In this issue of Insurance and reinsurance news we discuss the rule applying within the European Economic Area that (re)insurers should limit their objects to the business of (re)insurance. We also consider how the application of the rule is likely to evolve over the coming years.
The European background to the rule
The purpose of the rule is to protect insurers from the risk that losses or liabilities from non-insurance activity might deplete or divert their resources. It dates from the original European Insurance Directives that were adopted in the 1970s. These directives applied only to:
- insurers who carried on direct insurance business; or
- insurers (such as the Society of Lloyd’s) that carried on a combination of direct and reinsurance business.
The Insurance Directives provide that ‘the home member state shall require every insurance undertaking for which authorization is sought to... limit its objects to the business of insurance and operations arising directly therefrom [emphasis supplied], to the exclusion of all other commercial business.’ In this context insurance includes reinsurance.
The Reinsurance Directive (RID) was adopted in 2005. It required pure reinsurers to limit their objects to the business of reinsurance and related operations [emphasis supplied]. This suggests a less restrictive regime than applies to direct insurers. Pure reinsurers are insurers who carry on no direct insurance business. The RID gave a number of examples of what might amount to ‘related operations’, including ‘provision of statistical or actuarial advice, risk analysis or research for clients’.
The rule, in its distinct application to direct insurers and reinsurers, will be grandfathered word for word into the Solvency II Directive, likely (if and when it is eventually adopted) to come into force in 2013.
UK implementation of the rule
The UK implementation of the rule provides that direct insurers ‘...must not carry on any commercial business other than insurance business and activities directly arising from that business’. Insurance business in this context means ‘effecting and carrying out contracts of insurance’. This includes, for instance, underwriting risks and dealing with claims. Often a question may arise as to whether a contract is indeed insurance or something else, such as a credit derivative. The answer to the question will be relevant in determining either:
- whether the insurer should enter into the contract in question (if it is not insurance); or
- whether a person other than an insurer may enter into the contract (if it is insurance) without creating a regulatory breach.
The UK implementation arguably represents a ‘gold plating’ of the directive standard. The restriction applies not only to the objects of the direct insurer but also to its actual business activities. Moreover any non-insurance activities must arise not just directly from ‘the business of insurance’ (which could be any insurer’s business) but also directly from the insurance business of the insurer in question.
So the FSA’s rules say that ‘insurers cannot carry on an insurance mediation activity [eg through their direct sales force] in respect of a third party’s products, unless they can show a natural fit or necessary connection between their insurance business and the third party’s products’.
This is not always the position in other member states. In Germany, for instance, the rule is not interpreted as restricting one insurance company from selling another insurance company’s products.
The UK implementation of the rule relating to reinsurers says that they ‘must not carry on any business other than the business of reinsurance and related operations’.
How the rule is applied
The rule, in its application to UK direct insurers, prevents them from carrying on other commercial activities as distinct revenue-generating businesses. This does not preclude non-insurance activity that is incidental to the insurance business. Examples include:
- lending on domestic mortgages or on the security of insurance policies;
- buying and selling in the financial markets; and
- engaging in derivatives transactions for the purpose of managing insurance and investment risk.
An insurance company may also provide insurance cover which, in effect, enables a derivative transaction to take place because it reduces the exposure of the issuer.
Here again the German approach is different. In that jurisdiction the rule is not, for instance, interpreted as preventing a life insurer from selling third party noninsurance investment products. In France the Insurance Code merely requires that the scope of an insurer’s noninsurance activities should be ‘limited in relation to the firm’s entire business’.
Where a UK insurer cannot itself carry on a noninsurance activity it may achieve the same result by establishing other companies in its group that are able to do so.
Does the rule still serve a useful purpose?
It is questionable whether the original justification for the rule should still carry the same weight. Increasingly sophisticated risk management arrangements might arguably permit a greater level of diversification within an insurance company.
The rule is also arguably a little at odds with the aims of the Solvency II project. In general the new prudential standards allow insurers to manage their own risk appetitite, provided that higher levels of capital are maintained for higher levels of risk.
A more appropriate restriction might be that already contained in the FSA’s rulebook:
‘A [(re)insurer] must limit, manage and control its noninsurance activities so that there is no significant risk arising from those activities that it may be unable to meet its liabilities as they fall due.’
Future of the rule
The rule is ‘hard coded’ into the proposed Solvency II directive text. So, except in the very long term, it is only likely to evolve to the extent that it can be reinterpreted.
Some change is likely. Whereas the existing Solvency I prudential standards are contained within a minimum harmonisation regime, the intention is that Solvency II should be nearer to maximum harmonisation. It should normally create a level playing field across Europe.
A new approach to derivatives such as credit default swaps might perhaps be justified. This could be on the basis that they represent a mechanism for risk transfer that is an alternative to an insurance transaction. It seems unlikely, however, that direct insurers will become major players in the derivatives market. A creditor of an insolvent direct insurer under a derivative will be postponed, under the 2001 Insurers Winding-Up Directive, to the insurer’s ‘insurance creditors’. This, in any event, would put direct insurers at a significant disadvantage in the derivatives market.