The Reinsurance Directive was approved by the European Parliament on 7 June 2005. It establishes a legal framework for the regulation and prudential supervision of reinsurers that have their head office in one of the 27 countries of the European Union. The Reinsurance Directive is required to be implemented by each Member State by 10 December 2007.
The Reinsurance Directive will be an interim measure as Solvency II will replace the prudential requirements at the end of the decade. The aim of Solvency II is to link an insurer’s capital to its business risks. Solvency II will update the whole system of solvency requirements for the insurance industry, including reinsurance. It will take account of changes in the financial markets, such as the use of derivatives, new insurance products, and new risk management techniques introduced since the current insurance directives were first introduced in the 1970s.
Key elements of the Reinsurance Directive:
- A requirement for all EU reinsurers to be authorised – each reinsurer must be licensed by the state in which that reinsurer has its head office.
- A single passport regime – as with direct insurers, this enables a reinsurer authorised in any Member State to carry on business in any country within the EU, on either a branch or services basis, by using the passport regime.
- Responsibility for financial supervision for each reinsurer to rest with the home state.
- Prudential supervision – rules about solvency margins and minimum guarantee fund to apply throughout the EU.
- Member States will not be allowed to require reinsurers to pledge assets to cover its part of cedent’s technical provisions.
- Provisions permitting the use of finite insurance and special purpose vehicles in accordance with the rules of the home Member State.
- Reinsurance undertakings must limit their objects to reinsurance “and related operations”. Specifically, reinsurers are prohibited from carrying on any unrelated banking or financial services activities.
- Portfolio transfers – these must be in line with the single authorisation provided for in the Reinsurance Directive.
- There is a duty on auditors to report to regulators if they become aware of facts which are liable to have a serious effect on the financial situation or administrative or accounting organisation of a reinsurer.
- Reinsurers will be subject to the Insurance Groups Directive (Directive 98/78/EC) and the Financial Groups Directive (Directive 2002/87/EC).
Who does the directive apply to?
The Reinsurance Directive applies to:
- reinsurers who carry on pure reinsurance business. It does not apply to direct insurers carrying on reinsurance business who are already caught by the existing insurance directives. However, the provisions on solvency margins in this directive will apply to the reinsurance business of those insurers if the volume of reinsurance activities represents a “significant part” of the business;
- captive reinsurers. The Directive specifically prohibits insurers or reinsurers in a financial conglomerate from owning a captive.
Who does the directive not apply to?
For reasons of public interest, the Reinsurance Directive does not apply to reinsurance carried out, or guaranteed, by Member States. In other words, where a government or governmental body acts as insurer of last resort in relation to a liability where there is a lack of adequate commercial cover. This would apply in the UK, for example, to Pool Re. To fall within this exemption the requirement is that there is no cover available in the commercial market – the Reinsurance Directive specifically points out that a high premium does not mean that there is no cover.
How to obtain authorisation?
The directive requires:
- that the company’s objects be limited to reinsurance and related operations;
- the company submit a scheme of operations;
- the company possess the minimum guarantee fund; and
- the company is run by persons of good repute with appropriate professional qualifications and experience.
The scheme of operations
Reinsurers must submit to the home state regulator a “scheme of operations”. This comprises particulars or evidence of:
- the nature of proposed risks to be covered;
- the kinds of reinsurance arrangements the company intends to enter into;
- the guiding principles as to retrocession (i.e. what retrocessions the company intends to enter into);
- the items constituting the minimum guarantee fund;
- estimates of the costs of setting up the administrative functions required to generate business and how such costs will be met; and
- for the first three years of trading, the company must also submit estimates of management expenses, estimates of premiums and claims, a forecast balance sheet and estimates of financial resources intended to cover underwriting liabilities and the solvency margin.
Reinsurers must notify the home state of the identity of shareholders (direct or indirect) and the home state must refuse authorisation if they are not satisfied as to the qualification of those shareholders or members, taking into account the need to ensure sound and prudent management.
The home state is required to consult with the regulators in other Member States prior to granting any authorisation to a reinsurer which is either (i) a subsidiary of an insurer (or reinsurer) authorised in another Member State; or (ii) a subsidiary of a parent undertaking of an insurer (or reinsurer) authorised in another Member State; or (iii) controlled by the same person who controls an insurer or reinsurer authorised in another Member State.
Conditions Governing the Business of Reinsurance
The home state regulator is ultimately responsible for the supervision of its reinsurers, although any host Member State can report to the home state regulator if they believe that activities of that reinsurer in their host country are likely to affect a reinsurer’s financial soundness. Financial supervision includes verification of the reinsurer’s solvency, and the establishment of technical provisions and of the assets covering them. The Reinsurance Directive specifically states that the home state regulator cannot refuse to recognise retrocession contracts concluded by the reinsurer with an authorised insurer or reinsurer on grounds directly related to the financial soundness of the retrocessionaire.
Where a reinsurer has a branch, the Member State of the branch is required to ensure that the home state regulator may carry out on-the-spot verification of the information necessary to ensure the financial supervision of the undertaking. The responsibility of the home state regulators
The responsibilities and rights of the home state as regards reinsurers are:
- To obtain annual accounts, which must show all operations, the financial situation and the solvency of the reinsurer. In particular, regulators are specifically enabled to make detailed enquiries regarding a reinsurer’s situation and the whole of its business by gathering information or requiring the submission of documents concerning both its reinsurance and retrocession business, and are permitted to carry out on-the-spot investigations at the reinsurer’s premises.
- To authorise portfolio transfers. The Reinsurance Directive states that each Member State shall authorise reinsurers who have their head office within its territory to transfer all or part of their portfolio, including those concluded under a branch or services passport, to an accepting office established within the EEA if the home state of the accepting office certifies that the latter possesses the necessary solvency margin.
- To be notified with details of persons acquiring or disposing of a qualifying holding (being 10 per cent or more of the capital or voting rights) in reinsurance undertakings. In addition, any such person who increases his holding such that the proportion of capital matches or exceeds 20, 33 or 50 per cent, or where the reinsurer becomes his subsidiary, must inform the home state. Member States have up to three months to object to such acquisitions.
The Reinsurance Directive sets out detailed provisions relating to financial supervision. In essence, reinsurers are required to establish adequate technical provisions and appropriate assets to cover both those technical provisions and, where relevant, equalisation reserves. Such assets must be appropriately diversified.
In addition to this, reinsurers need a solvency margin, which, pending the introduction of Solvency II, will broadly be set at the same level as for direct insurers. The exception is in relation to life insurance, where the Reinsurance Directive allows the general insurance basis of calculation to be used instead of the basis specified in the Consolidated Life Directive. This option is potentially available to all types of life business (including investment contracts).
A minimum guarantee fund is also needed. One-third of the solvency margin constitutes the guarantee fund. It comprises the same type of assets as the solvency margin and must not be less than €3 million. Member States can set lower minimum guarantee funds for captive reinsurers than for “normal” reinsurers.
Items of interest to note are:
- the Reinsurance Directive contains a specific prohibition on the retention or introduction of reserving requirements which require the pledging of assets to cover un-earned premiums and outstanding claims provisions;
- where the home state allows any technical provisions to be covered by claims against reinsurers who are not authorised by the Reinsurance Directive (for example non-EEA reinsurers) then it must set conditions for accepting such claims (for example, collateral requirements);
- assets covering technical provisions are required to comply with the prudent person principles in Article 34 which states that:
- the assets must take into account the type of business carried out, in particular, nature, amount and duration of the expected claims payment in order to secure the efficiency, liquidity, security, quality, profitability and matching of investment;
- the reinsurer must ensure assets are diversified and adequately spread;
- investment in assets which are not admitted to trading on regulated financial markets must be kept to prudent levels;
- investment in derivatives is permitted, provided they contribute to a reduction of investment risk or facilitate efficient portfolio management;
- reinsurers must avoid excessive risk exposure to a single counterparty and other derivative operations.
- the solvency margin or capital held must consist of assets free of any foreseeable liabilities, for example, paid up share capital, statutory and free reserves, profit and loss brought forward (after deduction of dividends), preferential share capital, subordinated loan capital and securities with no specified maturity date.
What happens if the solvency margin or guarantee fund are not maintained?
If this is not maintained, the home state regulator can require the reinsurer to increase the solvency margin to the required level, which is determined from a recovery plan which must be submitted to the regulator for approval. The home state can also prohibit a free disposal of the reinsurer’s assets both in the home state and across all Member States.
The guarantee fund
If this is not maintained, the home state regulator can require the reinsurer to submit a short-term finance scheme for its approval and may also prevent a free disposal of assets.
The Reinsurance Directive sets out special provisions relating to finite reinsurance and insurance special purpose vehicles. Finite reinsurance is defined in the Reinsurance Directive as
“reinsurance under which the explicit maximum loss potential expressed as the maximum economic transferred, providing both a significant underwriting risk and time risk transfer, exceeds the premium over the lifetime of the contract by a limited but significant amount together with at least one of the following two features:
- explicit and material consideration of the time value of money; and
- contractual provisions to moderate the balance of economic experience between the parties over time to achieve the target risk transfer.”
The Reinsurance Directive provides that home states may lay down specific provisions concerning finite reinsurance activities including:
- mandatory conditions for inclusion in all contracts; and
- sound administrative and accounting procedures, adequate internal control mechanisms and accounting and essential information requirements, the establishment of technical provisions, investment of assets and rules relating to solvency margin.