The question of collateral?

Reform of current U.S. collateral requirements should be one of many steps the industry takes to modernize reinsurance regulation to achieve open global markets on fair terms.

by Sandra G. Blundetto, Kelly Cruz Brown and Beth Vecchioli

Pressure for reform of the U.S. regulatory system for credit for reinsurance led the Reinsurance Task Force of the National Association of Insurance Commissioners recently to take a much needed step forward at the Summer NAIC meeting by voting to advance a proposal to ease collateral requirements for non-U.S, reinsurers. The proposal, which would apply to all reinsurers, would replace collateral requirements with a ratings-based system predicated on the financial strength of reinsurers. It is commendable that the NAIC has acknowledged that credit for reinsurance and collateral provisions need revision. However, further modernization and reform regarding U.S. reinsurance regulation is necessary to reflect the global nature of the reinsurance industry and to achieve open markets on fair terms.

Current U.S. credit-for-reinsurance rules require unauthorized reinsurers to provide funds in trust or other collateral equal to 100% of their gross actuarially estimated liabilities to U.S. cedants, even if they have significant retrocessional protection and a history of meeting their obligations. However, the rules demand no such collateral from domestic companies--even those with lower financial security ratings. These requirements dictate that non-U.S, reinsurers essentially pay twice--once to secure the same liabilities when they purchase retrocessional cover and again to post collateral.

Opponents of change contend that collateral is required to protect U.S. ceding companies from insolvent reinsurers that can't pay claims in the event of major catastrophes. They argue that U.S. insurers are incapable of evaluating alien reinsurers because of differing regulatory and accounting regimes and national barriers to the exchange of information. Requiring collateral for American ceding companies to get credit for reinsurance on their balance sheets may have been justified years ago when reliable information about the financial security of foreign reinsurers was not widely available. However, with the formation of the International Association of Insurance Supervisors, the integration of financial services worldwide, the development of credible international accounting standards, increased reliability of rating agencies, and advances in technology allowing for the rapid exchange and communication of information, this argument is not persuasive.

Reinsurance is a global, international business. The major reinsurers that underwrite the majority of reinsurance business ceded by U.S. companies operate internationally, and there is a growing international consensus that many non-U.S, major reinsurance jurisdictions are sophisticated and implement and maintain effective regulatory systems.

The requirement that unauthorized insurers provide funds in trust or other collateral equal to 100% of their gross actuarially estimated liabilities to U.S. cedants, and simultaneously liquidate assets to pay claims being settled, forces reinsurers to shift their investment strategies and portfolios to highly liquid assets that could reduce investment returns for reinsurers and therefore could arguably affect the amount of offshore capacity available to U.S. insurers. The transaction costs involved in securing collateral, which are passed on to ceding companies, exacerbate the inefficiencies in the marketplace and increase insurance costs for U.S. insurers and policyholders.

Examining Other Models

The events of September 11, 2001, and the 2004 and 2005 hurricane seasons underscore the unacceptable burden and unintended consequences of these requirements. The NAIC has begun to listen seriously to the concern of the world's leading reinsurers and regulators in the European Union that national boundaries should not be a barrier to providing needed capacity. The European Union has taken steps to eliminate collateral requirements and create a system of regulation equivalence across the 25 countries of the Union. The United Kingdom, Germany (non-life), Switzerland, Bermuda and Japan are among the major reinsurance jurisdictions in the world that do not have collateral requirements, and maw have represented in comment letters to the NAIC that they do not have major problems with uncollectible reinsurance recoverables. Why can't we do the same?

U.S regulators should consider the non-collateral safeguards of these leading reinsurance jurisdictions. The E.U. Reinsurance Directive regulates and supervises European reinsurers through a harmonized system based on a "home country" passport. It requires reinsurers to be authorized by the member state in which the reinsurer has its head office and imposes certain capital requirements to ensure that assets are prudently invested, properly diversified and sufficiently liquid, having due regard to the amount and duration of the expected claims payments. Furthermore, the European Union is reviewing its current solvency regime through its Solvency II project, which is intended to create more efficient and secure markets and a level playing field among reinsurers in Europe and a stronger position for European insurers generally.

International comity demands mutual recognition of other jurisdictions whose regulations are as secure and strong as--if not better than, as some argue--those maintained in the United States. Furthermore, given the tact that most reinsurance is ceded to non-U.S. reinsurance companies, it makes sense that the most efficient regulatory structure would involve harmonization among regulatory systems to address international or cross-border reinsurance transactions. Mutual recognition and harmonization of reinsurance supervision likely would result in a more efficient reinsurance marketplace by removing unduly burdensome requirements for reinsurers.

Those in favor of maintaining the 100% collateralization status quo cite, among other reasons, the uncertainty in foreign enforcement of U.S. judgments against foreign reinsurers. However, as noted in the NAIC Reinsurance Task Force of the Financial Condition (E) Committee U.S. Reinsurance Collateral White Paper: 1) key European countries consistently recognize U.S. judgments, which will be simplified and enhanced upon ratification of the Hague Convention on Choice of Court Agreements; 2) most reinsurance contracts contain arbitration clauses, and arbitration awards are enforceable though the Hague's 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards; and 3) regulators can require preferred jurisdiction and law clauses in reinsurance contracts.

Federal Standards

In addition to considering the non-collateral requirements of other foreign reinsurance jurisdictions, U.S. insurance regulators should explore adoption of federal standards to provide a comprehensive and uniform system of reinsurance regulation. Our current multistate system of reinsurance regulation fosters inefficiencies and significant differences among jurisdictions that are unnecessary and inappropriate for the reinsurance business and a global marketplace. The costs associated with satisfying regulatory requirements for 51 different systems is an expense that is borne by the industry and ultimately paid by consumers.

Federal regulation of insurance is not a new concept to the insurance industry and is currently being considered as an alternative to our current state -based regulatory system.

Reinsurance is critical to the financial services markets by contributing to the efficient functioning of risk management. Reform of our current collateral requirements should be one of many steps our industry takes to reform our overall regulation of reinsurance so that reinsurers operate within a common regulatory framework that balances the need for insurers to transfer risk and reinsurers to optimize the use of their capital to fund claims. Our system of reinsurance regulation is archaic and woefully out of step with the global nature of our business.

NAIC Proposal

The National Association of Insurance Commissioners is closer than ever to ending the long held practice of mandating non-admitted reinsurers to post 100% collateral for their U.S. liabilities. With the goal of changing the old approach in favor of a ratings system that bases reinsurance agreements upon a company's financial strength, the NAIC's Reinsurance Task Force hopes to have a comprehensive draft in place by year's end. From there, the item would advance through senior NAIC committees, with the hope of coming to a final vote by early 2007.

Currently no final draft exists and no consensus has been reached. But regulators continue to keep in mind guiding principles contained within a September 2005 task force report:

1. The current rules on collateralization need to be changed. Among the alternatives to the 100% collateralization rule to be considered are those that would facilitate:

* Enhanced reporting from reinsurers to regulators consistent with U.S. reporting requirements

* Better matching of a ceding insurer's credit and the assuming reinsurer's reserves

* A reduction in coverage disputes between ceding companies and reinsurers

* A pass-through of the savings achieved in the reinsurance costs to the ceding company and ultimately to the primary policyholder

2. New rules are to apply uniformly regardless of the reinsurer's state or country of domicile.

Both Sides of the Question

* Current U.S. collateral requirements, coupled with the responsibility to pay claims, force reinsurers to shift their investment strategies and portfolios to highly liquid assets.

* These liquid assets could reduce investment returns for reinsurers and therefore could affect the amount of offshore capacity available to U.S. insurers.

* The most efficient regulatory structure would involve harmonization among regulatory systems to address international reinsurance transactions.

Contributors: Sandra G. Blundetto is senior vice president and general counsel of U.S.RE. Kelly Cruz-Brown is a shareholder in the Tallahassee, Fla., offices of Carlton Fields and practices insurance regulatory and administrative law. Beth Veccbioli is a senior government consultant in the Tallahassee office of Carlton Fields and provides government consulting services to insurers and reinsurers operating in Florida.

The Question Of Collateral?

Relaxing U.S. collateral requirements is directly at odds with the regulatory objectives of adequate capacity, affordable coverage, market stability, and most importantly, insurer solvency

by Karen Horvath

Property/casualty insurers, with the exception of perhaps a handful of the very largest companies, require reinsurance to provide appropriate policy limits to their customers. Accordingly, the security provided by reinsurers is paramount to the ongoing success and solvency of the primary carriers who cede business to them, and any threat to these reinsurance recoveries would have lasting repercussions on the individuals and businesses the primary companies insure. Insurance companies rely on reinsurance for a variety of purposes, including expanding capacity, stabilizing underwriting results, financing growth, securing against shock losses such as those arising from catastrophes, and shortening the time to run oft certain businesses, but primarily sharing exposure to large risks.

The National Association of Insurance Commissioners has proposed a relaxation of the collateral requirements for alien reinsurers--those that are formed according to the legal requirements of another country and not subject to U.S. regulatory requirements. However, such a move is directly at odds with the regulatory objectives of adequate capacity, affordable coverage, market stability, and most importantly, insurer solvency.

At the heart of the issue is alien reinsurers' alleged concern over the liquidity and capacity constraints generated by requirements to post collateral on losses ceded to them by their clients, particularly immediately following a significant insured event. In the wakes of events such as the Sept. 11, 2001, disaster and Hurricane Katrina, alien reinsurers found themselves in a position where they had to dramatically increase their collateral as losses ceded to them spiked, constricting their ability to grow their business as the market hardened. However, these collateral requirements are generally no less constraining than capital requirements for licensed reinsurers, which effectively post collateral by setting up reserves on their financial statements that regulators require to be supported by liquid assets.

A Matter of Choice

All reinsurers doing business in the United States have the option to become licensed, and consequently become subject to U.S. tax and regulation in their state of domicile and the states in which they operate, or alternatively post collateral. Collateral provides regulators with a tool for protecting reinsurance recoveries and thus securing policyholders' interests, while at the same time providing flexibility for reinsurers that ensures a viable market. Most choose the collateral option, as it takes a significant amount of time and energy to become individually licensed in all 50 states and the various U.S. territories, and they can maintain their tax advantage--in other words, avoid U.S. taxation.

Most other countries, including most European Union and Asian countries, require local licensing and provide no option for collateralization, creating greater barriers to entry in those markets. Licensing requirements necessitate that insurers in those territories hold assets locally and pay taxes in that country, and also often restrict the expatriation of funds. Proponents of relaxing the collateral requirements for alien reinsurers in the United States cite financial services modernization and the globalization of the business as basic reasons for their position. However, no common set of accounting rules, global regulator nor court system exists to protect the interests of cedants and provide a level playing field around the world. Without local capital that is subject to regulatory oversight, the deposit of funds in trust or the provision of letters of credit, cedants have no direct access to funds recoverable under their reinsurance contracts, and their chances of recovery are lowered by their inability to pursue them through the U.S. court system.

Importantly, however, this is not an issue of global regulation. It is an issue of the legal capability of collecting on contractual liabilities in a timely fashion. Access is restricted to premiums on deposit or funds held. In addition, changing conditions in the political and legal environments have lengthened the tail on reinsurance recoverables, and collateral is necessary to protect recoveries from long ago. Small companies have the potential to be hurt more than large companies by the absence of collateral, as the very largest companies can exert greater leverage in negotiations. One of the greatest consequences of relaxing collateral requirements will be the relative weakening of small players relative to their large competitors.

The collateral option provides alien reinsurers the opportunity they desire to participate in the U.S. market, as well as the flexibility to move capital freely and choose the most favorable venue for taxes and regulation. Why should the United States, which already provides the most flexibility to alien reinsurers and which has one of the most financially sound insurance regulatory regimes in the world and what could be one of the most efficient if Optional Federal Charter legislation is enacted, relinquish its rights to protect the solvency of its domestic players?

Other arguments in favor of relaxing the collateral requirements play on the fears of cedants and regulators, suggesting that current rules restrict capacity, particularly for property reinsurance in catastropheprone areas. According to a recent study by Reinsurance Association of America, nearly 50% of the U.S. reinsurance premium is ceded to non-U.S. reinsurers--a figure that suggests there is no barrier to entry. The reason capacity has constricted in coastal property is that rates for underlying insurance do not reflect risk due to political posturing and the volatility associated with the business generates high capital requirements, causing risk-adjusted returns to remain inadequate despite increasing pricing. Relaxing collateral/licensing requirements may indeed bring additional capacity to such areas, but that kind of impetus risks the entry of naive capital and/or financially suspect players, which are likely to exit quickly following a severe event--either voluntarily or through insolvency. Ultimately, that kind of capacity will hurt the market and cause serious disruptions. In fact, it is just such new capacity that should be required to provide collateral.

The Role of Ratings

In its proposal, the NAIC suggested an option whereby ratings could substitute for regulation or collateral. Rating agencies and regulators both play very important roles in promoting insurer solvency, but they are very different roles. Although some are fond of referring to rating agencies as de facto regulators, ratings are opinions that provide important information for credit decisions and comparisons of relative financial strength, but are no substitute for regulation. These organizations have no legal authority to enforce capital requirements, limit dividends, restrict transactions that could diminish cash and/or capital, or otherwise cause alien reinsurers to maintain financial strength. Rating agencies can, and do, exert significant influence over a company's financial condition as companies strive to maintain or improve their ratings, but once the rating falls below a level that is acceptable to the market, rating agencies lose power and only the regulators can protect policyholders. In addition, a rating downgrade can cause a run on the bank and without collateral, the reinsurer may have insufficient liquid resources to pay claims.

Finally, ratings provide an opinion as to a reinsurer's ability to meet its ongoing obligations to policyholders, but not its willingness. Collateral takes that issue off the table to a certain degree. In recent years, losses in the reinsurance sector resulted in downgrades to ratings below a level that is acceptable to the market for several reinsurers--including Gerling, Converium, and most recently PXRE--causing them to cease writing new and renewal business and focus on the run-off of existing liabilities. While coverage disputes were reported to be minimal, slow pay was a significant concern for cedants, and collateral accounts became of paramount importance. Even Lloyd's was able to limit its liability through the Reconstruction and Renewal plan that ultimately gave birth to Equitas, but those that held collateral have continued to collect on outstanding liabilities. Consequently, it would not be prudent for the NAIC and its members to relinquish their role and effectively endorse one or more rating agencies. In fact, it may be rather awkward. While the proposal suggested creating a new rating structure through the NAIC, regulators are not equipped to perform this function, in particular due to their lack of prospective evaluation focus.

All in all at a time when reinsurer financial strength has declined and slow-pay/dispute issues have been on the rise, it seems that relaxing collateral and licensing requirements for alien reinsurers is ill advised.

Contributor Karen Horvath is vice president of external financial communications for W.R. Berkley Corp.

Both Sides of the Question

* Current U.S. collateral requirements are generally no less constraining than capital requirements for licensed reinsurers.

* One of the greatest consequences of relaxing collateral requirements would be the relative weakening of small players relative to their large competitors.

* Ratings cannot substitute for collateral because ratings agencies have no legal authority to enforce capital requirements, restrict transactions that could diminish capital or otherwise cause alien reinsurers to maintain financial strength.