exposures; then this total required is divided into the amount of capitalactually available to arrive at a definite ratio. The regulator requires an overall marginabove a 100% ratio, which has been escalating in recent years, and pays more attention tocompanies below 150%.

An alternative approach is to define required assets as the book value of liabilities, plus aspecified safety margin for claims and unearned premiums (the margins are increased ifclaims experience has been relatively high), and divided into the adjusted assets for theregulators ratio. Adjusted assets include investments at market value and exclude certainassets such as computer equipment. The regulator expects a margin of adjusted assetsover the required amount of at least 10%.

Some countries, such as the UK, argue that, although solvency problems in a reinsureraffect the ultimate consumers of insurance only indirectly, the greater potential forvolatility in the results of reinsurance business (especially non-proportional) suggests thata degree of supervision at least equal to that of direct insurance is appropriate. The EUCommission’s current proposals for reform of direct insurers’ solvency marginrequirements include a proposal that a 50% uplift be applied to marine, aviation andgeneral liability business. It may be appropriate for this, or a higher percentage, to beapplied also to proportional reinsurance business of these classes and all non-proportionalreinsurance business. This would reflect the following factors in such business: greatervolatility, the effect of catastrophes, the longer tail nature of the claims run-off and theuncertainly in establishing technical provisions. However, we believe that this view doesnot reflect the diversification potential and other risk mitigation techniques of reinsurers.

Generally, the regulatory returns regarding the solvency margin required by supervisoryauthorities are in the same form and level of detail as for direct insurers. In some cases, asin Switzerland, there is no solvency requirement required by law for reinsurers, but theregulator applies a benchmark of 20% of net premium as a minimum equity requirement.In other cases, as in France, reinsurers are not required to prove their solvency position tothe regulator. In Germany, although there is no statutory solvency margin requirement,the supervisor tries to ensure that reinsurers have a minimum capital of 10 per cent of netpremiums. In the UK, the basic system of regulation is the same for reinsurers and directcompanies, but some detailed provisions are different.

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Solvency requirements change nowadays from a single company view to a view of thewhole insurance group. Further developments are shown in the “Study into themethodologies to assess the overall financial position of an insurance undertaking fromthe perspective of prudential supervision”.

Risk-based capital methods could be technically justifiable, but for the regulator thesemethods are difficult to apply since they presuppose a strong knowledge of managementcontrol and of the risk portfolio of the reinsurer. Risk-based capital methods are discussedin more detail in the “Study into the methodologies to assess the overall financial positionof an insurance undertaking from the perspective of prudential supervision”. A possibleapproach to supervision could be the definition of standards that have to be covered bythe risk-based capital method. If these standards are not met the supervised companieshave to demonstrate their solvency by the common method based on ratios.

6.5.8.2 Resilience and scenario testing

Resilience testing is well established for direct life business where companies arerequired to consider the impact of sharp falls in investment values and interest rates.Jurisdictions which regulate reinsurance companies also apply such tests to lifereinsurance companies.

To date supervisors have not generally extended the principle of resilience testing to otherareas; for example it could require companies to disclose the impact of a 10% adversedeviation from expected loss ratios or to require that the solvency margin was sufficientto withstand an adverse deviation of this magnitude. Resilience testing may represent analternative approach to calculating minimum solvency requirements which avoids theinflexibility of formula-based approaches.

6.5.8.3 Equalisation and catastrophe provisions

EU regulation requires non-life direct insurers to establish equalisation provisions forcredit business. Some member states have extended these requirements to other classes ofbusiness that are inherently volatile such as frost and hail. Catastrophe reinsurancebusiness is similar in nature to these classes of direct business in that there are expected tobe occasional years of heavy losses balancing most years when profits are made.

Equalisation provisions should be extended to reinsurance business. Reinsurance businessoften tends to be more volatile than direct insurance business for the reasons given inchapter 2. However, it is not the objective of equalisation provisions to smooth outvolatility in general rather than to depict fairly the equalisation process over time takingplace in the insurance business. Therefore, there is no higher need for an equalisationprovision for reinsurance business than for direct insurance business.

By contrast, the concept of catastrophe provisions is important with respect to thereinsurance business. Reinsurers are to a significantly higher extent exposed tocatastrophe risks than direct insurers. They tend to build in the ability to take a majorshock periodically and the capital needs to be adequate for this.

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Concerning catastrophe risks, it is unlikely or it may even not be possible at all todiversify the different risks within a portfolio of contracts during a single accountingperiod, especially when the likelihood of occurrence of such risks is relatively low, butthe volume of the potential cost of each of these risks is individually high. For examplefor earthquakes, the relevant extreme losses have return periods of about 200 years andthese losses can arise out of only about 10 scenarios of comparable size. As a result, thetypical insurance principle to balance losses within a large portfolio cannot be appliedhere. In such cases, it must be the aim to diversify the different risks over a period oftime, i.e. the time span for covering claims expenses with revenue extends beyond asingle accounting period into an unlimited period in the future.

The necessary coverage of the insured risks over time can only be achieved, if the riskpremiums which are not used for claim expenses are carried forward to later accountingperiods. It must be deemed that the insurance enterprise has an obligation at the reportingdate.

6.5.9 Market conduct

Countries which regulate reinsurance companies do not subject them to their marketconduct rules since they do not deal directly with members of the public.

6.5.10 Financial reporting

Reinsurance companies are already subject to the general requirement to produce annualaccounts. Supervisors may also require more detailed information or for the reporting tobe more frequent and to tighter timescales. The basic rationale for applying morestringent reporting requirements to insurance and reinsurance companies than thegenerality of companies is two-fold:

§ to enable the supervisor to assess the financial strength of the companies supervised;and

§ to enable buyers of insurance and reinsurance to assess the financial strength ofpotential providers of cover.

In addition, reporting assists the supervisor in monitoring compliance with otherparameters, such as conformity with business plans, and diversification of investments.

It would be possible to introduce additional harmonised reporting without subjectingreinsurers to full direct supervision. There would, however, need to be sanctions whichcould be imposed on companies which failed to comply with the reporting requirements.

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The present lack of an international method for accounting for the insurance andreinsurance sector may hinder the supervision of parameters at an EU and/or internationallevel. There are different bases under which the assets and liabilities arising frominsurance and reinsurance contracts are measured and reported and the results of suchtransactions are calculated (an overview is given in chapter 5). Although, under Europeanlegislation, an effort has been made to ensure that the accounts of member insurers andgroups are prepared on a consistent basis, limitations already exist due to the wide rangeof options available under the legislation and a lack of harmonised guidance on thepolicies. A harmonised framework of accounting practices could promote greatercomparability and transparency and provide relevant and reliable information tosupervision authorities.

Uniformity in assessing the reinsurer’s security will be essential to a world-wideacceptance of a system of reinsurance supervision, with converging supervisoryprinciples and standards. This objective can only be achieved with harmonisation of theinformation on reinsurers, namely by regulation of accounting standards. The use offuture harmonised standards for supervisory issues is discussed in more detail in the“Study into the methodologies to assess the overall financial position of an insuranceundertaking from the perspective of prudential supervision”. Usually, reportingrequirements for reinsurance companies are not so detailed as for direct insurancecompanies.

Generally reinsurance companies generate their financial information from data providedby cedant companies. Because of the international nature of the business there is always adelay in receiving the information or, if financial statements are prepared soon after thebalance sheet date, there could be a lack of quality because a high degree of estimation isneeded. In particular, the claims reserves are subject to estimates. This causes estimatedamounts in reinsurance receivables and payables as well as in profit-sharing. Forproportional business, premiums also have to be estimated. Finally, the profit for the yearis influenced by estimates. There is a trend to producing financial statements morepromptly as a result of pressure from the capital markets. Therefore the impact ofestimations increases.

To keep the quality of the financial statements, in practice, sophisticated estimationsystems are designed for the companies. To give a judgement of the quality of theseestimates, these systems have to be analysed. However, even if the implementedestimation system meets the highest standards, misstatements caused by the lack ofinformation are common and have to be reflected as an adjustment in the next period.

Supervision of reinsurance should take this aspect into account. Financial supervision ofreinsurance companies may not need to be as extensive as for insurance companies.

6.5.11 On-site inspections

6.5.11.1 Inspection by the supervisor

On site inspection is not merely a supervisory parameter. It represents a distinct approachto supervision, one in which the regulator takes an active role in monitoring the activitiesof a company and its compliance with the regulations.

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On site inspections enable supervisors to:

§ evaluate the management and internal control systems;

§ analyse the company’s activities;

§ evaluate the technical conduct of the business being carried on, such as theorganisation and management of the company, its commercial policy, and itsreinsurance cover and security.

These activities are time-consuming and require a technical knowledge of a complexbusiness. On the other hand, on-site expections allow the supervisory staff to extend itsexperiences which are necessary for an effective off-site supervision. The issue with on-site inspections is whether supervisors have sufficient resources to carry them out.

6.5.11.2 Inspection by third parties, such as auditors

In many cases, the objectives of on-site inspection can be achieved by requiring auditorsor other third party experts to investigate and report on companies.

Auditors will already be considering the adequacy of controls and provisions as part ofthe statutory audit so that extending these requirements might be a more feasible andcost-effective approach than the extensive use of on-site inspection by the regulatorsthemselves.

6.6 Parameters relating to indirect supervision

6.6.1 Direct review of reinsurance programme

As defined by the IAIS in the Insurance Core Principles, the insurance supervisor must beable to review reinsurance arrangements to assess the degree of reliance placed on thesearrangements and to determine the appropriateness of such reliance. Insurance companieswould be expected to assess the financial position of their reinsurers in determining anappropriate level of exposure to them. IAIS asks the insurance supervisor to setrequirements with respect to reinsurance contracts or reinsurance companies addressing:

- the amount of the credit taken for reinsurance ceded. The amount of credit takenshould reflect an assessment of the ultimate collectability of the reinsurancerecoverables and may take into account the supervisory control over the reinsurer; and

- the amount of reliance placed on the insurance supervisor of the reinsurance businessof a company which is incorporated in another jurisdiction.

The supervisor has to ensure that the reinsurance programme is appropriate to the level ofcapital of the insurer and the profile of the risks it underwrites and that the reinsurer’sprotection is secure.

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The Australian Prudential Regulation Authority (APRA) also recommends a systembased approach in supervising the reinsurance arrangements of insurers. This approachrecognises primary responsibility for reinsurance management rests with the board andsenior management of an insurer and focuses on the quality of the processes and controlsadopted by that insurer. Reinsurance management is a critical component of an insurer’sability to meet policyholders obligations.

The objective of such an examination is for the cedant to make sure that the chosenreinsurance undertakings, the professional reinsurers as well as the direct insurers writinginward reinsurance, offer the best possible guarantee that they will be able to fulfil theobligations they have accepted.

The monitoring of these reinsurance programs is often less strict than supervision ofdirect business and in many cases simply requires copies of treaties and other contractualdocuments and the list of reinsurers to be submitted to the supervisory authority.Submission of these documents focuses on ensuring observance of technical and financialrequirements rather than evaluating the market conditions of reinsurance contracts.

Requiring insurance companies to report details of their exposures and reinsurancearrangements may encourage management to be more rigorous in devising appropriatereinsurance programmes.

Such security analysis is not always successful, either because of the lack of necessarydata to serve as a basis for assessment or because of the inability of the ceding companyto use the available data to obtain an appropriate assessment of the reinsurers. In thisrespect, insurance supervisory authorities can play a role in exercising some control overthe choice of reinsurers by the ceding companies to ensure the good security of chosenreinsurers.

If the ceding company does not obtain all the information necessary to get acomprehensive overview of the reinsurer, the examination cannot be appropriate. Also,the ceding insurer may not have the capacity to carry out a proper assessment of thereinsurer. However, examining the reinsurance protection of the direct insurer is usefulwhen reinsurance companies are unable to provide information for reasons of clientconfidentiality and if foreign reinsurance companies and/or their branches are notsupervised in their domestic country.

This parameter of indirect supervision has the advantage of reducing the scope ofsupervision. Such an approach can transfer the cost of monitoring the security of foreigncompanies to the foreign reinsurers interested in operating in the domestic market. Butthis indirect supervision parameter brings with it disadvantages such as administrativecosts for cedant companies in providing the information.

A system in which it is the primary insurer’s responsibility to assess the reinsurer’ssecurity may not be totally secure. The ceding insurer will be motivated by the desire tominimise cost as well as to maximise security. For financial reasons the ceding insurermay choose a secure reinsurer, but not necessarily the most secure 27.

27 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles,

standard and practices, February 2000

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The industry is of the opinion that the review of reinsurance programmes is afundamental part of supervising the reinsurance market. Assessment of reinsurer securityis a function of the direct insurer, and supervision authorities must monitor theappropriateness of the protection of the direct insurer by the reinsurer.

In some EU member states the techniques used to assess the reinsurance programme of aninsurer are generally based on data from financial statements and other availableinformation (e.g. Germany) or in some cases based on on-file and on-site audits (e.g.France), but in many cases there is no evidence that the regulator supervises thereinsurance programme beyond an analysis of the documentation which has to besubmitted. In Switzerland no special focus is given to this area by the regulator.

In some countries, for example in France, the information required with respect tocompany’s outwards reinsurance programme is quantitative and does not provide theregulator with a view on the quality of the reinsurance programme.

6.6.2 Limits on maximum exposures

Assessments of the adequacy of an insurer’s reinsurance protection need to be made inthe context of an insurer’s maximum exposure. For example, a company might have aworking rule that it will not expose itself to a loss from a single event of more than 5% ofits capital. Clearly such limits will vary greatly from company to company depending onthe scale and diversity of the insurance business that they write. Any potential loss inexcess of such a limit would need to be protected by reinsurance. In practice, manysupervisors have informal internal guidance on what are appropriate maximum exposures.It may be possible to develop this guidance into harmonised rules on the maximumexposures that companies may accept relative to their capital.

6.6.3 Admissibility of reinsurance assets for the primary insurer

Reinsurance recoveries are hard to quantify as their estimation depends on the estimationof losses during any given period.

The Prudential Supervision of General Insurance Companies in Australia (APRA)proposed that the minimum statutory solvency requirement should take into account therelative riskiness and diversity of reinsurance, in deciding whether, and to what extent,these assets should be allowed to count towards an insurer’s statutory solvencyrequirement. It recommended the consideration of a system of risk weighting the assets ofinsurers, reinsurance assets be risk weighted according to ratings assigned by ratingagencies. More information was sought on how risk weights would be applied toreinsurance assets such as those relating to incurred but not reported claims liabilitieswhere it was uncertain which reinsurer would be called upon.

The pool of reinsurance recoveries would be risk weighted according to the risk-weightedaverage of premiums ceded in the previous reporting period.

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This proposal uses the same general principles in the risk weighting of reinsurance assetsfor insurers as those proposed in June 1999 by the Basel Committee on BankingSupervision28. The proposed reforms include the introduction of credit risk weights basedon the ratings assigned by rating agencies.

Further developments will be shown in the “Study into the methodologies to assess theoverall financial position of an insurance undertaking from the perspective of prudentialsupervision”.

6.6.4 Credit for reinsurance and collateral requirements

Credit for reinsurance concerns the deduction of reinsurance in the calculation of thesolvency margin. The admissibility of reinsurance recoverables for the determination ofrequired minimum regulatory capital has been addressed in the previous sub-section.Collateralisation concerns the reduction of the reinsurers’ credit risk through securitydeposits. Collateral requirements may also affect the calculation of the solvency marginof the primary insurer. According to EU rules, the solvency margin allows just 50% of thereceivables against reinsurers if there is no deposit.

Credit for reinsurance is given either by increasing the assets or reducing liabilities. Toqualify for credit, ceding insurers must meet certain supervisory requirements. These mayinclude the holding of collateral to secure the obligation or the constitution of a trust fundif reinsurance is not ceded to a reinsurer licensed in the home country of the insurer.

One disadvantage of credit for reinsurance with regard to the calculation of the solvencymargin is that reinsurance recoverables are based on past claims while the solvencymargin is supposed to put the reinsurer in the position to cover future claims. Therefore, ithas to be noted that reinsurance recoverables can only be an approximation of riskreduction provided in the future.

Collateral requirements can enhance the domestic supervisor’s comfort level with thereinsurer’s ability to meet its financial obligations to ceding insurers and their requisitepolicyholders.

There are a number of disadvantages: collateral for the benefit of certain classes ofpolicyholders may act to the detriment of other classes of policyholders. Collateralrequirements create classes of preferential creditors and can lead to capital withdrawnfrom the local markets. For many users these restrictions are seen to have the effect ofdispersing a reinsurer’s capacity and thereby hindering its freedom to trade. Finally, therates of return on deposits held by ceding companies are often far lower than wouldactually be earned by reinsurers on these funds, and the practice of requiring depositsactually increases the cost of reinsurance (leading to higher premiums).

Part of the industry argues that with this mechanism of protection, no additionalsupervision is needed for reinsurers.

28 Consultative Paper “A New Capital Adequacy Framework”

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Some supervisory authorities have always held that gross reinsurance technical reservesmust be covered by assets which meet strict criteria. In those cases, reinsurers must makeappropriate deposits or pledges in favour of cedants to enable the direct insurers to meetregulatory liabilities coverage constraints, for example in France. According to the Frenchauthorities, this practice adequately protects cedants against default by their reinsurersand is the only available proof that the reinsurer agrees with the cedant’s computation ofreinsurance recoverables.

It is argued that, considering the difficulties in controlling reinsurance, this system is atthe moment the only one which allows an efficient protection against reinsurer default.Abandoning such a system would only be possible if the new system could give the samelevel of protection for insurers. The system of control over reinsurers would need to besufficiently harmonised and coordinated at an international level and would involve theexchange of confidential information about ceded business.

Within the EU, France, Belgium and Spain use indirect deposits by “gross reserving”. InBelgium, exceptions have to be approved by authorities. In the US, trust funds are used orother collateral under State credit for reinsurance laws.

The US has developed a system whereby the reinsurance transaction is regulated throughthe mechanism of credit for reinsurance. The fundamental concept underlying the USregulatory view is that the reinsurer must either be licensed and subject to the fullspectrum of reinsurance regulation or provide collateral to ensure the payment of thereinsurer’s obligations to US ceding insurers (through a trust, letter of credit or otheracceptable security) 29.

The idea behind this approach is that the ceding insurer is allowed financial statementcredit for cessions to non-US reinsurers, only if US regulators have the confidence thatthe non-US reinsurer is able and willing to pay its obligation to US ceding insurers asthey become due. This is accomplished through the collateralisation of the reinsurers’obligations.

According to US authorities, collateralisation eliminates the regulator’s need to assess thelevel of regulation in the non-US reinsurer’s domiciliary jurisdiction or the financialstrength of the particular reinsurer. Collateralisation ensures that funds are available tosatisfy the non-US reinsurer’s obligations whether it is solvent or not. Collateralisationalso serves to ensure that funds are available in the event that the ceding insurer becomesinsolvent. Cost and difficulties are mitigated or even eliminated if sufficient collateral isprovided to satisfy the obligations of the reinsurer.

European reinsurers are pressing for a less stringent regulatory system in the US thatwould benefit them. They argue that US regulators have established deeper and broaderworking relationships with foreign insurance regulators and have a better understandingof the solvency regulation of many foreign countries. European reinsurers believe itwould be appropriate to reassess the US credit for reinsurance rules, particularly as theyrelate to cessions of reinsurance by US reinsurers to non-US reinsurers. They believe thatit would be appropriate to reduce the level of funding required for the multi-beneficiaryreinsurance trusts maintained by a number of these reinsurers. Today European reinsurersoperating in the US are highly-rated, professional reinsurers dealing with sophisticated

29 Reinsurance Association of America, Alien Reinsurance in the U.S. Market 1996 Data

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buyers. A mutual recognition where reinsurers regulated in the EU are free to trade withinthe US and vice-versa, would facilitate free trade and competition at an internationallevel. This would also reduce the bureaucracy involved in trading in the US and help tocreate a free and transparent market in reinsurance. The IUA has been working on aproject with the objective of reducing trust fund requirements for overseas reinsurers. InMarch 2001 some progress had been made, when the NAIC agreed to the concept ofirrevocable letters of credit being used as an allowable asset. This allows a system withgreater flexibility and improves the reinsurer’s cash flow, but it is only a small stepforward.

Today most of the professional reinsurers handle the problem by establishing a subsidiaryin the US which is subject to supervision, so that there are no obligations for non residentreinsurers.

6.6.5 Diversification requirements

Supervisors can reduce the reinsurer default risk by placing limits on the amount of creditthat can be taken for reinsurance with any one reinsurer.

In general, EU regulators have not enshrined diversification requirements in legislation.This reflects the fact that there are great differences in the types and amount of coverobtained by direct insurers.

6.6.6 Use of rating agencies

As part of an insurer’s assessment of the credit-worthiness of a reinsurer, there isnormally a significant reliance on the ratings provided by rating agencies. Credit ratingsare also important in the context of primary insurance companies, but tend not to be usedextensively where private consumers are concerned, due to the protection afforded byguarantee schemes and existing solvency supervision in many territories.

From a supervisory perspective, this difference is of relevance because there may bescope for supervisory authorities to make greater use of the market mechanism whichexists in relation to credit ratings. Also, downgraded credit ratings will act as signals tosupervisors, particularly as financial difficulties of reinsurers may in turn result indifficulties for insurers, with consequent implications for the protection of policyholders.

At present, there is no explicit use of rating agencies by the regulator, except as generalinformation. But many insurers use rating agency information in their selection ofreinsurers. Insurers that select only highly rated reinsurers, in conjunction with othercriteria, are less likely to have problems with uncollectable reinsurance and will spendless time and resources evaluating reinsurers 30.

Some argue that there will be an extension of their use in response to pressure byregulators who will try to upgrade the quality of companies by insisting that they getratings from acceptable agencies.

30 Principles of Reinsurance, Insurance Institute of America, p.201

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The role of rating agencies is becoming more important. They have already had the effectof improving discipline in the reinsurance market. Although insurers cannot endorse thevalidity of these independent credit evaluations, they do provide a useful indication of thesecurity of various reinsurers in the global market place.

The supervisor has to be careful in using ratings of reinsurance companies because ratingagencies react slowly to market trends and, as stated by the Groupe Consultatif desAssociations d´Actuaires, history shows that they do not provide timely early warningsignals in case of reinsurance failure. However, it would make sense for supervisors to beaware of the external ratings.

Part of the industry is of the opinion that companies have to take precautions when usingratings. The main concern of rating agencies should be the recognition of risk; the riskcannot be assessed with poor proxies such as premiums, but refined exposure measuresare required for adequate risk assessment. Some argue that solvency control throughsupervisory authorities would be preferred to ratings. Rating agencies are in the businessfor commercial reasons and any involvement in supervision would conflict with this.Where the regulator does have recourse to ratings, an acceptable rating level should beestablished (for instance BBB by Standard & Poor’s).

From a rating agency point of view, reinsurance company ratings are used bybrokers/intermediaries banks and equity analysts and are serving policyholders and thecedants. Rating agencies provide benefits to management control and to companies whichcan compare themselves with their peers. In their opinion, they are an early warningsystem for regulators by providing ratings on reinsurance recoveries and insurancecompanies. They point out that there could be a conflict of interest, when companies payfor ratings which the supervisor would be using to regulate them, similarly wheninsurance companies look at claims payment ratings of reinsurers (paid for by thereinsurer). At the moment this is a commercial decision. However, it could become moreserious if regulators use rating agencies.

The main agencies on the market are A.M. Best Company, Standard & Poor’sCorporation Moody’s Investors Service and Fitch IBCA/Duff & Phelps Credit RatingCorp. They provide credit ratings for insurance companies worldwide and also rate themajor reinsurers. They generally have their own models based primarily on historicalfinancial analysis and capital adequacy statistics. A brief overview of the methods usedby these agencies is presented below.

Best’s ratings are based on a comprehensive evaluation of a company’s financial strength,operating performance and market profile against A.M. Best’s quantitative and qualitativestandards. The quantitative evaluation is based on an analysis of each company’s reportedfinancial performance for at least the five past years, using over 100 key financial testsand supporting data. These tests, which vary in their importance depending on acompany’s characteristics, measure a company’s absolute and relative performance inthree critical areas: leverage/capitalisation, profitability and liquidity. A company’squantitative results are compared with standards of its peer composite as established byA.M. Best for property/casualty and life/health insurers. Peer standards are based on theperformance of many insurance companies with comparable business mix and size. Inaddition, industry composite benchmarks are adjusted annually for underwriting,economic and regulatory market conditions to ensure the most effective and appropriate

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analysis. The interpretation of these quantitative measurements involves incorporatingmore judgemental, qualitative considerations into the process 31.

A Standard & Poor’s Insurer Financial Strength Rating is a current opinion of thefinancial security characteristics of an insurance organisation with respect to its ability topay under its insurance policies and contracts in accordance with their terms. Standard &Poor’s employs two approaches when rating the financial strength of insurer: interactiveratings, and “pi” ratings. The difference between the two reflects the amount and type ofinformation the analysts are expected to receive. Interactive financial strength ratings arepublished only after a thorough review, which includes an extensive interview with themanagement. The “pi” subscript indicates that the insurer has not voluntarily subjecteditself to Standard & Poor’s most rigorous review. Therefore, the analysis is based on aninsurer’s published financial information and other data found in the public domain 32.

A Moody’s Insurance Financial Strength Rating assigned to an insurer measures theability of that company to punctually repay senior policyholder obligations and claims.These ratings are based on industry analysis, regulatory trends, and an evaluation of acompany’s business fundamentals. Industry analysis examines the structure ofcompetition within the company’s operating environment and its competitive positionwithin that structure. Analysis of regulatory trends attempts to develop an understandingof potential changes in a particular country’s regulatory system, accounting system, andtax structure. The analysis of a company’s business fundamentals focuses primarily onfranchise value, management, organisational structure/ownership, and financial analysis.The financial analysis includes an assessment of capital adequacy, investment risk,asset/liability management, profitability, liquidity, underwriting, reserve adequacy, andfinancial leverage33.

A Fitch insurer financial strength rating (IFS rating) provides an assessment of thefinancial strength of an insurance organisation, and its capacity to meet senior obligationsto policyholders and contract holders on a timely basis. Fitch’s analyses incorporate anevaluation of the rated company’s current financial position as well as an assessment ofhow the financial position may change in the future. Consequently, the ratingmethodology includes an assessment of both quantitative and qualitative factors based onin-depth discussions with senior management. Fitch’s insurance ratings generally includean approximate 60% quantitative and 40% qualitative element through such weightingscan vary drastically given unique circumstances. The company’s ability to meet itsobligation is evaluated under a variety of stress scenarios, not just the “most likely”scenario. Incorporated into the analysis is a review of the company specifically, as well asthe macro trends affecting the industry in general. Rating methodology focuses on theindustry review, operational review, organisational review, management review andfinancial review34.

31 Best’s Key Rating Guide, Life and Health Edition32 Standard & Poor’s Property/Casualty Insurance Ratings Criteria33 Moody’s Rating Methodology Assessing Credit Risks of US Property and Casualty Insurers34 Fitch Non-Life Insurance Ratings Criteria

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Analysis of reinsurance companies, as pointed out by Standard & Poor’s, must becontinually reinvented in order to be reflective of the expanding boundaries andinnovative approaches of “non-traditional” reinsurance mechanisms, like the emergenceof alternative market mechanisms; the gradual diminution of true risk transfer embodiedin finite risk reinsurance; the connection of reinsurance with financial markets in thesecuritisation of various type of risks. The issue of reinsurance recoverables remains asignificant one for the reinsurance industry and is focused on the ultimate collectability ofretroceded liabilities.

Generally, the major players in the reinsurance market are rated by the majorinternational agencies. Most smaller companies do not engage a rating agency. Generally,no use of ratings is made by the regulator.

For the implementation of a framework of supervision of reinsurers the reliance on ratingagencies is a possible approach. On the one hand this approach does not give rise to highcosts, but on the other hand the judgement of rating agencies is driven by subjectiveconsiderations. The reinsurer and the supervisory authority have no influence on thesubjective elements of a rating.

6.6.7 Restrictions on use of non-regulated reinsurers

At present this issue is greatly influenced by the fact that many of the largest andstrongest reinsurers are currently unregulated or only regulated to a relatively limitedextent. The two largest reinsurers, Munich Re and Swiss Re, have some 20% of thereinsurance market between them, and both have the highest security ratings. Of the tenlargest non-life reinsurers, five are regulated to a relatively limited extent only (MunichRe and Swiss Re plus Gerling, Allianz Re and Hannover Re). In such circumstances, it isimpractical for supervisors to restrict the extent to which direct insurers place reinsurancecover with unregulated reinsurers.

However, if the EU introduced a regulation requirement for reinsurers, it could becomepossible for EU insurance supervisors to restrict the amount of credit given forreinsurance placed with unregulated reinsurers.

6.6.8 Restrictions on use of “unapproved reinsurers”

Another approach that supervisors could take would be to restrict credit for reinsurance tocover from “approved reinsurers” which could include all regulated reinsurers plus otherunregulated reinsurers which were explicitly approved by the supervisor.

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7 The arguments for and against reinsurance supervisionand a broad cost-benefit analysis

7.1 Scope

In accordance with the Terms of Reference, this chapter analyses “the arguments for andagainst reinsurance supervision (e.g. contribution towards strengthening the prudentialsupervision of primary insurers, access to global markets by European reinsurancecompanies, etc.)” and provides “a broad cost-benefit analysis of the public policybenefits achieved by supervising reinsurers relative to the costs of supervision”.

7.2 Approach

In reporting on the above objective, we undertook the following approach:

§ Use of existing specialist knowledge;

§ Use of questionnaires to KPMG offices and a number of interviews with reinsurers;

§ Discussions with regulators and use of public information where necessary, tosupplement information gathered from local offices;

§ Reviews of existing published sources.

7.3 Arguments for reinsurance supervision

There is one single directive, adopted in 1964, which applies specifically to reinsurance;it was intended to abolish regulations which restricted freedom of establishment andfreedom of services. In practice, its principal effect has been to facilitate the freedom ofestablishment for specialised reinsurers. However, the experience of these three decadesshows that the freedom ratified by the directive of 1964 no longer satisfies all concerns ofreinsurers. This directive had left national supervisory authorities the option to implementlocal reinsurance supervision regimes. This has led to a proliferation of national rules onreinsurance, often very disparate, which has hindered the creation of a single market.Differences in the regulation of reinsurers across EU member states has resulted in adistortion of competition of the single market. On the other hand, harmonised supervisioncan create distortion of competition with reinsurance providers from European thirdcountries (e.g. US).

Growing pressure is coming from international discussions between central bankers andfinance ministries for international reinsurance to be brought more under control.Generally, there is a consensus about more supervision. In fact major reinsurers are low-regulated or differentially regulated, but the main factor is that globalisation and e-commerce are creating an international flow of capital. But there has been no empiricalevidence of any systemic risks (see section 3.4 for the definition of systemic risk) causedby or in connection with the reinsurance sector35.

35 Financial Stability Forum, Report of the Working Group on Offshore Centres, April 2000,

p.15

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EU harmonised market

Enhanced regulation of reinsurers is part of an inexorable trend towards regional andglobal coordination of the conduct of financial services business generally. WithinEurope it is an anomaly that the direct insurance market should benefit from a levelplaying field while the reinsurance market, which serves it, remains subject to tradingbarriers within the EU, contrary to the principles of free movement of capital and servicesupon which it is based. However, reinsurance has historically always been international.Because of its international nature, a heterogeneous system of supervision within the EUor even world-wide may lead to impediments and distortion of competition.

A level playing field in the regulation of reinsurance in Europe is proposed by manyassociations such as the IUA or the CEA, which could be achieved by the implementationof a mutual recognition system such as a single passport. For the IUA the objective is fora European passport for insurance and reinsurance to attain mutual recognition with theequivalent North-American system.

Such a system would help to eliminate discriminatory treatment and trade obstacles (suchas additional licensing procedures, reporting requirements, deposits or similarrequirements). In a number of countries, the collateral system determines the reinsurancearrangements where local regulation focuses on the security of the primary insurer. Theserequirements have the disadvantage that they result in capital being withdrawn from thelocal market. From a reinsurer’s point of view it is argued that such restrictions on thelocation of capital unduly hinder the freedom of trade.

Higher reinsurance costs caused by market barriers

Barriers to foreign reinsurers, such as exist at present, increase the cost of reinsurance tocedants and thus also the cost of insurance to policyholders. They reduce access to thecompetitive international reinsurance market which would offer not only lower cost, butalso a better and broader range of services.

For instance the obligations involving letters of credit bring additional costs forreinsurers.

Indirect additional protection of policyholders

Direct or indirect supervision of reinsurance does not only protect the direct insureragainst failure of its reinsurer, but maintaining stability and confidence in reinsurancemarkets through the application of supervision parameters in turn also leads to a higherdegree of policyholder protection.

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Transparency of the market

The existence of harmonised supervision rules would also improve transparency in theEuropean industry. Implementation of common accounting standards and practices andprudential ratios applicable to all is essential to enable operators to establish andterminate relationships based on a full knowledge of the facts. Transparency ofinformation in the marketplace facilitates market discipline which in turn maintainsstandards of conduct and creates incentives for companies themselves to maintainstandards. However, harmonised regulation can only work with adequate standards andsimilar core requirements imposed by each country, to permit free trade anywhere in thegeographical area of mutual recognition.

Market performance

Moreover, supervision could help ensure a strong image and could possibly improveindustry performance. As “unsuitable” reinsurers could be identified more easily and, ifthere were an authorisation or licensing system, could be removed from the market theoverall reputation of the market would be enhanced. Regulation may help remove firmsguilty of misconduct from the market that would otherwise contaminate the reputation ofall firms in the market.

Reduction in insolvency risk

In recent years, the reinsurance market has shown a clear trend towards concentration andan abundance of risk-seeking capital supply. Fraud risks may occur in the complexmarkets of risk transfer products because of the insufficiently transparent retrocessionprocesses. The combination of severe competition and continuous entry of new supplierscan lead, among other things, to bankruptcy.

Supervision may contribute to limit the risk of fraudulent bankruptcy or default. Even if areinsurer’s bankruptcy only rarely leads to insolvency of its cedants, it is important for thereputation of the reinsurance sector to avoid such occurrences.

Increase in market efficiency

Regulation that could enhance competition and overall efficiency in the market couldcreate a market which overall works more efficiently and through which everyone couldgain. Competition can result in a transfer from the less to the more efficient reinsurerwhich has the effect of increasing the overall efficiency of the market. In this respect,efficient reinsurers may possibly benefit from meaningful regulation. Regulation canmake competition more effective in the market by requiring the disclosure of relevantinformation that can be used by insurers in making informed choices.

Bargaining power against non-EU countries

Supervision could lead to European insurance associations having increased bargainingpower to oblige non-European countries to lower the constraints which still all too oftenhamper geographical expansion of reinsurance operations. A common Europeanframework could also provide European reinsurers with a competitive advantage overunsupervised non-EEA reinsurers and could thus be used as a marketing tool. But thisobviously depends on the nature and structure of the framework.

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Many European associations believe harmonised supervision could give Europeanreinsurers a strong image and a negotiating tool, vis à vis foreign regulators (e.g. US), forbeing considered adequately supervised. Restrictions placed by regulators on foreignreinsurers, such as having to keep trust funds in the US, are in fact protectionist in theireffects.

Cost savings by harmonised supervision

Harmonised supervision would reduce the scope for duplication, with only homesupervision, which would reduce the costs at an EU level. A standard system will lead toa saving on the costs of compliance with different legal and regulatory regimes. A systembuilt on mutual recognition (i.e. a passport system) in the country where the reinsuranceundertaking is registered would mean that supervisors in host countries would not have toperform additional supervision or checks.

Capacities of direct insurance industry increase by harmonised supervision

A recognised harmonised system could mean that more credit could be given forreinsurance in the solvency margin calculation for business ceded to EU licensedreinsurers. This would mean that the maximum reduction of 50% today might beincreased in order for direct insurers to rely to a large extent on their reinsurancearrangements with EU recognised reinsurers. AISAM strongly considers that the currentmaximum reductions for reinsurance are too low and should be increased to between 90%to 100% for all contracts, provided of course that the reinsurer was properly supervised.For the Groupe Consultatif, the amount of the solvency margin reduction should dependon both the standing and type of cover applied, given the insurer’s portfolio and expectednew business. Under these conditions regulation increases the capacity of direct insurers.

Harmonisation allows a lower level of regulation

Any harmonisation of reinsurance regulations should minimise such regulation as isalready in place. Even the opponents of reinsurance supervision prefer harmonisedsupervision to the current situation because this would reduce the effort required to fulfildifferent local rules from supervisory authorities. In many countries, there are severalreporting requirements for foreign reinsurers. The requirements differ from country tocountry, for example in relation to the accounting rules.

7.4 Arguments against reinsurance supervision

Generally, the reinsurance industry is of the opinion that there is no need for regulation,arguing that in several European countries there are low-level regulated markets whichoperate effectively.

The reinsurance industry also argues that the evaluation of adequate protection andsecurity of reinsurance companies is the business of direct insurance. Companies are ofthe opinion that supervision should be based at this level, focusing on whether thereinsurance protection of the direct insurer is appropriate.

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Professional market

Reinsurance is a professional market. The customers of reinsurers are sophisticatedcompanies who do not need the same protection as private consumers. In a wholesalebusiness such as reinsurance, commercial insurers and reinsurers deal with otherprofessional corporations, business to business, and do not need special protection likefinal consumers (policyholders). The view of the IUA is that, this situation means thatreinsurers should be subject to a lower degree of regulation than insurers. For someprofessionals, this shows that there is no justification for detailed state supervision.

Practical implementation of supervision

Given the internationality of the reinsurance business and its dynamism and flexibility,which differs from direct insurance, the practical implementation of national supervisionmay be difficult. For example the types of contracts differ from region to region. Inrelation to the business which is highly heterogeneous, requirements for reinsurancesupervision are also high.

Global market

Global reinsurance business needs more freedom of action than the direct insurancebusiness which is usually regionally limited, so that the intensity of supervision shouldnot be the same for the professional market of reinsurance as for the direct insurancemarket.

Market barriers

Regulation, particularly state regulation, brings initial barriers to entry, and can introducedelays which conflict with business objectives. State regulation is necessary for theprotection of consumers, but reinsurance is a business between sophisticated commercialundertakings, not consumers.

Impact on effective competition

Reinsurance supervision may have adverse effects on the functioning of the reinsurancemarket. Where legislation is deemed necessary it should not create an inequality whichhinders fair and effective competition. Trying to harmonise supervision on a global basismay avoid discrimination between EU and non-EU reinsurers. Restriction in the EU thathinders reinsurers in their business relative to non-EU reinsurers may ultimately result inadverse pricing differences which subsequently impact adversely on the EU reinsuranceindustry.

EU harmonised market

Such regulation may introduce in Europe restrictions not previously thought to benecessary, which is contrary to the freedom of establishment and the freedom to providecross-border services within the EU, as guaranteed by treaties. Under European law, thesesort of restrictions have to be objectively justifiable in the public interest. Regulation mayhamper the supply of reinsurance capacity provoking a negative effect for insurancepolicyholders, as insurance companies would provide less capacity as a consequence.

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Experience in regulated markets

The reinsurance industry argues that most reinsurance insolvencies have occurred inregulated markets. There is no evidence that the financial collapse of a reinsurer wouldpose any systemic threat to the insurance market, although it could have a real negativeeffect for any particular insurance company.

Flight of capital

Regulation in Europe may encourage a flight of capital to more amenable jurisdictions,such as Channel Islands or Barbados (off-shore markets), as companies will find waysaround regulation or even exploit it. Changing the supervisory system may createopportunities for those who wish to escape from regulation which can lead to anincreased risk of default in the reinsurance market.

EU harmonisation versus global markets

Although there is an argument that regulation would enable the European authorities tonegotiate reciprocal agreements of mutual recognition with other countries, notably theUS, it seems unlikely that it would achieve such an objective, since American authorities(for protectionist reasons) would certainly resist such an opening up of the reinsurancemarket. The Reinsurance Association of America argues that the US reinsurance industrycannot support any proposal that would permit non-US reinsurers to assume reinsurancerisks from US cedants on the basis of a single licence through mutual recognition whileUS reinsurers continue to be constrained by a 50-state regulatory system. Mutualrecognition is not feasible until US reinsurers are permitted to do business in the US in amanner that will maintain a level playing field with non-US reinsurers.

According to the OECD and the CEA, obstacles still exist in some countries such asmonopolies, compulsory cessions, supervisory restrictions, tax restrictions (e.g. USA witha Federal excise tax in reinsurance), compulsory deposits by reinsurers (as in France orUSA) or administrative impediments.

A common system of supervision in Europe should take into account the systems existingin other countries, especially Switzerland. Also, supervisory practice should be taken intoconsideration. The existing bilateral agreements between the Swiss Confederation and theEU could probably be updated by a demand for local application of the same elements toSwiss reinsurance. A system with a “high” degree of supervision would be difficult toimplement in Switzerland and other reinsurance markets.

Knowledge

Another difficulty in implementing reinsurance supervision arises from the limitedavailability of reinsurance specialists. Given the small number of experts, according tothe Groupe Consultatif, it might be difficult for supervisory authorities to find appropriatehuman resources. It may not be feasible or cost-effective to expect each local supervisorto have the necessary skills to assess reinsurers’ security as well as their products.

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Harmonised supervision for the whole industry

There is a network for reinsurance and direct insurance within all the EU market. If asupervision system is implemented it seems to be necessary to set up a uniform systemfor the industry as a whole, as the businesses of direct insurance and reinsurance areconnected.

Costs

Regulation leads to on-going costs, direct and indirect. If regulatory authorities developregulation with costs that outweigh their benefits, the market will become less efficient.Any regulation brings costs for the industry as a whole. Closer regulation increases thecosts for the companies, arising from the additional time spent in preparing and providinginformation to the regulator.

Implementing or enforcing regulation leads to higher costs for regulatory authoritieswhich will need more resources and in particular for specialists in the reinsurance market.Due to the current situation in the reinsurance market, the reinsurer may not be able torecoup the increase in costs through higher premiums.

7.5 Impacts on the different approaches to supervision

The extent of the impact of supervision will depend on the supervisory regime adoptedand the extent to which it is more or less direct and detailed. A harmonisation of thesystem and of the requirements at an EU level is recommended by the majority ofmember states, whereby a model based on direct supervision is preferred.

If it is decided to introduce harmonised supervision, some operators consider that directand detailed supervision of reinsurance undertakings will not necessarily be the onlysolution and may have restrictive effects. In the large majority of cases, the prudentialsupervision currently exercised in the reinsurance undertaking’s head office countryshould suffice, whether exercised directly or not. Some argue that a stricter and closersupervision should be reserved for new players in the market. The Groupe Consultatif’sview is that, if reinsurance is supervised, this should not be at as detailed a level as directinsurance.

The strength of the arguments for and against supervision presented above will depend onthe level of supervision adopted. A more stringent level of supervision would increase thestrength of the arguments.

For example, a supervision equal to the supervision of direct insurers leads to mainly highsecurity against insolvencies but creates a very high level of costs and market barriers forthe reinsurers.

7.6 Cost-benefit analysis

The arguments in favour of supervision need to be balanced against their cost. Closersupervision needs to be justified in terms of the value added for society. When there arealternatives for regulating an aspect, the most cost-effective regulatory practice should bethe one which least impedes the ability of the market to respond to the consumer’s needs.

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Before undertaking important regulatory changes, the scale of the cost implications at alllevels (supervised institutions, supervisory authority and possibly third parties) needs tobe established and set against the anticipated benefits.

Regulations will bring benefits where there is a probability that they will reduce marketimperfections and failures or eliminate them. The extent of benefits is equal to thereduction in damages caused by market imperfection and failures. But regulation alsogives rise to costs.

The comparison of costs and benefits of regulation gives information about economicadvantages. It has to be checked very carefully if the benefits of additional requirementsof supervision are worth the costs of the impact on the reinsurance industry. Regulationshould only be undertaken when the benefits outweigh the additional costs. Anassessment of benefits should be oriented to regulatory objectives.

Regulatory intervention is only likely to be justified if the nature of the marketimperfection (if any) is causing a problem, if there are solutions for the imperfections todeliver a net improvement and if the regulation does not cause any other greaterdisadvantages.

An analysis of the nature and degree of market failure should also involve an analysis ofwhether the benefits of regulation can ever exceed the costs. There are costs involved inpursuing regulation and, if pursued too far, the costs may come to exceed the benefits.Regulation can always be made more effective in terms of its defined objectives, but atthe expense of higher costs. The aim is to balance the benefits of a higher degree ofachievement of objectives against the costs.

The view of the FSA (Financial Services Authority) in the UK is that some regulation canbe counter-productive if, for instance, it erects unwarranted entry barriers, restrictscompetition in other ways, controls prices, stifles innovation, restricts diversification byfinancial firms, impedes market disciplines on financial firms, etc. For these reasons, theFSA recommends that all regulatory requirements should be subject to some form of cost-benefit discipline though, in practice, such exercises encounter formidablemethodological problems.

7.6.1 Description of supervision cost-impacts

The costs/benefits deriving from supervision can be classified into two categories: micro-economic which are more easily quantifiable and macro-economic which are not readilymeasurable.

7.6.1.1 Micro-economic impacts

Costs directly related to the supervisory regime

Designing, monitoring and enforcing regulations requires extra resources. These includeadministrative costs for the State, IT resources, human resources, training costs, controland supervision division costs and other administrative expenditures. This will be the casewhen no supervision already exists and a regulatory body has to be created. This situationwill also occur when supervision already exists but must be extended into a new areawhich requires specialist knowledge of the reinsurance market.

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In order to monitor the highly specialised market of reinsurance, a high level of trainingwill be required in the supervisory organisation. Education of regulators will give rise toadditional costs of supervision. Such costs are generally quite easy to measure as theyconsist of expenditure by regulatory bodies.

The regulatory body could recover part of these costs and implement a fee charged toregulated companies. In practice costs for current supervision are mainly transferred tothe supervised entities. In Germany, for instance, the industry pays about 90% of thesupervisory costs. As implementation of reinsurance supervision is complex, the cost ofits implementation are probably not recoverable. In turn these fees charged to reinsurersmay lead to an increase of premiums.

Costs of compliance

The regulated reinsurance companies must use extra resources, including time, to complywith new regulations. These costs may include allocating the resources internally, costs oftraining, management time, authorisation costs, costs arising from disclosure. Generallythese costs could have an impact on the final price to the consumer (policyholder).

The use of extra resources can be significant. Global reinsurance companies estimate thecost being approximately four persons per year to comply with reporting obligations.

The cost of harmonising supervision at an EU level will result in direct costs and costs ofcompliance that will be different for each country, as they depend on the extent to whichregulatory practices already exist. These costs will also vary regarding the extent of therequirements required for harmonised supervision.

Increase in premiums

An increase in costs for reinsurers, directly or by a possible fee charged by the regulator,may lead to an increase in premiums for policyholders as explained previously. Costs ofreinsurance to cedants would increase and as a result the cost of insurance topolicyholders would increase too.

At the moment the market situation of reinsurance companies would not permit anincrease in premiums. In this case the costs have to be paid by the shareholders. Thesituation will possibly change in the future.

7.6.1.2 Macro-economic impacts

Besides the micro-economic impacts on the economy as a whole, regulation may alsobring indirect costs or indirect benefits which are generally hard to measure.

Negative market impacts

Negative market impacts include the costs of reduced competition arising from the lossassociated with increased charges. Higher costs for reinsurers, brought by regulation, mayreduce efficiency and lead to uncompetitiveness in the reinsurance market. The increaseof costs for EU reinsurers could have a negative impact comparatively with non-EUreinsurers, and a consequence could be the flight to other countries as explained below.

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Regulation may hamper the supply of reinsurance capacity producing a negative effectfor insurance policyholders, as insurance companies will provide less capacity as aconsequence.

The demand in the reinsurance market can decrease as a result of regulation costs. Thesecosts may have a repercussion on the cost of reinsurance and indirectly on the cost ofinsurance for policyholders.

It is possible that the introduction of supervision would cause some companies to ceasebusiness, or that financial services would be transferred to less regulated areas. Indeed theenforcement of new regulations may create opportunities for those who wish to escaperegulation (to amenable jurisdictions) which can lead to a weakening in the security of thereinsurance market. One possible impact would be the reduction in the choices ofreinsurance products in the market. That situation also would mean higher costs whichcould also lead to a lack of competitiveness and job losses.

Regulation can have also an impact on the availability of the products in the market, incase of licensing system in which unsuitable reinsurers are removed from the market.This may reduce a cedant’s scope for achieving an optimal allocation of capital.

Regulation may also have a negative effect on small businesses. If regulation imposeshigh fixed costs, it may hinder new small businesses entering the market which couldreduce competition.

7.6.2 Description of supervision benefit-impacts

7.6.2.1 Micro-economic impacts

Reduction of costs

Harmonised supervision can also lead to a reduction of costs at an EU level, as it wouldreduce the scope for duplication and eliminate the costs associated with different legaland regulatory regimes.

Reinsurance companies doing business worldwide already have departments to serve thedifferent supervisory regulations in different countries. This is highly cost intensive dueto the existence of different disclosures required under different accounting principles.

A single administration would avoid duplication of compliance costs arguably withoutany reduction in benefit.

7.6.2.2 Macro-economic impacts

Positive market impacts

Regulation can have a significant effect on competition. As explained in the first part ofthis section, harmonised regulation would permit free access to the competitiveinternational reinsurance market and may lead to lower cost of reinsurance and indirectlyof insurance. This situation could create a benefit for the policyholder by reducingpremiums.

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Under a European passport system, regulation would enhance competition and create abenefit by reducing the resources wasted competing for the market (e.g. highcommissions). The value of this benefit would equal the value of the reduction inresources wasted, which in turn would equal the reduction in the costs of the firmscompeting for the market.

Efficient competition also leads to a better and broader range of services. This means anincrease in quality that is brought about by regulation. Improved quality in thereinsurance products leads to more secure products in the market. The benefit is to allowinsurers to select products more appropriate to their level of risk.

Confidence in the market, enhanced through regulation by setting minimum standardrequirements, leads to increased demand for reinsurance products which is beneficial tothe insurance industry as a whole (reinsurer, insurer, policyholder). As a general rule, anincrease in choice creates a benefit.

Regulation which removes firms guilty of misconduct from the market that wouldotherwise contaminate the reputation of all firms in the market should increase overallsecurity. Reinsurance regulation implies more security for insurers which indirectly leadsto more security for policyholders. Greater security for insurers means less risk of failuresin the insurance market, although in the past there have been no significant cases wherean insolvency of a reinsurer did cause insolvency of direct insurer.

Finally, regulation that enhances market transparency for insurers due to a harmonisedlevel of quality of reinsurers leads to costs savings in the process of reinsurer selection.

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8 Summary of reinsurance market practice for assessingrisk and establishing technical provisions

8.1 Scope

In accordance with the Terms of Reference, this chapter provides “ a summary ofreinsurance market practice for assessing risk and establishing adequate technicalprovisions, the impact of securitisation and how reinsurers measure or take into accountportfolio diversification in assessing their own capital requirements. Techniques for thecalculation of probable maximum losses (PML) should be specifically addressed”.

8.2 Approach

In reporting on the above objective, we undertook the following approach:

§ Use of existing specialist knowledge;

§ Use of questionnaires to KPMG offices and a number of interviews with reinsurers;

§ Discussions with regulators and use of public information where necessary, tosupplement information gathered from local offices;

§ Reviews of existing published sources.

8.3 Market practice for assessing risk

The risks for reinsurance companies are set out in chapter 3 of this report. The range ofrisks is diverse. Moreover, the amount of information available to the reinsurer dependson the cedant and will vary considerably, for example according to the segment ofbusiness, and the territory, as well as the individual cedant. Specific comments on foreigncurrency risk are included below, and reserving risk is covered in section 8.4. Theassessment of other risks is highly dependant on the individual reinsurer.

Soundly managed reinsurers will undertake exposure analysis as part of their assessmentof underwriting risk. Individual records of contracts written will capture the underlyingexposures, sum insured limits, etc. Overall risk assessment depends on modelling basedon this. Different reinsurers extend this to different degrees of depth. We describe belowa modelling approach which attempts to model all aspects of the reinsurers risks acrossthe whole enterprise. This description is comprehensive and some parts of the overallprocess are adopted in isolation by some companies.

Reinsurance companies face several categories of risks doing their business. The differentrisks are similar to those of direct insurers. The underwriting risk as an essential riskdiffers especially because the business written by a reinsurer is derivative. Usually, thespread of the business written by a reinsurer is much wider in terms of geography andtype or line of business than that written by a direct insurer. This has a significantinfluence on the calculation of underwriting risk. The reinsurance industry deals withthese higher risks by a diversification of its portfolio and pooling of individual risks.

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For better risk management the reinsurance industry is working on internal risk models,especially relating to underwriting risk.

Underwriting risk is the key risk for reinsurers. There are several other risks facingreinsurance companies. These risks are discussed in chapter 3. The risks considered to bethe most significant after underwriting risk are:

§ credit risk

§ investment risk

§ currency exchange risk

The reserve risk is part of the underwriting risk but is so significant that reinsurersconsider it separately. There are risk management strategies established to handle theabove mentioned risks. As the complexity of interdependencies and the interrelationsbetween these risks differ significantly the risk management strategies differ for each risk.

8.4 Establishing adequate technical provisions

8.4.1 General comments

Today most reinsurance companies use actuarial methods to assess the adequacy ofreported reserves. Generally the reserves reported by the cedant are taken into the booksof the reinsurer. The reinsurer receives claims reserves from all over the world and has tojudge the quality of these reserves. Reserving quality is very different from country tocountry. For example, reported reserves on business written in the US tend to be verylow. German business used to be reserved strongly at least in some lines of business (suchas motor in the past) and has ultimately produced significant run-off profits.

Incurred but not reported (IBNR) claims in proportional business are, in principle, set upin accordance with the amounts reported by the cedant. In some cases theIBNRprovisions set up by the cedants are not included in the accounts of the reinsurer orthey are not sufficient, e.g. in third party liability. This is common practice for non-proportional business. In these cases and in the case of differing accounting policiesbetween countries it is important that the reinsurer does its own analysis of IBNR claims.IBNR claims reserves can only be assessed using statistical methods which are discussedfor the reported claims reserve generally in the following sections. These methods areapplied to both proportional and non-proportional business although assumptions in non-proportional business are much more uncertain because of the higher volatility of non-proportional business and respective historical data.

The actuarial calculation of the reserves in life and non-life business mainly addressesthree major subjects

- adequacy of the reserves set up in the published accounts;

- adequacy of premium calculation;

- adequacy of the retrocession program.

For this analysis actuaries apply different tools.

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Life actuaries tend to model or remodel the premium and reserve calculation of thecedants by applying (modified) assumptions received by the cedant or derived from theirmarket databases. The accuracy of the results of the life actuaries mainly depend on theunderlying assumptions. In life business significant uncertainties remain in those caseswhere either not enough data is available from the cedant or other sources or where nodata records are available due to the missing history of new products (for example incurrent processes of privatisation of health insurance).

Non-life actuaries generally use triangulation methods for their work. In these models, theavailable data is divided into accident years and the related run-off years. If the earliestreliable accident year is not settled, it is necessary to set a so called tail factor to take theremaining run-off into account. Various kinds of models are used. Most of the modelsfocus on the prognosis of the development factors that have to be used for the differentdevelopment years. For these prognoses it is necessary to have as much homogeneousdata as possible and, therefore, the underlying data is segmented. Large claims andcumulative claims are eliminated for a separate estimation. The quality of the non-lifeactuaries work heavily depends on the volatility of the development factors of therespective segment. The more homogeneous the underlying database is, the more reliableare the results of the actuarial analysis and vice versa. Because of the underlying business(i.e. environmental liability, US liability or catastrophe risks) there is a probability ofsignificant uncertainties. The methods of reserve analysis for non-life business arediscussed in the following section.

Overall it can be stated that a well organized and well diversified reinsurance company isable to monitor its reserve risks properly.

The impact of the reserve risks on the underwriting risks are obvious. Therefore this kindof analysis plays a significant part in the calculation of the underwriting risk of areinsurance company. More details on that are discussed below.

8.4.2 Actuarial reserve analysis for non-life business

Actuarial reserve analysis can be regarded as a three step process: definition andobtaining of the required data, segmentation of the business, analysis of the segments.

8.4.2.1 Required Data

Defining and obtaining the required data is the most crucial step for a reinsurancecompany.

For reinsurance companies it is difficult to obtain the data needed for the analysis. Asmentioned in section 2.5.4. there is usually a delay in reporting claims. Another reasonfor the difficulties is that, depending on the complexity of reinsurance contract terms,cedants may want to evade a high effort of supplying the data or need more time to do so.In addition, a cedant may be interested in delaying the supply of data until the renewal ofreinsurance contracts with advantageous contract terms. The problems of obtaining therequired data from cedants could somewhat diminish in the future with the improvementof data systems. Systems which allow estimations of unearned premiums and claimsprovisions with an acceptable extent of reliability in an environment of constant delays inclaims reporting do not exist yet and are currently being developed in practice.

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For proportional business the figures are usually available on an accident year basis butthere is no information on single claims. Even this information is not visible from thecedant’s account. For non-proportional business it is even more difficult to obtain therequested data, especially for the layers written by the reinsurer. The historical data canonly be taken as significant if the structure of the written layers is comparable over theyears. Otherwise, claims information has to be adjusted for projection purposes. Data isonly available for the gross business of the reinsurer. To calculate deficiencies with animpact on equity the calculation has to be done on a net business. The retro data is evenmore difficult to get, because generally the retro cover is not based on single treaties orsegments of the incoming business, but is for example segmented differently or based onwhole accounts for a line of business.

For the analysis of gross business payments, outstandings, earned premiums andcommissions (brokerage) are essential. Usually the number of losses is taken into accountbut generally these numbers are not completely available to the reinsurer. To calculate anaverage loss size on the existing base would leave the analysed segments too small for astatistical analysis.

The claims data may be available in accident year or underwriting year cohorts dependingon the type of business and the practices of the individual cedant. For each cohort, theclaims for each development period need to be available.

Companies often book their losses on an underwriting year (UY) basis. Underwritingyears may have a different duration which would distort the homogeneous behaviour of asegment. Moreover, if an insurance contract with a period of e.g. five years is part of areinsurance treaty on underwriting year basis, any loss that is incurred in the second treatyyear would be allocated to the second development year and therefore regarded as anIBNR loss which is not the case in strict terms. The problem with multiyear reinsurancecontracts on an underwriting year basis is that it is simply not known for losses incurredin years following the underwriting year to what extent they are caused by increasedclaims expenses (corresponding to a run-off loss on an accident year basis), IBNR orclaims incurred in years following the underwriting year. This makes an adequateanalysis of data difficult.

Because of such difficulties, the split by accident year if available is in many wayspreferable for analysis purposes.

Often the split by accident year is not available, and analysis has to be done on anunderwriting year basis, or this may be necessary as the market has always beenorganised on an underwriting year basis (e.g. Lloyd’s and many other London Marketinsurers and reinsurers).

For the analysis the actuary only takes business into account that has a bearing on the lossdevelopment. Clean cut business is not analysed using triangulation projectiontechniques.

Run off treaties should be available with their total history. If parts of the history of run-off treaties are not available there should be a separate analysis.

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If at the date of the actuarial analysis the current calendar year is not totally reported,reinsurance actuaries may leave out the last diagonal and correct the total reserves whichare the result of their analysis by the payments booked for the current calendar year.Alternatively, the current calendar year can be extended to a full year by pro-rata grossingup or, better, using monthly or quarterly development factors. For the estimation of thecurrent year’s reserve the Expected Loss Method may be utilised.

8.4.2.2 Segmentation of the Business

The analysed business has to be sub-divided. The aim is to get segments with ahomogeneous development of the run-off. The segmentation has to leave a statisticallyusable group of claims for the analysis. As mentioned before, cumulative events likecatastrophes and other special features have to be eliminated in advance.

Basically, the segmentation of the reinsurance business should be three-dimensional: lineof business (LOB), type of reinsurance, region.

The different lines of business have to be divided into at least long-tail and short-tailbusiness. It is very important that any liability business is kept separate. This is difficultfor motor business because generally reinsurance does not divide motor liability and otherdamages. For statistical reasons lines of business may be accumulated for the analysis –for example the complete property business might be analysed as one LOB.

Within a LOB the business should be segmented by three types of reinsurance:proportional, non proportional and facultative business. Geographical segments have tobe defined as well. Reinsurance business can be very different according to the regionwhere it is written. The regional split can only be made according to the region where thebusiness is written and data recorded. This does not necessarily mean that this segmentonly includes risks of this region.

8.4.2.3 Analysis of the Segments

The first step in an analysis is the definition of the data to be used. If all necessary data isavailable the analysis can be run based on payments or on incurred amounts (includingreserves). Incurred amounts may be influenced by the cedants’ accounting policy onreserves, but contains more information in the outstanding claims and reflects legal andother changes which may not work their way through to payments for some years. Thus,both the payments basis and the incurred basis should be considered.

For non proportional business an analysis based on payments is often not possible sincethe payments for these contracts begin in later development years. For those cases the useof the incurred values is necessary.

For the evaluation of the required reserves several actuarial methods are available, e.g.:

§ Chain Ladder Method

§ Bornhuetter-Ferguson Method

§ Cape Cod Method

§ Additive or Loss Ratio Step-by-Step Method

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§ Expected Loss or Naïve Loss Ratio Method

§ Berquist-Sherman Method

§ Benktander Method or Iterated Bornhuetter Ferguson Method

§ Separation Methods

§ Fisher-Lange Method

§ Salzmann Methods

Variations of the above methods are also available. Some methods require data which isusually not available to reinsurance companies.

The standard techniques applied by reinsurance actuaries are Chain Ladder (withvariations), Cape Cod, Bornhuetter-Ferguson, Additive Method and Expected LossMethod. Detailed descriptions of the methods used are included in Appendix 4. 36

The methods used most commonly in practice are based on a triangle of loss data. Theonly exception is the Expected Loss Method which only requires an estimation of theultimate loss ratio.

These methods require homogeneous segments. Since large losses or catastrophe losseswould distort the homogeneous development, they have to be treated separately. Ideally,the complete development of such losses should be taken out of the triangles. A minimumrequirement is to avoid applying the year-to-ultimate factors to those losses but to reviewtheir case reserve separately.

Which method will be chosen for a certain segment will depend on the actuarial analysisof the available data. For example, if there has been a clear trend in claims developmentin the past years, a Chain Ladder method would be appropriate. If there is a correlationbetween loss development and premiums, Cape Cod could be the appropriate method.Whatever method will be chosen, nobody can say for sure that it is in fact the correct one.

All methods require significant judgment in order to select the result to be adopted fromthe different methods, with the key issues being:

§ The company’s philosophy regarding the degree of prudence will affect theprovisions. There is no generally accepted level of prudence in the industry. Thedegree of judgement may be more or less limited by accounting principles. Forexample, if accounting rules require the use of best estimates, a provision is set up tothe extent that the probability that claims will be greater than estimated is the same asthe probability that they will be less than estimated.

36 Examples of the Chain Ladder, Cape Cod, Bornhuetter-Ferguson and Separation method are

contained in Swiss Re (2000) Late claim reserves in reinsurance, (Zurich).

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§ Particular judgement has to be applied to the loss ratio adopted for the recent yearswhich is blended in as part of the reserves in the Bornhuetter Ferguson method andforms the reserve for the loss ratio method. If this loss ratio is provided byunderwriters there may be undue optimism about the business performance, and theloss reserving specialist must understand and if necessary challenge the loss ratiobeing included.

§ The tail on long term business is particularly important and if the business categoryhas not been written that long then there will not be adequate data and curve fitting orjudgment must be applied.

§ The degree to which large losses are regarded as exceptional and removed from thedata is also important. If too readily removed, there may not be sufficient allowancefor future large loss emergence.

§ New market issues have to be understood and the effect on the development dataavailable allowed for in the projection process.

It is also relevant to note that for some classes development statistics in triangulationformat are not appropriate. Examples of this are asbestos claims development; pollutionclaims development; health hazard claims development, and “spiral business” wherebusiness had been retroceded several times in the market. Also for complex pieces ofbusiness, specific modelling of the workings of the underlying business contracts isnecessary. In all of these categories traditional methods are not applicable and are notlikely to produce sensible results. The approach must be specifically tailored to thecircumstances driving the loss development.

The degree to which different reinsurers model specific situations separately from thebalance of the account varies considerably. Best practice is for the reinsurer to understandthe loss development in their account sufficiently to be able to identify contracts or typesof claim which should be analysed separately. Smaller reinsurers are less likely to havethe resources or sophistication to do this to the same degree as larger reinsurers.

The ability to set adequate reserves is influenced by the degree to which actuarial analysisis undertaken, the independence of the loss reserving function from the underwriting andthe degree to which the management takes a prudent stance on reserving issues. It ispossible to consider past run-off to see if there is a pattern of setting reserves which had afavourable run-off, or whether the converse applies. Also it is possible to project futurecash flows, and future loss emergence, and to monitor actual emergence against thatanticipated.

8.5 Management of underwriting risks

Underwriting risk is the fundamental risk of the reinsurer. The risk that the actual costs ofclaims will exceed the premiums earned is determined by several factors, which makesthe management of underwriting risk very complex. The management starts with theanalysis of the profitability of every single contract and ends with the capacity of thewhole company limited by the amount of equity. In practice management of underwritingrisk is organized for segments of business via several steps that are connected. Thefollowing steps are taken:

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§ for the business units the maximum amounts of liability with respect to premium thatshould be accepted are determined;

§ underwriting guidelines are issued;

§ checks are installed by third parties or computer systems that ensure that theunderwriting guidelines are followed;

§ retrocessions are defined that cover the incoming risk so that the retention rate isadequate in relation to the companies capacity.

Whilst the principles are basically the same the precise steps differ significantly fromcompany to company.

Underwriting guidelines include the business segments and contract types that arepermitted or not permitted to be written, respective minimum premium rates, themaximum risk exposure allowed (e.g. per segment, risk or treaty), maximum amountsallowed to be written by one or several underwriters and criteria to assess if and to whatextent retrocession coverage is necessary. Usually, underwriting guidelines exist forbusiness segments, which are quite detailed, but still leave a certain range of discretion tothe underwriter. The process of preparation of underwriting guidelines is described in thefollowing sections. Underwriting guidelines are prepared by one department of thereinsurer, e.g. the controlling department, approved by the board of directors and usuallyrevised annually. Most importantly it has to be assured that they are being consistentlyapplied in practice.

8.5.1 Fixing of capacities and premium rates

The underwriting requires an allocation of the capacity in advance of a renewal season.The company has to determine what degree of risk it is willing to take. For the calculationthe existing portfolio and the renewal has to be taken into account.

The capacity is determined by the total amount of net equity available in the company orgroup. The net equity has to be allocated to the existing portfolio and to the differentsegments in order to come up with the maximum risk that the individual business unitsmay write without jeopardizing the solvency of the company or group as a whole.

To achieve this the company has to analyse the amount of risk borne by writing differentkinds of contracts in different kinds of segments or regions. The amount of equityrequired depends on the risks included in the different products as well as on theretrocession purchased.

These analyses lead to the process of fixing of capacities and the amount of net equitythat the company is willing to risk within the individual selling units.

The result of the analysis is documented in the underwriting guidelines and is mandatoryfor underwriters. If the individual underwriter or the business unit want to exceed theseguidelines explicit permission has to be granted.

In practice the process described above is applied by different methods. The methodsused by the companies to derive their capacity and to allocate it differ significantly.

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Basically one can distinguish between a ratio approach and a risk modelling approach.

Ratio approach

A well known ratio approach which is similar to the methods used in the industry is theStandard & Poor’s model. The model is applied in the assessment of the financial strengthof a company. The financial strength is measured in the long run by the ability to avoidinsolvency. So the major aim of the Standard & Poor’s rating is to identify capital riskthat can lead to insolvencies by using the complete net equity of the company.

The Standard & Poor’s approach defines the four major risks. There are risk factorscalculated by using ratios on a defined basis. The major risks are the underwriting risk,the reserve risk, the credit risk and the investment risk. The basis for these ratios is easyto calculate from the balance sheet of the company. They are:

major risk basis

- underwriting risk - premium

- reserve risk - book value per segment

- credit risk - receivables

- investment risk - book value per risk category

Also, reinsurance companies define ratios similar to the Standard & Poor’s approachbased on criteria like booked premium or liability taken. The concrete ratios aredeveloped by historical analysis based on the segments extrapolated to the future. Forhigh risk products like natural perils separate analysis is performed. The quality of thisapproach is as good as the factors that are applied. In particular, the historical analysis hasto be done on special segments which have to be as homogeneous as possible. To achievethis, all events that are not of a regular statistical relevance (like cumulative claimsevents, catastrophes, and so on) have to be eliminated and analysed separately. There areoften difficulties caused by data quality especially for the older data. The analysis ofbusiness needs to be done over the long term to see a significant development.

Risk modelling approach

A total enterprise risk model develops the risk categories discussed in chapter 3 of thisstudy like underwriting, credit, investment and reserving taking into consideration theirinteractions.

A relatively new approach is the stochastic method for the analysis of risks based onsegments or the total account like for example capital at risk or optimising theretrocession program. However, stochastic methods are not yet frequently applied byreinsurers.

The allocation of capacities based on the calculation of a risk portfolio that uses aprobabilistic approach modelling different business segments diverges from the ratioapproach used by the rating agencies.

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The most advanced models developed and employed by the leading reinsurance groupsmodel underwriting risks using stochastic approaches and analysing the impact of specialevents (for example: a crash at the stock exchanges) using scenario techniques.

In practice this has to be done at group level rather than at entity level.

To handle the complexity of the problem total risk models are designed to derivedistributions of losses taking into consideration the influence of different portfolio mixesand different retrocession programs.

In due course, these approaches will become widespread. At present only the big marketplayers are able to do these calculations.

The currently used methods for the analysis of underwriting risk are comparable. Adiscussion of total enterprise risk models is included in section 8.5.3.

The other important requirement is the premium rate that has to be paid by the cedant.The rates are usually derived from pricing models. These are actuarial models, based onreasonable assumptions on loss ratios which derive the premium level required. Theparameters used for these analysis are either also developed from historical data of thecompany based on internal data basis or are drawn from external sources taking intoconsideration the results of the own reserve analyses.

For the pricing of facultative business the parameters may be specific to the risk exposureof the risk insured and reflect its probable maximum loss. The probability of a major lossis also taken into account.

In practice, it may happen that the underwriter gives discounts on the calculatedpremiums. There is a control issue on the extent to which these premiums are agreedwhen entering into the contract. If there are these agreements, the discount has to be takeninto account for the risk calculation.

8.5.2 Organization of risk management

The requirements concerning capacity allocation and premium calculation have to beapplied to the individual business units. It is essential for the company to control thisprocess.

It is best practice to have separate organizational units which

- perform the pricing and capital allocation (capacities)

- do the underwriting

- control the observation of the requirements

If there is no separation of the different departments, this may cause additional businessrisk. In practice, this separation of execution and control is not always in place.

It should also be noted that depending on the reinsurance cycle the priced rates oftencannot be achieved. A good risk management should reflect this when updating theunderwriting guidelines.

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Another major risk management factor relates to the information gathered from thecedant. The reinsurer has to rely on the information gathered by the cedant. There areother general sources of information which can be used, but the input on how much riskhas been assumed by the portfolio has to come from the cedant. Especially for non-proportional business, portfolio information about the cedants portfolio gives no completeindication of the development of the reinsurance portfolio.

History has proved that a lack of information on the reinsurer’s side about the cedant, itsproducts, its risk strategy and its economic environment can lead to disastrous losses.This risk is greatest for business written through intermediaries.

Accordingly, the underwriting guidelines have to define the degree of information to begathered and the procedures to be taken before accepting businesses from direct insurersespecially in the case of business accepted via intermediaries.

One method of ensuring compliance with underwriting guidelines is to require that twounderwriters have to sign a contract. However, this is of less practical use, because it isindustry practice for the written documentation of a contract to be completed a monthafter entering into a contract.

8.5.3 Risk management across the whole enterprise

This section describes a common approach to risk management across the wholeenterprise. As most of the companies use a similar approach, the basic principles will beillustrated.

There are differences concerning the approach over one or more periods. Some modelsautomatically allow for investment risk. The techniques for deriving results differ fromcompany to company.

The model includes all lines of business, (possibly macroeconomic variables) andquantifies the variability of investment returns. It is based on an adjusted capital approachwhich allows the user to allocate the capacity of a company or group. It gives a completeoverview of the risk portfolio of a reinsurance company.

Claims are segmented into basic losses, large, single and catastrophe losses. Basic lossesare assumed to follow a normal distribution. Large, single and catastrophe (cumulative)claims are simulated by the estimation of the expected amounts and the frequency. Theamounts mostly follow a Pareto distribution while their frequency is generallyrepresented by a Poisson distribution.

There are alternative approaches where the probability distribution is determined byreference to special classes of frequency distributions without a division into differentcategories of claims. There is no information available on how these classes are designed.

The risk based capital can be derived from the probabilistic distribution of risks andallows for an assessment of capital adequacy.

In summary, the most advanced models developed and employed by the leadingreinsurance groups model underwriting risks using stochastic approaches and analyse theimpact of special events (for example: a stock market crash) using scenario techniques.

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In practice, the modelling has to be done at group level rather than entity level.

General implications

The aim of all the models is to identify a figure that quantifies the company’s overall riskand enables the company to assess the adequacy of its capital or to allocate the availablecapital.

The risk portfolio of a reinsurance company is a very complex dynamic system. It iscomposed of underlying risk-driving factors, including events that may threaten thebusiness, as well as portfolios of insurance and financial market products or combinationsof both. The risk factors are by nature outside the company’s control, but can be managedby portfolio techniques. Risk factors subject to portfolio management are time dependent.For simplicity the models generally take a time horizon of between one and a few yearsinto account. In reality the time scale goes from an hourly basis for investment portfoliosup to the basis of decades for mortality rates.

The effect of fluctuating risk factors is generally measured in terms of changes in capitaland in the annual result.

The structure can be determined via identification of the various risk factors and acombination of similar products in portfolios.

The risk portfolio is structured in line with the information required by management. Inparticular, key factors concerning different lines of business, types of contracts orgeographical segments are taken into account.

Risk factors

The first step is the identification of the risk factors. It is necessary to distinguish betweeneconomic and underwriting-specific risk factors. Economic risk factors comprisemacroeconomic variables such as fluctuating interest rates, foreign exchange rates,inflation, gross domestic product growth or equity indices. Risk factors relating tounderwriting are large and cumulative claims like natural perils (earthquakes,windstorms, floods) or man made threats such as fire in a large industrial plant, which canresult in business interruption. Other risk factors are, for example, changes in the legalenvironment which can have a huge impact on liability claims (e.g. asbestosis). Thepossible losses caused by underwriting specific risk factors usually have a major impacton the portfolio but the probability of those events is relatively low. Due to this lowfrequency and high severity aspect, these events are analysed as loss scenarios whenspecifying underwriting risk factors.

Events with high frequency and low severity are excluded from the loss scenarios. Theimpact of these claims is referred to as normalised business fluctuations which is assumedto be a normal distribution. It is modelled directly at portfolio level by estimating yearlyaggregate loss or result distributions.

Finally, for each segment the claims ratio is split into categories of claims, for example,basic claims, large claims, single claims and catastrophes.

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Risk factors trigger claims or influence the size of claims on many different contracts andthey influence the diversification of portfolios. For each possible event cumulative claimsmay impact on many contracts.

The modelling of risk factors concerning underwriting loss scenarios has to be based onexpert knowledge and experience. Some loss scenarios can be based on events whichactually occurred in the past, allowing the company to fall back on past experience likenatural perils or liability threats (asbestosis). Other scenarios may not yet have beenexperienced but they represent situations which could occur in the future.

The identified risk factors have to be quantified. For many underwriting specific riskfactors it is sufficient to specify a single distribution for frequency (per year), strength orseverity. It is assumed that these events can be regarded as independent and that theunderlying probability distributions do not change over time. For example, windstorms indifferent years can be assumed to be independent of each other and their frequency andstrength are more or less constant. In the case of loss scenarios for which observationswere made in the past, analyses can be made of the losses incurred in the insurancemarket as a whole. Physical models can also be used to assess loss scenarios associatedwith natural perils.

Loss scenarios are, in practice, often described by frequency and severity distributions.Severity distributions contain information about a specific portfolio or line of business sothat the generic concept of a risk factor is abandoned. On the basis of common underlyingrisk factors there is only the possibility of an approximate calculation of dependenciesbetween losses on different portfolios.

Examples of underwriting loss scenarios are in property business arising from naturalperils such as earthquakes, floods, windstorms.

For third party liability losses there are no well established models as in the case ofnatural perils. Quite often in practice it is necessary to rely on foresight and intuition.Changes in people's attitudes and in legislation can have a significant impact. Examplesof third party liability losses include environmental pollution, asbestosis or productliability.

Even lines of business that seem little exposed to risk, such as the motor business, requirecloser examination. Events such as hail may cause significant losses on a motor portfolio.

Life and health loss scenarios include infectious diseases, such as Aids. Further exampleswhich have a more local influence include pollution or nuclear contamination, andvarious natural perils, such as earthquakes or storms. Also, changes in the long termtrends of mortality and morbidity rates have an impact on loss scenarios. For example, thetrend of changing compensation payments to long-term care claims influencessignificantly the development of a scenario. These potential losses are likely to have amore long-term impact and are therefore more significant for long-term business.

In addition to the calculation described above there are also macroeconomic risk factorsthat have to be taken into account. There can be factors which influence the business as awhole for the company such as recession, domestic product growth or inflation.

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For long term business like third party liability or life and health management of interestrate exposure of the portfolio has a strong impact on profitability. The interest-rate riskcan be limited by adopting a duration matching strategy.

For life business there is in practice a widespread use of asset liability matching to reducethe long-term portfolios‘ sensitivity to interest rates. In contrast, property-casualtybusiness is less exposed to interest rate fluctuations given the long-term nature of theirliabilities. Here a matching strategy is generally not common.

The global nature of reinsurance business means that the market is exposed to the risk offluctuating foreign exchange rates which have to be modelled too. By and large foreignexchange exposures can be reduced to a low level. Adequate reserves for claimspayments are held in each currency.

Investment risk is another risk factor which has an impact on the capital adequacy offinancial institutions in general. We refer to our analysis in section 8.7 of this study.Credit risk also has to be taken into account. This is the possibility of a counterparty notbeing able to meet its financial obligations. The loss potential is assessed by quantifyingthe underlying exposure and the default probabilities of counterparties. The wholecontractual period must be considered and recoveries taken into account.

There is a trend towards increasing exposure to credit risk in view of the growing numberof new financial and alternative risk transfer products that encompass explicit or implicitcredit risk (see section 8.6).

Probability distribution

For the determination of a probability distribution for the yearly result the identified riskfactors are combined with the exposures and normalised business fluctuations have to bequantified and added. The calculation is done either for the existing portfolio or for theportfolio the company anticipates will be written.

The portfolio associated with high frequency events usually has a small claim fluctuation.The normalized fluctuations are generally described by aggregate distribution doneyearly. Usually the distributions are based on the historical frequency and severity oflosses in the portfolio. The historical data used in this procedure should first be adjustedfor trends in claims inflation and changes in the underlying exposure. The claims data hasto be filtered for claims associated with the loss scenarios, to avoid double counting.

The identified results have to be aggregated. The probability distribution for the wholeexposure has to be constructed to account for all the different risk factors on the portfolioand to show an overall result for the company.

To account for the interdependencies between different sub-portfolios, it is necessary tostart with the individual risk factors and their impact on the results of each portfolio. Theprocess is repeated for all risk factors in order to arrive at the overall result. With theinclusion of retrocession into the model, the final result is derived either from netunderwriting results or from a separate analysis of the retrocession cash flows.

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Risk capital

After the probabilistic model of the company’s risk portfolio is calculated, the results canbe compared with the level of risk capital. There is no standardised formula for risk basedcapital. The underlying methods and assumptions have to be taken into account so thatthe management can understand the applicability of the model to the company and itslimitations. Only then will the company be in a position to judge whether the underlyingassumptions correspond to their aims and if the scenarios used to model the risk portfolioare adequate.

Once a company has selected a model for calculating the risk adjusted capital and fixed acertain survival probability, it can determine the required level of risk adjusted capital. Ifthe risk-bearing capital exceeds the required level of risk adjusted capital, there is scopefor taking on additional risk by changing the risk portfolio. If the risk-bearing capital islower than the required level of risk adjusted capital, risk can be reduced by eitherimplementing measures on the investment side or by modifying underwriting exposure bymeans of reinsurance or retrocession.

The information obtained from a probabilistic description of the risk portfolio can be usedfor purposes other than the control of capital adequacy. For example, pricing can becombined with the model described above. The actuarial pricing of reinsurance cover isusually based on the principle of the premium being equal to the sum of the riskpremiums plus a loading. This calculation includes the net present value of liabilities e.g.expected future cash flows discounted with an appropriate rate. A loading principle canserve as a benchmark for the underwriter to allow a comparison of market conditions witha targeted return. After inclusion of investment income and potential losses, thedistribution gives an indication of the probability of insolvency for a given portfolio andretrocession programme.

Limitations

The major limitations of these models result from the following factors:

- the determination of the different probability distributions is to a certain extentsubject to judgement

- the distribution parameters are gathered from historical data and there is a riskthat future events will not resemble the past

Because the functionality of adjustable features ( profit sharing ) cannot be modelled, themodel does not fully reflect reality.

The argument against this criticism is that this represents an additional prudence factor.

In summary, it can be concluded that even such models do not represent the real world. Itis often necessary to work with planned portfolios. At present there are no betterapproaches available at the corporate level.

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8.6 Monitoring credit risk

Credit risk (excluding credit risk of investments) mainly relates to the collectability ofreceivables. Credit risk or counterparty risk (sometimes referred to as default risk) ariseswhen the counterparty of a creditor fails to fulfil his contractual obligations. In general,all types of lending entails default risk.

For assumed business this mainly belongs to premium income, for ceded business to therecoverability of loss reserves. The issue of reinsurance recoverables remains asignificant one for the reinsurance industry and is focused on the ultimate collectability ofretroceded liabilities.

The use of retrocession creates a significant level of credit risk if amounts due under aretrocession contract are not fully collectible in case of insolvency. The monitoring ofcredit risk is important when placing retrocession cover.

For international businesses, even if it is not common, sometimes bonds or stocks aredeposited to secure technical reserves. Therefore, not all recoverables are at material risk,as companies may have used these techniques to substantially reduce the financial riskassociated with future recoveries.

However, the risk strategy of reinsurance companies depends on the market expertise oftheir underwriters supplemented by ratings of international rating agencies to makeinformed judgements about the good standing of the trading partners.

Appropriate counterparties should be selected to diversify and limit credit risk, taking intoaccount the importance of qualitative aspects such as the skill of management, marketbehaviour and long-term relationships, as well as their strengths and their ability to pay.

Reinsurers should maintain an active dialogue with their partners and continually monitortheir financial conditions so that the security that was originally anticipated will berealised at collection.

The use of ratings by international rating agencies should complete the analysis ofreinsurance companies to evaluate security. Ratings not only take into consideration otherareas of analysis, such as operating performance and business position, but also benefitfrom the insight and judgement of experienced analysts. A rating is an indicator of acompany’s ability to meet its financial obligations.

Proper credit risk analysis performed throughout the industry leads to an efficientdistribution of capital funds on competitive terms. In the absence of credit risk analysis,the credit risk still exists but can only be estimated. This risk is then charged back to thecompany through higher reinsurance fees. Credit analysis done by competing reinsurersdrives down costs by reducing the uncertainty.

Reinsurers with a high degree of directly written business tend to have enough marketknowledge to evaluate the solvency of their customers, whereas reinsurers which writebusiness through intermediates often have a more limited overview and have to rely onother sources of information. There is a high risk that the failure of an intermediary couldresult in bad debts.

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Naturally, credit risk increases with the duration of the reinsurance contracts, such asannuity reinsurance and the run-off of losses.

As already explained, credit risk is the risk of a counterparty not being able to meet itsfinancial obligations. There is a trend towards increasing exposure to credit risk in viewof the growing number of new financial and alternative risk transfer products thatencompass explicit or implicit credit risk.

The loss potential is assessed by quantifying the underlying exposure and the defaultprobabilities of counterparties. The whole contractual period must be considered andrecoveries taken into account. The default probabilities are closely linked to retrocession-driving factors and are assessed per category of creditworthiness. A feature of credit andsurety business is that periods of large losses typically persist for several years, with theresult that the different underwriting years are not independent. Furthermore, it is difficultto hold well-diversified credit risk portfolios in a single economy given their strongdependence on macroeconomic variables.

8.7 Management of investment risks

Generally the management of investment risk for reinsurance companies gives rise to thesame considerations as for other financial institutions and therefore, general approachesto the management of investment risk are not discussed here.

However, there are several aspects which are specific to the reinsurance industry:

§ Because of the international nature of underwriting, in practice the investmentportfolio covers many currencies. These multi-currency investments bear special kindsof risks.

§ The reinsurance exposure has a potentially higher degree of volatility of the cashflows than the direct insurance. The volatility arises from the variety of different typesof contracts (e.g. proportional, non proportional, facultative business) and the differenttypes of business caused by the geographical spread of the exposure.

§ The premium calculation regularly takes into account investment income on fundssupporting outstanding losses. Therefore, the reinsurance company depends oninvestment income (cash flow underwriting).

Sometimes there is even an investment income guaranteed to cedants.

These aspects indicate the need for sophisticated investment management. As a result ofthis, the market has started to develop asset liability management techniques. Our reviewof the industry revealed that the application of highly sophisticated multi-year simulationmodels is the exception rather than the norm. In practice, approaches such as durationmatching are frequently used.

Almost all companies frequently apply stress tests. Generally, there are systems in placethat calculate the impact of defined changes in indices or interest rates. This area is dealtwith in more detail in the “Study into the methodologies to assess the overall financialposition of an insurance undertaking from the perspective of prudential supervision”.

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Taking only the underwriting risk into account, the investment strategy is, in general,rather conservative. Exceptions are some investments in compound instruments andderivatives. For example in Germany by the end of 1999, on average 47% of totalinvestments of professional reinsurers were investments in affiliated undertakings, 24% infixed income securities and loans, 18% in investment funds and only 3% in shares andother variable-yield securities.

This means that the inherent risk of reinsurance business is regarded as being high.Therefore, management strategy is generally to avoid a risky investment strategy. Themanagement of the company becomes difficult if assets are subject to a significant riskwhich is independent of underwriting.

As the volatility in underwriting business is high, the modelling of an appropriatesophisticated asset-liability-management-system is quite complicated. Given the highdegree of uncertainty, the confidence that can be placed in these models is limited. On theother hand, the efforts to implement such systems are significant. The reason is thecomplexity of the portfolio structure of a reinsurance company.

The cash outflow of a reinsurance company, even in short tail business, tends to take twoor three years. This is longer than in other industries. Therefore, even for short tailbusiness, investment returns have to be taken into account.

8.8 Management of foreign currency risks

As reinsurance is an international business, most of the reinsurance companies areexposed to adverse currency exchange movements.

Most reinsurers write business in a large number of currencies. Therefore, the liabilitiesas a result of the international risk portfolio are paid in several different currencies.Although this kind of risk may have different aspects, the industry generally invests inrelevant currency assets to match the equivalent currency liabilities.

Companies enter into hedging transactions to reduce risks that can adversely affect theirfinancial position and net income, including risks associated with changes in foreignexchange rates.

A hedging instrument is defined as an asset or liability whose value moves inversely, andwith a high degree of correlation, to changes in the value of the item being hedged.Various financial instruments can be used to implement hedging strategies to reduceforeign exchange risk.

The industry practice of matching liabilities with the assets in the corresponding currencycannot cover the complete risk as generally investors are not able to manage perfecthedges as the timing and severity of the liabilities are subject to estimation.

Two issues need to be addressed:

§ how can liabilities be hedged?

§ what is the amount of liabilities at the year-end and in the course of the year?

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How can liabilities be hedged?

Hedging instruments are intended to reduce risks resulting from changes in foreigncurrency exchange rates. However, the hedging instruments themselves generate specificrisks. Risks associated with hedging instruments include correlation risk, basis risk, creditrisk and opportunity cost.

Correlation risk is the risk that the gain on the hedge position will not offset the loss onthe hedged item to the extent anticipated because the hedge and the hedged item did notmove in tandem.

Basis risk is the risk that the difference between the spot price of the hedged item and theprice of the hedging instrument will increase or decrease over time. The basis issometimes referred to as the spread. Many factors can influence the pricing of hedginginstruments and the underlying items being hedged.

Credit risk is the risk that the counterparty to the transaction will not honour itscommitments. The creditworthiness of the other party is particularly important whendealing in instruments not traded on a securities or commodities exchange.

A commonly used technique of hedging is to match foreign liabilities directly withinvestments in the same currency to eliminate the risks described above.

As long as these investments are not subject to market value risks, this form of hedging issufficient.

Unfortunately, this method of hedging may be suboptimal in terms of investment income.Investments in bonds nominated in other currencies may earn higher interest. Shares havein the past consistently achieved higher returns than bonds.

In addition a complete management of the liabilities in the books of a reinsurancecompany could involve the handling of over 50 foreign currencies giving rise tosubstantial administration costs.

Furthermore, hedging of liabilities generated from underwriting may not fit in with theinvestment strategy of the company. In particular, the investment of the operational cashflow in liquid investments may be inconsistent with a company’s investment priorities,for example when a company is interested in the foundation of a major subsidiary whichhas to be financed.

Therefore, in practice, as well as matching investments in the same currency as theliability, hedging is practised by investing in a currency basket. Other methods areinvestment in foreign currency options, future contracts or similar derivatives.

The use of a currency basket gives rise to the issue of the degree of correlation betweenthe basket of a few currencies and the development of the multi-currency portfolio.Although analysis might show that this correlation has existed in the past this is notnecessary true for the future.

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Derivatives frequently do not match the payment pattern of the liabilities in regard totheir duration. In particular either contracts with long duration are not available on themarket or they are too expensive. Even if these derivatives are bought they do notguarantee full protection against adverse developments.

What is the amount of liabilities at year-end and in the course of the year?

With respect to this question several problems exist:

§ What is the amount of liabilities to pay per currency and do the reported loss reservesrepresent this amount;

§ How to deal with the time lag between the beginning of the contract and the reportingof the reserves by the ceding company.

The effective amount of liability has to take into account whether the reported reservesare adequate. The reserves in that currency should not include significant margins ordeficiencies.

In practice, there are actuarial methods available which are capable of giving reasonableanswers to the adequacy of loss reserves. In section 8.4 these approaches are discussed indetail.

Although in many reinsurance companies actuaries are employed to work on lossreserving, they seldom do reserve analysis based on currency segments. As long as this isnot done or impossible to do due to erratic developments within a currency definedsegment, approximations have to be applied which result in additional uncertaintiesregarding the amount of liabilities in a certain currency.

Another significant problem that may arise is the time lag between the signing of thecontract and the reporting of loss reserves. In most countries loss reserves are reportedjust once a year. The reinsurance company has to estimate the loss reserves to overcomethe information lag between the first cash flow at the beginning of the contract (e.g.premium payment) and the reserve reporting. The risk of misestimating significantlydepends on the quality of the estimation system of the company and the generalinformation available.

8.9 The role of securitisation

Securitisation is used as a basic method for transferring insurance risk to the capitalmarkets. This allows traditional risk-bearers such as insurance companies to be replacedby the capital market or investors. The capital markets can provide more capacity forrisks than the reinsurance market especially for low frequency, high severity risks. Theserisks can otherwise be very difficult to insure.

When traditional reinsurance capacity is insufficient or unavailable, securitisation iswarranted, if the economic conditions are reasonable.

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8.9.1 Recent and future evolution

In February 1994, reinsurance risks were securitised for the first time. Reinsurancemarkets nearly collapsed due to catastrophe losses in the previous years. Propertycatastrophe reinsurance was in very short supply in the wake of Hurricane Andrew andthe Northridge earthquake in the early 1990s. The short supply, of course, led to inflatedprices. All this led to the development of financial instruments capable of transferringinsurance risk to the capital markets.

More than USD 5 billion in property catastrophe risk has been securitised worldwide todate (about USD 1 billion annually). Securitisation has become established as animportant tool for placing risk for insurers. However, securitisation has somewhat slowedin recent years. A possible reason for this could be the consolidation of capital markets ingeneral. Although investments in securitised risks bear for the investor the advantages ofover-average yields and a dispersion of investment risks, securitisation products remaincomplex and sometimes difficult to analyse.

The future development of risk transfer through securitisations is being assesseddifferently within the industry. Some industry players primarily consider securitisation aform of advertising. This is certainly a positive effect that goes along with the initialoffering of new and innovative products. Others believe that the volume of securitisationin the future will vary with the level of reinsurance prices and the development of capitalmarkets. Still others contend that the role of securitisation will remain limited tocatastrophe risks and not expand on traditional reinsurance as long as reinsurance ratesremain stable and costs involved in securitisation remain high. The financing of new lifeinsurance business, i.e. the financing of policy acquisition costs in life insurance througheither bank loans or securitisation, is expected to gain importance.

Undoubtedly, the relatively short experience with securitisation makes a forecast difficult.Swiss Re outlines in its study on capital market innovation37 that key issues such asstandardisation, regulation, and education still have to be resolved for an activesecuritisation market to develop. Swiss Re estimates the volume of annual catastrophebonds to grow up to perhaps USD 10 billion by 2010 and sees a vast market potential forcapital market solutions linked to non-catastrophe risks as well, although these willremain a complement for traditional reinsurance.

8.9.2 Aspects of securitisation

Securitisation brings with it several advantages such as reduction of credit risk,diversification of funding for insurers and of investment for investors as well as arelatively high rate of return for investors, to name a few. Through securitisation, capitalmarket participants have had the opportunity to become more familiar with thereinsurance concept.

Securitisation has the quality of an AAA reinsurer and provides management with anunprecedented level of security. Underwriting risk could be transferred completely to themarkets.

37 Swiss Re (2001) “Capital Market Innovation in the Insurance Industry” Sigma No. 3 (Zurich).

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Pricing and availability

The search for coverage for larger amounts of reinsurance often proved unavailing or thecoverage available was too expensive, since reinsurers limit their exposure to any onerisk. Hence, securitisation can eventually be less expensive, with almost unlimitedcapacity making it a viable alternative. Securitisation provides in addition protectionagainst fluctuations in the price of reinsurance through a multi-year coverage at set prices.

Credit Risk

Counterparty risk plays a significant role in the selection of reinsurers. During periods offinancial stress, reinsurance becomes increasingly important. Diversified reinsurancesources and business relationships with financially strong reinsurers is paramount forinsurers at such times. Instruments involving the capital markets can be structured tominimise credit risk.

Insurance solutions involving the capital markets can be structured to minimise creditrisk. Funds collected through the issuance of catastrophe bonds are invested in investmentgrade securities and held as collateral in a trust account for the benefit of investors andthe reinsured. A non-US reinsurer commonly establishes a special purpose vehicle (SPV)as a trust account. This SPV then transforms the reinsurance risk into an investmentsecurity. The SPV matches every dollar in potential claims with a dollar of capital, givingthis arrangement greater credit quality than conventional reinsurance.

Higher rates of returns

Catastrophe bonds tend to pay higher rates than those for corporate bond or asset-backedsecurities of the same credit rating. This spread or the difference between these ratestypically compensates investors for model risk, when expected losses are higher thenestimated, allowing for a cushion and the relative illiquidity of catastrophe bonds.

Portfolio diversification

Insurance linked securities reduce the overall statistical risk of an investment portfolio asinsurance events are uncorrelated with fluctuations in the price of stocks and bonds.

8.9.3 Type of transactions

A great amount of insurance securitisation transactions have involved catastrophe bonds,although long-tail risks could also be handled through this technique.

Typically, a reinsurance contract between cedant and a SPV is entered into. The SPV inturn issues catastrophe bonds to investors. If there is no loss event, investors receivecoupon payments on their investments and a return of principal. If there is a loss event,which is predefined, investors suffer a loss of interest and perhaps even principal as thefunds are paid out to the cedant in fulfilment of the reinsurance contract.

There are three types of triggers for the majority of catastrophe bonds, namely indemnity,index or physical. Settlement of the first type is based on actual insurer losses. This typehas no basic risk, but there is the threat of adverse selection and moral hazard. This meansthe insurer tries to cede those risks that are most problematic or after reinsurance ispurchased, the insurer is less motivated to mitigate the risks.

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Settlement of index based securitisation is based on industry losses and could, therefore,expose an insurer to a material amount of basic risks. Lastly, a physical index is used insettling claims of the third type of securitisation.

Although there have been a few securitisation transactions involving life insurance also,these transactions seem primarily motivated by the need for financing of new business incontrast to catastrophe bonds which primarily transfer risk.

8.9.4 Techniques of securitisation

Insurance linked securities can be structured to minimise portfolio risk. As mentionedearlier, most insurance linked securities involve catastrophe bonds (short “cat bonds”).Returns stemming from cat bonds depend on the performance of an index of industrylosses reported by an independent agency, for instance Property Claims Services.

A typical transaction involves the investor, who purchases bonds from the issuer, in thiscase the SPV (special purpose vehicle), which in turn enters into an insurance contractwith the cedant. Special purpose vehicles are usually licensed as reinsurers on an offshorelocation such as Bermuda or the Cayman Islands. Its sole purpose is the business relatedto the securitisation. Total focus on this one order of business works to minimise the riskto which the counterparties are exposed.

Proceeds provided by or invested in the bonds end in a trust account, which purpose theSPV normally serves, with restrictions as to investment and withdrawal of the funds.These investment earnings together with premiums paid by the cedant serve as couponpayments to the investor. If there has been a loss event, the amount due to the cedant asthe defined coverage is paid out to the cedant at the end of the “loss development period”following the maturity date, during which the amount of losses payable is determined. Ifthere are no loss events, the principal amount along with final coupon payments is paidout to the investors.

There are many variations to this model. For instance, often a reinsurer serves as anintermediary between the SPV and the cedant. The reinsurer can then retain some risk forhimself before retroceding to the SPV. The amount retroceded could also be dividedamong two contracts, for example, allowing for recovery under the first based on indexlosses and the second based on actual losses of the cedant. Another variation would be abond issue with a guarantee to return some percentage of principal to the investors atmaturity if there is no loss. This feature is known as defeasance. If there is a loss a fullreturn on principle can be paid out at a later date. This delayed repayment is then fundedby zero coupon bonds, that are purchased at the maturity date with the guaranteed portionof the proceeds.

There is an alternative to cat bonds for transferring risk, namely through swaps. Here aseries of fixed payments is exchanged for a series of floating payments whose values aredetermined by the occurrence of an insured event. The counterparties of a swap must beinsurers in some jurisdictions. But in New York, insurance regulators ruled in 1998 thatinsurance linked swaps, in which payments are not based on the actual loss of the cedant,are financial contracts, and it is questionable whether such contracts can be entered intoby insurers and reinsurers.

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8.9.5 Techniques for the calculation of probable maximum losses (PML)

Reinsurers assess PMLs on both a contract by contract basis and across segments. Overallloss scenarios are also considered by many reinsurers and can be thought of as a wholeaccount probable maximum loss. However, the degree to which such assessments aremade is very variable.

The techniques for calculation depend on the type of reinsurance written. For facultativebusiness, cedants should advise a PML based on an individual exposure assessment e.g.from an engineer’s report. The reinsurer needs to know the basis of this PML and ensureit is a probable maximum loss rather than possible maximum loss or estimated maximumloss. The reinsurer then assesses its PML by applying the underwriting limits, sumassured, etc.

For per event insurance, the reinsurer needs to identify for each contract and each line ofbusiness the value and location of the exposures. A catastrophe model can then be used toassess the accumulated exposures and possible losses. All such assessments can besummarised in a database/spreadsheet. For pro-rata business, cedant’s PMLs should beused and pro-rated.

Some reinsurers use PML factors e.g. an estimated percentage which is considered apossible loss is applied to the sum insured. All PMLs so assessed must be capturedcentrally. However most reinsurers would not be in a position to set up fully complete setof PMLs. Any individual reinsurer will be able to assess PMLs far more satisfactorilywith some books of business than for others.

Overall PMLs necessitate sophisticated modelling of the underlying exposures on whichPMLs have been assessed as considered above. These must include consideration ofdisaster scenarios.

8.10 Financial condition reporting

The nature of the business that reinsurers are exposed to is extremely diverse and is notsuitable for standardisation of the approach to risk assessment and the establishing oftechnical provisions unless broken down to more standardised sub-segments. Even thenmost reinsurers will have exposure to non-standard books, and there is the issue ofaggregation across different classes.

This aggregation requires assessment of the dependence structures across the differentrisk factors. This is a difficult process usually involving significant uncertainty andrequiring judgment as well as adequate analytical abilities to exist. Any standardisedapproach is likely to be difficult to carry through to this part of the process. However, truerisk assessment and assessment of capital adequacy cannot be completed except at thisfinal stage.

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Given this diversity good governance requires some centralised assessment of the issueswithin each reinsurer. This type of approach has been covered in section 8.5.3. Withoutsuch an approach a reinsurer will be more restricted in seeing how the various types ofrisk interact and affect the capital levels required. However some reinsures will not havethe sophistication to develop these techniques in the short term and moreover there willoften be issues such as lack of information from cedants which will restrict the ability touse this approach.

In these circumstances it would still be possible for a suitable expert in a central positionto assess the various issues faced by the company. Given that any rule bound form ofregulation of reinsurers is faced with difficulties caused by the diversity of the business, itwould appear that any such rules would be enhanced by an assessment by a suitableexpert backed by a financial condition report. This would cover the approach to riskassessment and technical provisions, including comments on the retrocession program,dependencies between classes, and other wider issues affecting the company. A financialcondition report should also cover risk accumulations, the effect of any securitisationswritten or placed, and other matters relevant to the assessment of capital adequacy.

The availability of such a report would provide the regulator with the ability tounderstand the approach being taken and the quality of the work being undertaken. Itwould provide a significant amount of information that would not be available throughstandardised rule based regulatory approaches. Also, it would form a basis for discussionswith companies.

8.11 Summary

There is a very high degree of diversity of reinsurance business. The approaches to riskassessment and establishing technical provisions are therefore very wide. Practicalconstraints on the degree of sophistication which can be utilised are very real and noteasily overcome due to the international exposures involved.

Good practice involves a central function assessing the overall picture. A financialcondition report which summarises the issues and the assessments made would be anexcellent source for regulators to become aware of the controls and practices in place.

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Appendix I

Description of certain reinsurance arrangements

Main types of reinsurance

Facultative business and treaty business

Reinsurance can be arranged between the insurer and the reinsurer, in respect ofindividual risks or in respect of a group of risks. Facultative reinsurance relates to onespecific risk. Treaty reinsurance relates to a group of risks.

Reinsurance

Facultative TreatyReinsurance contracts can be divided up intotwo main groups; facultative arrangementsapply to one specified risk, treaty arrangementsapply to a group of risks

Under facultative business the reinsurer receives an offer from the insurance company tounderwrite a risk. The offer determines the nature of the risk, start and end of theinsurance period, the sum insured and the premium. The reinsurance company can acceptthe risk offered by the ceding company in full or in part as a proportion or as a fixed sum.This type of agreement is designed to cater for the following unusual factors.

§ size (personal accident cover),

§ type or conditions (chemical plants particularly prone to explosion),

§ likelihood of occurrence (such as the insurance of a satellite).

There is also a relatively unusual type of contract known as facultative obligatory cover.Under this type of arrangement the cedant chooses which risks are to be ceded and thereinsurer is obliged to accept them. This type of contract is not very common, but issimilar to treaty polices.

Under treaty reinsurance the cedant (the company taking out the reinsurance cover)agrees to cede, and the reinsurer agrees to accept all business written by the cedant whichfalls within the specific terms of the contract (the treaty) that they have entered into.Individual risks are not negotiated.

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Proportional and non-proportional business

Both, facultative and treaty contracts, may be concluded on a proportional or non-proportional basis.

Reinsurance

Facultative Treaty

Non-proportional Proportional Proportional Non-proportional

Quota-Share Surplus Excess of loss Stop loss

Under proportional reinsurance the reinsurer agrees to cover a proportionate share ofthe risks ceded. Premiums and losses will follow that of the ceding company. Lossadjustment expenses, however, are not necessarily shared on the same basis.

Non-proportional cover allows the insurer to retain risks up to a certain predeterminedlimit, whether on a risk by risk basis or in aggregate (risks are pooled to determinewhether or not the limit has been exceeded). Non-proportional reinsurance arrangementsplay an important role in an insurer’s risk management. Arrangements of this nature, ifconstructed carefully, can enhance an insurer’s results.

Proportional reinsurance arrangements dilute an insurer’s results by ceding an element ofpremiums and claims. They make both profits and losses smaller. In this way,proportional reinsurance increases an insurer’s capacity to accept risks. Proportionalarrangements cannot improve the loss ratio of an insurer’s net account compared to thatexperienced on its gross account. Non-proportional reinsurance however can enhance theresults of its net account compared to the results of its gross account.

Proportional treaty reinsurance

Quota-Share

The quota share contract is the simplest of all forms of treaty reinsurance. The reinsureragrees to reinsure a fixed proportion of every risk accepted by the ceding company, andso shares proportionately in all losses. In return, the reinsurer shares the same proportionof all direct premiums (net of return premiums), less the agreed reinsurance commission.The treaty will specify the class(es) of insurance covered; the geographical limits and anyother limits on restrictions (such as any specific types of risks or perils excluded from thetreaty). The treaty usually provides that the ceding company will automatically cede therisk while the reinsurer will correspondingly accept the agreed share of every riskunderwritten that falls within the contract.

(Source: Carter, 2000)

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Surplus

Similar to “quota-share”, surplus treaty is a form of proportional reinsurance by which theinsurer accepts a certain share of risk, receiving an equivalent proportion of the grosspremium (less reinsurance commission) and paying the same proportion of all claims.

The basic difference between the two are that under surplus treaties the reinsured onlyreinsures that portion of the risk that exceeds its own retention limit while under quotashare arrangement, there are no retention limits. Furthermore, quota share reinsurance canbe used for any class of insurance whereas surplus treaties can only operate for propertyand those other classes of insurance where the insurer’s potential maximum liability iscategorically expressed.

(Source: Carter, 2000)

Non-proportional treaty reinsurance

Excess of loss reinsurance

Under a contract of excess of loss reinsurance, the reinsurer only becomes liable once aclaim exceeds the retention of the ceding company (the retention is also known as thedeductible). The treaty may set an upper limit on the reinsurer’s liability. These limits areoften referred to as excess points. Any further element of the claim is borne by the cedingcompany, or may be covered by further layers of excess of loss reinsurance.

Stop Loss reinsurance

A stop loss treaty is a form of non-proportional reinsurance which limits the insurer’s lossratio, (the ratio of claims incurred to premium income). It may apply either to a particularclass of business or to the insurer’s total result. For example the reinsurer may be liable topay for claims once a loss ratio of 110% of net premium income is reached, upto amaximum limit of a 150 % loss ratio. Should the loss ratio exceed 150% any furtherlosses are borne by the insurer.

Reciprocity Business

This is the reciprocal exchange of reinsurance business. Reinsurance companies mightseek an exchange of reinsurance business in return for their own cessions, particularlywhen their own business is profitable. Reasons for reciprocity business can be thecompany’s desire to obtain a more diversified business, to increase their net premiumincome by adding to premiums retained from their direct business the premiums forreinsurance business (Source: Carter/ Lucas/ Ralph: Reinsurance, 4th Ed., 2000).Reciprocity business in these cases can be understood as traditional reinsurance business.However, reciprocity business can also be understood as ART business if the reinsuranceassumes both profitable and unprofitable business from the same ceding company withprofits and losses offsetting each other.

Factors determining the risk profile of reinsurance contracts

The risk that the reinsurance company is exposed to when writing a reinsurance contractdepends, amongst others, upon the contractual features of the respective contract. Thefollowing provisions can increase or decrease the risk:

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Sliding-Scale Commission Rate : by using sliding-scale commission rates thereinsurance company can reward a ceding company for ceding profitable business andconversely penalise a cedant for poor experience. This gives the ceding company anincentive for underwriting (and ceding) high quality business.

Profit Commission: by paying a profit commission in addition to a flat commission thereinsurance company can reward the ceding company for a better than averageexperience. In the case of a poor experience the reinsurance company pays lower profitcommissions partly offsetting the higher loss payments.

Loss Participation Clauses: by using loss participation clauses the assuming companycan penalise the ceding company if a treaty’s loss experience deteriorates. Under theseprovisions the reinsurer can recover expenses from the ceding company.

Profit sharing: under profit sharing agreements the insurance company returns at regularintervals a varying percentage of the amount by which net premiums exceed claims.

Overall, the risk the reinsurer is exposed to depends on the overall reinsurance program ofthe ceding company. For example a reinsurance company writing a quota-share contractis exposed to a higher risk if the quota-share is not accompanied by an excess-of-losstreaty (compared to a quota-share that is accompanied by an excess-of-loss).

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Appendix II

(Source: Reinsurance, January 2000)

Captives by domicile –1998

The following data gives an overview of other important captive domiciles:

Domicile Official statistics

Non-US western hemisphereBermuda 1497Cayman Islands 485Barbados 215British Virgin Islands 80Bahamas 23British Columbia 16Curacao 15Subtotal 2331

Europe & AsiaGuernsey 360Luxemburg 255Isle of Man 175Ireland 151Singapore 51Switzerland 23Jersey 14Gibraltar 10Subtotal 1039

US onshoreVermont 334Hawaii 54Georgia 15Colorado 14Tennessee 9Illinois 8US Virgin Islands 8Delaware 6New York 2Maine 1Rhode Island 1Subtotal 452

Total 3822

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Appendix III

Lloyd’s: summary of the regulatory approach

Anybody wishing to establish a new syndicate at Lloyd’s (whether intending tounderwrite insurance or those writing predominantly reinsurance) must obtain consent todo so. The consent will be for:

§ the management of a specific syndicate (with effect from a specified date);

§ for specific years of account; and

§ to write specific classes of business (Risk Categories) – this will include writingreinsurance business.

Any Lloyd's consent to form and manage a new syndicate may be subject to conditions.

Applicants must produce Realistic Disaster Scenarios. These are designed to enablesyndicates, managing agents and Lloyd’s Regulatory Division to see a syndicate’spotential exposure to major losses. They enable the syndicate to demonstrate that risk ismanaged adequately. They also highlight to the syndicate where their major exposure isand allow the Regulatory Division to see whether the necessary systems and controlsexist within the syndicate and there is adequate reporting at board level. Fifteen disasterscenarios have been prescribed by Lloyd’s (e.g. European storm/flood with a £10 billioninsured loss, loss of a major North Sea oil/gas complex to include property damage,removal of wreckage, liabilities, loss of production income and capping of well).

Lloyd's will test the assumptions in the business plan and application against realisticultimate loss ratios by class of business. Lloyd’s sets capital levels for the supporters ofthe syndicate on the basis of these realistic assumptions and in conjunction with a riskassessment which uses, inter alias, the Risk Based Capital (“RBC”) system.

In addition, a new syndicate will attract an additional loading calculated using variousfactors from the business forecast and other conclusions drawn from the overallapplication, and interviews with key staff including the compliance officer and theproposed active underwriter. A syndicate loading will be added to the RBC figure for thefirst three years of account for every new syndicate. This will be recalculated each yearbased on updated information obtained from the agent

Monitoring

The regulatory focus at Lloyd’s is risk-based, as opposed to rule-based. Best practices andbenchmarks are established in conjunction with the leaders in the major lines of business,not just among Lloyd’s syndicates but also among major companies.

All syndicates (insurers and reinsurers) have to publish an annual business plan. Theseare provided to capital providers of each syndicate, and are monitored centrally by theRegulatory Division of Lloyd’s. The plans must include information on:

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§ Management and management control systems

§ Description of market conditions

§ Each class of business written

§ Reinsurance arrangements

§ Potential impact on the syndicate’s results of Realistic Disaster Scenarios

§ Aggregate monitoring

§ Forecast levels of business

In the past, Lloyd’s required independent loss reviews of any syndicate incurring losses inany one year exceeding 100% of syndicate capacity, and the findings of the reviews wereused as a basis for strengthening regulatory practices in the market.

Although such reviews are no longer automatic, the major themes which emerged –namely risk management practices, individual competence, and the LMX spiral underpinthe current regulatory approach. Lloyd’s monitoring efforts focus on perceived high riskareas. Investigations are targeted on business plans, realistic disaster scenarios and peergroup comparisons. The aim is to highlight problems and encourage stronger riskmanagement.

As a result of investigations into the LMX spiral, Lloyd’s instituted a daily review ofunderwriting slips: regulatory staff check slips for inherent risk, coding, pricing andconsistency with syndicate business plans. The review also considers large risks, andthose written 100% by individual syndicates. The Regulatory Division has also, in thepast, conducted reviews into the market-wide use of specific reinsurers, so as to identifypotential problems should the reinsurer collapse.

Lloyd’s also undertakes reviews of all managing agents and syndicates; these includeexamination of underwriting slips and outward reinsurance cover notes, examination ofthe practices used to establish the reinsurance to close, and those used to establish therealistic disaster scenarios. On the basis of these reviews, agents and syndicates areallocated a competency rating, which is then fed into the risk based capital system.

Capital requirements

Risk based capital is the term used to describe Lloyd's methodology for calculatingmembers' funds at Lloyd's. There are two main elements : the Risk-Based Capital formulaand where appropriate, a capital loading.

The formula looks at the historic experience of each category of business (includingreinsurance) and seeks to equalise the expected loss cost to the Central Fund of eachportfolio. This means that each underwriting portfolio should present the same risk interms of Lloyd’s chain of security. For existing members, the formula determines thecapital required to cover both underwriting in the proposed year and the possibility thatthe reserves set for past years are insufficient. The formula largely assumes an averagelevel of credit for reinsurance but the actual reinsurance spend is currently being phasedin. Diversification credit is applied across years of account, for business mix and for

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participating across several managing agents. Where a syndicate feels its performance isbetter than market average it can apply to use its own data. Any resulting improvement inthe syndicate's ratio will feed through into those of its members.

In addition, a capital loading may be imposed if the monitoring work performed by theRegulatory Division gives rise to concerns. All existing syndicates and agents have beengiven a rating from 1 (least good) to 4 (best). Those causing concern i.e. ratings 1 or 2,may be subject to a loading (currently 20% and 10% respectively).

The Risk Assessed Capital ("RAC") software uses the formula and, if applicable, anyloading to calculate an RAC ratio. If the calculated ratio is below the minimum (45%) theminimum percentage will be applied to the member's capacity. This results in the Fundsat Lloyd's amount to be provided by that member. If the RAC ratio is above the minimumthen the RAC percentage figure is applied directly to the member's capacity to producethe FAL amount.

New syndicate ratios are produced by using the RAC model and a Lloyd's adaptation ofthe assessment undertaken by the FSA for new entrants to the insurance market. Thisinvolves, inter alia, reviewing syndicate business plans for the first three years of tradingand calculating minimum capital requirements sufficient to cover at least that period. Asimilar process is carried out in year 2, but this also takes into account the actual versusplanned situation for year 1. The new syndicate should submit an outline business planfor the first three years of account. Specific regulatory requirements in respect ofreinsurance

Lloyd’s maintains good standards with regard to the financial security of reinsurers. As amarket, it is one of the world’s largest reinsurers. The proportion of reinsurance cededwas 31.4% of gross premium income for the 1997 account. Inter–syndicate reinsurancehas fallen steadily and was £425 million in 1999.

There are no formal guidelines for excess of loss reinsurance arrangements although themarket has tended to be conservative in its use of unrated companies.

Financial strength ratings are widely used to as part of the decision to purchasereinsurance. Lloyd’s Regulatory Division does, however, place limitations on quota sharearrangements. To be acceptable, quota shares must not exceed 20% of syndicate capacityor 50% of premium in the particular risk category. Where the reinsurer is not a Lloyd’ssyndicate, it must have minimum net assets of at least £150 million, have a Standard &Poor’s rating of A+ or better and/or a Best’s rating of A or better, and be incorporated inone of a number of specified jurisdictions.

Lloyd’s has also introduced more general requirements for managing agents in the formof the “Code for Managing Agents: Managing Underwriting Risk”, issued in 1997. Itsets out the agent’s general responsibility in respect of risk management and providesguidance as to how this may be achieved. It includes sections on:

§ Determining the underwriting and reinsurance policy of the managed syndicate

§ Accepting risks on behalf of the syndicate

§ Managing the reinsurance programme

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With regard to the management of the reinsurance programme, the code suggests that,where practicable, a reinsurance security committee should be established to introduceprocedures for monitoring and assessing the security of, and exposure to, reinsurers on alltypes of reinsurance. In particular, it should compile a list of acceptable security for alltypes of reinsurance and, in respect of each reinsurer, should set appropriate maximumexposures at class of business, syndicate and agency level. This will ensure that adequateinformation is available to assess the syndicate's protections at any point in time.Procedures should also be developed and implemented for obtaining the Board's authorityfor purchasing reinsurance from reinsurers not currently on the list.

The reinsurance security committee will need to ensure that all individuals with authorityto purchase reinsurance are fully aware of the list of acceptable security for all types ofoutward reinsurance and of any maximum exposure levels. It will also need to satisfyitself that systems and procedures are in place to provide the necessary control frameworkand management information to enable those responsible for reinsurance security to fulfiltheir responsibilities.

Finally, the payment performance of reinsurers will need to be monitored, and anydisputes or failures of cover should be reported to the Board.

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Appendix IV

Detailed description of actuarial reserving methods used

Triangulation

The used triangles have the following format:

Development YearAY 1 2 3 … n-2 n-1 n

1 C(1,1) C(1,2) C(1,3) … C(1,n-2) C(1,n-1) C(1,n)2 C(2,1) C(2,2) C(2,3) … C(2,n-2) C(2,n-1)3 C(3,1) C(3,2) C(3,3) … C(3,n-2)

… … … …

n-1 C(n-1,1) C(n-1,2)n C(n,1)

where C(i,k) is the accumulated loss (either incurred or paid) for accident year i atdevelopment year k .

Corresponding triangles can be constructed for the development of the premium or thecommission and brokerage.

A wide class of methods can be specified as loss development factor methods.

In the underlying model each (conditioned) expectation of an unknown amount C(i,k+1)with k>n-i can be described as

E[C(i,k+1)| C(i,1),…,C(i,k)] = E[C(i,k+1)| C(i,k)] = f(k) · C(i,k).

Chain Ladder Method

The best known method to estimate the unknown factor f(k) is the Chain Ladder Method.

Chain Ladder estimates f*(k) are weighted averages of the historical development factors,i.e. the year-to-year factors f(i,k) = C(i,k+1)/C(i,k), k= n-i:

f*(k) = ∑∑−

=

−

=

+kn

i

kn

i

kiCkiC11

),(/)1,( .

Applied to the diagonal elements of the triangle, a square will be obtained with theultimate position in the last column.

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This is the standard version of the Chain-Ladder-Method. For a proper actuarial analysisseveral adjustments are required, e.g.

- a limitation of the scope of accident years- a consideration of trends within the observed development factors f(1,k),…, f(n-

k,k )- a smoothing of Chain Ladder-factors f*(1),…, f*(n-1) in case of instable patterns

via several functions (e.g. Exponential, Weibull, Power, Inverse Power)- a tail factor f(tail) if the earliest reliable accident years are not settled

Adequate estimates of tail factors are either market factors or an extrapolation of thesmoothing function.

Ultimate premiums and ultimate commissions also have to be estimated.

Since the estimates for the ultimate loss are heavily dependant on the diagonal valueC(i,n-i+1), any outliers on the diagonal will show a remarkable effect. Some methods canbe applied to adjust the diagonal. The diagonal value is split into a developing part (whichthe development factors are applied to) and a non-developing part, this part is added tothe other part.

A favourite method to calculate this split is the Cape-Cod-Method.

Using the so called year-to-ultimate factor

u(k) = f (k) · … · f (n-1) · f(tail)

– with f(·) being estimated with Chain Ladder or a smoothing or any other method – andthe lag factor

l(k) = u(k) 1−

the used premium l(i) · P(i) is computed (with P(i) being the ultimate premium for theaccident year i).

With the average diagonal loss ratio based on the used premium

CC = )()(/)1,(11

iPiliniCn

i

n

i∑∑

==

⋅+−

C(i,n-i+1) is split into a developing part

CC · l(i) · P(i)

and a non-developing part (which may be negative)

C(i,n-i+1) - CC · l(i) · P(i).

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Inherent in this method is the assumption that premium rates are stable. If this is not thecase, the historical premiums need to be adjusted to take account of rate changes. Thusfor proportional business information about changes in the quota of the cedant have to beavailable. For non-proportional business the cycle of the underlying rates needs to beconsidered.

Bornhuetter-Ferguson Method

Another method commonly used in the United States is the Bornhuetter-FergusonMethod.

Apart from the development factors described above this method depends on independentexpectations about the accident years. An initial loss ratio LR(i) for the accident /underwriting year is required that may be the underwriters’ estimation. Also marketinformation or the average of the historical loss ratios, calculated with the Chain ladder-ultimates, may be taken into account.

With the lag-factor l(i) and the ultimate premium P(i) the ultimate loss for year i isestimated to be

C(i,n-i+1) + l(i) · LR(i) · P(i).

Additive or Loss Ratio Step-by-Step Method

The Additive or Loss Ratio Step-by-Step Method is also a method sometimes used by non-life actuaries.

With P(i) being the ultimate earned premium the development of the loss ratio LR(i,k) =C(i,k)/P(i) is analysed instead of C(i,k) only.

In the underlying model each (conditioned) expectation of an unknown amount C(i,k+1)with k>n-i can be described as

E[LR(i,k+1)| LR(i,1),…, LR(i,k)] = E[LR(i,k+1)| LR(i,k)] = d(k) + LR(i,k),

and the unknown movement of the loss ratios d(k) is estimated by

d*(k) = ∑∑∑∑−

=

−

=

−

=

−

=

−+kn

i

kn

i

kn

i

kn

i

iPkiCiPkiC1111

)(/),()(/)1,(

which can be interpreted being the weighted average rate of year-to-year movements ofthe loss ratios.

Also this method takes trends, smoothing and a tail into consideration.

(LR(i,n-i+1) + d*(n-i+1) + … + d*(n-1) + d*(tail)) · P(i)

will be the expected ultimate loss within this model.

mk/nb/552 154

Expected Loss Method or Naive Loss Ratio Method

For business without any historical development or for the current year being not fullyreported the Expected Loss Method or Naive Loss Ratio Method may be the appropriateway to estimate the ultimate loss, which is calculated for the accident year i using

LR(i) · P(i).

The ultimate loss ratio LR(i) may be derived from the pricing process, underwriter’sinformation or, in case of a given history and a current year being not fully reported, fromhistorical loss ratios.

mk/nb/552 155

Appendix V

Main Sources

§ Basel Committee for Banking Supervision: ISDA’s response to the Basel Committee onbanking supervision’s consultation on the new capital accord, May 2001.

§ Brendon Young and Simon Ashby (2001) “Insurance As A Mitigant for OperationalRisk”Operational Risk Research Forum, Vers.2, (May).

§ IAIS (2000) “On Solvency, Solvency Assessments and Actuarial Issues”, Issues Paper(March).

§ IAIS (1998) “Supervisory Standard on Derivatives” Supervisory Standard No. 3,(October)

§ National Association of Insurance Commissioners (2001) Securities Valuation OfficeResearch Vol.1 , Issue 2, (February).

§ National Association of Insurance Commissioners (2000) Financial RegulationStandards and Accreditation Program, (December).

§ Insurance Steering Committee (2001) IASC Draft Statement of Principles, (December).

§ Tillinghast, Towers-Perrin (2000) European Commission ART Market Study, (October),London.

§ Babbel, D./ Santomero, A. (1996) “Risk Management by Insurers: An Analysis of theProcess” Wharton Financial Institutions Center Research Papers, No. 96-16.

§ Reinsurance Association of America (1996) Alien Reinsurance in the U.S. Market.

§ Financial Stability Forum (2000) Report of the Working Group on Offshore Centres,(April).

§ Comitè Europèen des Assurances (2000) Framework for a European Regime for theSupervision of Cross-Border Reinsurance, (May).

§ Comitè Europèen des Assurances (1999): “Towards a single “passport” for reinsurance inEurope” CEA Position Papers, (May).

§ IAIS (1998) “Supervisory Standard on Licensing” Supervisory Standard No. 1, (October).

§ IAIS (2000) “Guidance Paper for Fit and Proper Principles and their Application”Guidance Paper No. 3, (October).

§ European Commission (2001) “Approaches to Reinsurance Supervision-Follow-up andStructure of Work Programme” Discussion Paper to the IC Reinsurance Subgroup,(June).

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§ European Commission (2001) “Considerations concerning “licensing” system and“passport” of reinsurance supervision” Discussion Note to the Members of the ICcommittee on Reinsurance, (June).

§ European Commission (2001) “Solvency II: Presentation of the Proposed Work” Note tothe Solvency Subcommittee of the Insurance Committee, ( March).

§ European Commission (2000) “Approaches to Reinsurance Supervision” DiscussionPaper to the IC Reinsurance Subgroup.

§ European Commission (2002) “Study into the methodologies to assess the overallfinancial position of an insurance undertaking from the perspective of prudentialsupervision” A study by KPMG (to be published April/May).

OTHER REFERENCES

1. Cologne Re (1998) Risk Insights, (September), Vol.2, No.4.

2. Swiss Re (1996) Rethinking Risk Financing, (Zurich).

3. Swiss Re (2001) “Capital Market Innovation in the Insurance Industry” Sigma No.3(Zurich).

4. Swiss Re (2000) Late claim reserves in reinsurance, (Zurich).

5. Lloyds (1998) “A Review by U.S. State Insurance Regulators” Report of theExamination Team to the Surplus Lines (E) Task Force, (September).

6. Standard & Poor’s (2000) “The French reinsurance market 1999” GlobalReinsurance Highlights, (September).

7. Standard & Poor’s (1999) “Ten years in Reinsurance” Global ReinsuranceHighlights, (December).

8. Lloyd’s (2000) “Two top reinsurers team up to form web-based exchange”, Lloyd’sof London Press Limited, (December).

9. Stefan Förster, Dr. Alexander König (1999) “Capital at Risk“ Fachreihe derBayerischen Rück, (June), Issue 25.

10. Eberhard Müller(2000) “Sinn und Unssinn von RBC-Modellen – Anmerkungen zurNichtlinearität von Risiken“ Zeitschrift für Versicherungswesen, Nr.21/1, November.

11. Swiss Re (1997) “New perspectives: Risk securitization and contingent capitalsolutions”, (Zurich).

12. Standard & Poor’s (2000) Standard & Poor’s Response to Basel CommitteeProposals, Standard & Poor’s CreditWire, London, (January).

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13. G. Blomberg und Dr. W. Schnabel (2000) “ Nicht-proportionale Rückversicherung inder Sachversicherung” Versicherungswirtschaft, Heft 21/2000.

14. Ernst Wehe (1994) “Rückversicherung im Umbruch Versicherungswirtschaft, Heft21/1994.

15. Andrea Heß (1998) “Financial Reinsurance” Hamburger Gesellschaft zur Förderungdes Versicherungswesens mbH, Heft 20, (January).

16. Rolf Nebel (2001): The Case For Liberal Reinsurance Regulation, GenevaAssociation Etudes et Dossier No. 247.

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18. Hugh Rosenbaum (1998) “A Good time to hold an insurer captive” Reinsurance,(June), 17-19.

19. Tony Dowding (2000) “No holds barred” Reinsurance, (January), 14-15.

20. George Sandars (2000) “Growing appreciation of ART” Global Reinsurance, 64-67.

21. D. M. Jaffee and T. Russell (1997) “Catastrophe Insurance, Capital Markets, andUninsurable Risks” The Journal of Risk and Insurance, Vol.64, No. 2, 203-230

22. Dr. Peter Liebwein (2000) “ Klassische Rückversicherung als Tailor-Made solution”Versicherungswirtschaft, Heft 17/2000.

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24. Guy Carpenter (1998) “Global Reinsurance Analysis 1998” A Guy Carpenter SpecialReport, Guy Carpenter & Company Inc., (September).

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26. Moody’s Investors Service (1999) “Assessing Credit Risks of US Property andCasualty Insurers” Moody’s Rating Methodology, (March).

27. A.M. Best (2001) “Current Guide to Best’s Insurer Financial Strength Ratings” A.M.Best Ratings & Analysis, July.

28. Warren Cabral (1998) “Bermuda’s hidden treasure” Reinsurance, (February).

29. Janina Clark (1998) “Europe inside and out” Reinsurance, (September).

30. Marie-Louise Rossi (1998) “The world according to Europe” Reinsurance,(September).