In this issue of Insurance and Reinsurance News we discuss the regulatory treatment of direct insurers which also write reinsurance. This is an issue that regularly arises in the course of our practice. Direct insurers writing reinsurance risks are treated differently, sometimes for no apparent reason, from ‘pure reinsurers’ who only write reinsurance risks. This creates anomalies, but there seems to be no current intention to rectify and rationalise the current patchwork of rules.
Direct insurers writing reinsurance business (‘direct insurers’) and pure reinsurers are treated differently mainly because the former have always been regulated under the Insurance Directives. These, with very few exceptions, only apply requirements to direct insurance business. The Insurance Directives date back to the 1970s. By contrast pure reinsurers are regulated under the Reinsurance Directive of 2005. According to some estimates up to 20 per cent of global reinsurance capacity has historically been provided by direct insurers.
The two regimes will be brought together under the Solvency II Directive (if and when it comes into force – now unlikely before 2016), but with much of the distinct treatment as between the two business models preserved.
Direct insurers writing reinsurance business also include the Society of Lloyd’s which, under European law, is treated as a single insurance undertaking in its own right, despite writing risks through its individual members.
The directives provide for direct insurers to passport their direct insurance business into other EEA member states. Pure reinsurers can passport their reinsurance business.
There is no provision at European level, however, for direct insurers to passport theirreinsurance business. The directive prudential regime applied to direct insurers does, nonetheless, extend to their reinsurance business. On this basis some member states (such as the UK and France) specifically allow direct insurers from other EEA states to reinsure local risks without applying further formalities. However, this is not addressed in the ‘Siena protocol’ on insurance passporting published by the European Insurance and Occupational Pensions Supervisors, so there is no explicit European standard. We have had experience of direct insurers experiencing problems in this regard with insurance regulators in at least one EEA member state.
Where this problem arises the obvious solution is for the direct insurer to arrange for the reinsurance to be fronted by a pure reinsurer, although this brings with it the problems of additional expense and complexity.
Transfers of business
The insurance directives provide for member states to sanction transfers of direct insurance business from one firm to another. Such transfers are required to be automatically recognised in other member states. The Reinsurance Directive created a similar regime for the transfer of reinsurance business by pure reinsurers. Although it does not provide explicitly for recognition in other member states, there are valid arguments to be made that the right to recognition is implicit.
Recognition of transfers of reinsurance business by direct insurers, by contrast, is not provided for either under the current directives or under Solvency II. The UK has such a regime for such transfers, but it does not derive from the directives.This means that one must look elsewhere for potential powers of recognition for any such transfer order.
It is arguable that orders sanctioning such transfers are entitled to recognition in the EU under the Brussels Jurisdiction Regulation. However, the position is far from clear.
Restriction of business to insurance
In the UK direct insurers must not carry on any commercial business other than insurance business and activities directly arising from that business.
A pure reinsurer must not carry on any business other than the business of reinsurance and related operations. There is an extensive list of activities which are regarded as ‘related’.
So the restriction, which derives from the directives, is significantly tighter for direct insurers. This will not change under Solvency II.
Admissible assets and exposure limits
Under Solvency I, direct insurers are required to invest their regulatory capital in a specified list of assets. Most of those assets are also subject to exposure limits. These rules, which apply to such firms’ reinsurance as well as direct business, derive from directive provisions which have been unchanged since the mid 1990s and therefore tend to be obsolete, especially for firms using internal models. They do not apply to pure reinsurers. Under the current regime of the Prudential Regulation Authority (‘PRA’) UK insurers and reinsurers are, apart from this, required to invest their assets prudently (‘the prudent person principle’) and any risks arising from their investment portfolio will affect the capital they are required to maintain at Pillar II of the PRA’s prudential regime.
Here the treatment of direct insurers will be aligned with the treatment of pure reinsurers if and when Solvency II comes into force. The ‘prudent person principle’ will continue to apply and the composition of the investment portfolio of an insurer or reinsurer will affect the calculation of its Solvency Capital Requirement.
Life and non-life business
Direct insurers must, subject to minor exceptions, write only life or non-life insurance, but not both. The rule does not apply to a limited number of ‘composite’ insurers who have been writing both types of business since before the directives were adopted. The rule extends to the reinsurance business of direct insurers, but not to that of pure reinsurers. It is justified on the basis that each of life and general business requires specialised skills and should be kept separate.
Under Solvency II member states may allow direct insurers to reinsure both types of risk if they so choose, but there is no current indication that the UK PRA will depart from the current position.
It is perhaps questionable whether these rules operate fairly as between direct insurers and pure reinsurers and as between life and general insurers on the one hand and composite insurers on the other. For instance, a general insurer writing a wide portfolio of direct and reinsurance risks might well develop the expertise to write life reinsurance.
Creditors of direct insurers under direct insurance contracts have priority over most other creditors. Creditors of direct insurers under reinsurance contracts do not have equivalent priority and there is no equivalent rule in the insolvency of a pure reinsurer.
This rule puts direct insurers at a competitive disadvantage compared to pure reinsurers. It also creates problems in other contexts. An example of this arises where a life insurer issuing a unit linked policy gives its policyholders access to ‘guest funds’ of other direct insurers under a reinsurance arrangement. In that event policyholders may need to be protected by security arrangements which substitute for the lack of priority. Similar principles may apply when the policyholders of a cedant firm have cut through rights to its reinsurer.
Another point relevant to unit linked contracts (whether as direct insurance or reinsurance) is that currently direct insurers (but not pure reinsurers) are required to match their liabilities under such contracts to investments in equivalent assets or indices. This rule will continue under Solvency II.
Most favourable treatment
The Reinsurance Directive and Solvency II require member states not to treat non-EEA reinsurers more favourably than they treat their own pure reinsurers. This rule does not extend for the benefit of EEA direct insurers writing reinsurance business. It will continue in its existing form under Solvency II.
The points identified above argue in favour of the pure reinsurer as the preferable business model. It is more debatable, however, whether that model is, apart from that, inherently and necessarily more robust than the mixed model. The levels of reinsurance written by direct insurers suggests that it may not always be.
Where direct insurers writing reinsurance business are subject to discriminatory treatment and are not in a position to rely on directive provisions, they may be entitled to rely on other rights under the Treaty on the Functioning of the European Union. The rules on the right of establishment and the freedom to provide services are most likely to be relevant.
A Community directive as long ago as 1964 abolished restrictions on the operation of those rules in relation to reinsurance. However the process of challenging discriminatory treatment may be a long and expensive one, with every indication that the topic is not very high on the European agenda.