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Kpmg final

  1. 1. European Commission Study into the methodologies for prudential supervision of reinsurance with a view to the possible establishment of an EU framework 31 January 2002 Contract no: ETD/2000/BS-3001/C/44 KPMG This report contains 157pages Appendices contain 16pages mk/nb/552
  2. 2. Contents 1 Introduction 4 1.1 1.2 Summary GeneralApproach 4 5 2 Similarities and differences between insurance, reinsurance and other risk transfer methods 6 2.1 2.2 2.3 2.4 2.5 2.6 2.7 Scope Approach Definitions Similarities between insurance and reinsurance Differences between insurance and reinsurance Other methods of risk transfer Preliminary conclusions 6 6 6 7 9 13 15 3 Reinsurance and risk 16 3.1 3.2 3.3 3.4 3.5 3.6 Scope Approach Risks Systemic risks Assessing the importance of different risks Conclusion 16 16 16 21 22 27 4 Description of the global reinsurance market 28 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 Scope Approach The global reinsurance market The major reinsurance products The role of offshore locations Captives The future evolution of the market and developments in products Competitive position of EU reinsurers from a global perspective 28 28 28 30 35 36 37 38 5 Description of the different types of supervision approaches currently used in the EU as well as other major Non-EU countries 39 5.1 5.2 5.3 5.4 5.5 5.6 5.7 Scope Approach Introduction: reasons for supervision Supervising authority Forms of supervision Supervision of reinsurance in the EU Supervision of reinsurance in major non-EU countries 39 39 39 40 41 42 61 6 The rationale with regard to supervisory parameters 71 6.1 6.2 6.3 6.4 6.5 6.6 Scope Approach Extent of supervision Overview of supervisory parameters Parameters relating to direct supervision Parameters relating to indirect supervision 71 71 71 74 76 97 7 The arguments for and against reinsurance supervision and
  3. 3. a broad cost-benefit analysis 7.1 7.2 7.3 7.4 7.5 7.6 Scope Approach Arguments for reinsurance supervision Arguments against reinsurance supervision Impacts on the different approaches to supervision Cost-benefit analysis 8 Summary of reinsurance market practice for assessing risk and establishing technical provisions 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 Scope Approach Market practice for assessing risk Establishing adequate technical provisions Management of underwriting risks Monitoring credit risk Management of investment risks Management of foreign currency risks The role of securitisation Financial condition reporting Summary Appendix I - Description of certain reinsurance arrangements Appendix II - Overview of other important captive domiciles Appendix III - Lloyd's: summary of the regulatory approach Appendix IV - Detailed description of actuarial reserving methods used 151 Appendix V - Main sources 106 106 106 106 109 112 112 117 117 117 117 118 123 132 133 134 136 140 141 142 146 147 155 This report was commissioned by Internal Market Directorate General of the European Commission. It does not however reflect the Commission's official views. The consultant, KPMG Deutsche Treuhand Gesellschaft, Cologne, is responsible for the facts and the views set out in the document. Reproduction is authorised, except for commercial purposes, provided the source is acknowledged.
  4. 4. Foreword by the Commission Services The reinsurance sector has seen important changes during the last few years. The concentration to a few large players has continued through mergers and acquisition, new financial products have been developed and new information technology tools have emerged. The tragic events of 11 September 2001 will also have strong repercussions on the reinsurance industry, both as regards practices and available capacity. These developments make it even more important that a solid system of reinsurance supervision is in place to ensure that companies fulfil their obligations. The security of the reinsurance arrangements of a primary insurer is clearly of vital importance for the protection of its policyholders. In a changing market it is important that supervisory practices keep pace with developments. In the EU there is currently no harmonised framework for reinsurance supervision, and this has led to significant differences in approach between Member States. Such differences may duplicate administrative work and may also create barriers to a properly functioning internal market for reinsurance services. In January 2000, the Commission Services and Member States therefore decided to initiate a project on reinsurance supervision to investigate the possible establishment of a harmonised EU system. As a thorough investigation of all the different aspects involved is very complex and extensive, the Commission Services and Member States agreed to commission a study to provide the working groups with background research and discussion material. The Commission Services are pleased to present this study, which was prepared by a team from the KPMG under the supervision of Keith Nicholson and Joachim Kolschbach. We believe that the study presents a clear and pedagogical overview of the reinsurance market and reinsurance supervision. We also hope it will stimulate further debate in Member States, at the EU level and internationally. Please note that although the study was commissioned by the Directorate-General Internal Market, it does not express the Commission's official view. The consultants remain 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: Please also note that the Insurance Unit of the Commission has a website, where other documents of interest can be found: market/en/finances/insur/index.htm Brussels, January 2002 Jean-Claude Thebault Director 1 Introduction This report outlines our findings on the "Study into the methodologies for prudential supervision 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 and differences which are relevant to the prudential supervision of insurance and reinsurance. The major methods of risk transfer in reinsurance business are described. The concept of alternative risk 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 section differentiates between different kinds of products, different lines of business and other activities performed by reinsurance companies. This section summarises the most relevant risks in a risk matrix and gives preliminary views of mitigating strategies. The section includes a discussion of specific risks relating to different reinsurance activities. Chapter 4 provides an overview of the global reinsurance market. It discusses the main market players, different jurisdictions, the role of offshore locations, the major reinsurance products and the likely evolution of the market and product developments. Chapter 5 provides a description of the different approaches to supervision adopted in the EU and in major non-EU countries. It includes a comparison of the principal characteristics and differences of major or leading jurisdictions, with the aim of clarifying the rationale underlying 4
  5. 5. the adopted supervisory approach. This section is based on discussions with industry specialists within the relevant jurisdictions (both within and outside KPMG). Chapter 6 analyses the rationale underlying various supervisory parameters and the relative importance and feasibility of supervising the parameters in question. Based on key risks, the analysis prioritises the products / activities of reinsurance companies by their relative need for supervision. Chapter 7 analyses the arguments for and against reinsurance supervision. Based on the goals of supervision, the risk analysis, and current practices, this section includes a broad cost-benefit analysis of supervisory approaches. Chapter 8 provides a summary of techniques currently employed for monitoring key risks. It analyses the impact of securitisation and how reinsurers measure or take into account portfolio diversification in assessing their own capital requirements. The study also examines approaches adopted by reinsurance companies and other interested parties (such as rating agencies) to assess and monitor reinsurance risks. The study considers the ways in which supervisory approaches may benefit from existing market practices. Our analysis is focused on individual reinsurance companies as well as on reinsurance groups. 1.2 General Approach The work was performed using our knowledge of the reinsurance industry and based on detailed information requested from various KPMG offices. We have also researched information sources to obtain articles and data. We have had regard, in particular, to the Issues Paper on Reinsurance 1 produced by the International 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 in order 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 5 practices, February 2000
  6. 6. Similarities and differences between insurance, reinsurance and other risk transfer methods 2.1 Scope In accordance with the Terms of Reference, this chapter provides "an overview of the similarities and differences between insurance, reinsurance and other risk transfer methods especially 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 using examples 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 an economic 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 other financial 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 Committee suggests the following definition of an insurance contract: "An insurance contract is a contract under which one party (the insurer) accepts an insurance risk by agreeing with another party (the policyholder) to compensate the policyholder or other specified beneficiary if a specified uncertain future event adversely affects the policyholder or other beneficiary (other than an event that is only a change in one or more of a specified interest rate, security price, commodity price, foreign exchange rate, index of process or rates, a credit rating or credit index or similar variable)." 2 2 2.3.2 Draft Statement of Principles (DSOP); Insurance Steering Committee, IASC, June 2001 Reinsurance The IAIS Working Group defines reinsurance as "the form of insurance where the primary insurer reduces the risk by sharing individual risks or portfolios of risks with a reinsurer against a premium". Reinsurance is "insurance for insurers". The basis of most reinsurance arrangements is the spreading of risk and, in essence, reinsurance allows the insurer to take on an insurance risk and subsequently pass on all or part of that risk to a reinsurer. As a result, the original company is left with only a part of the original risk (although in law the insurer remains liable to the policyholder for the full amount of the claim, and if the reinsurer defaults or becomes insolvent the 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 the common forms of reinsurance contract. Reinsurance business is similar to insurance business in a number of ways, and supervisors in certain jurisdictions, both within and outside the EU, have developed regulatory regimes for 6
  7. 7. insurance business which encompass reinsurance. In some cases, whilst the legislative framework of regulation makes little or no distinction between insurance and reinsurance, supervisors may take a somewhat different approach in practice. In other cases, reinsurance is treated differently within the regulatory legislation. Despite the similarities, there are fundamental differences between insurance and reinsurance, which can have a significant impact upon supervisory objectives. In order to assess the rationale for different supervisory approaches, it is necessary to examine those similarities and differences between reinsurance and insurance which are of relevance to prudential supervisors. 2.4 Similarities between insurance and reinsurance The areas of similarity between insurance and reinsurance business help to explain the rationale for a similar regulatory approach in certain jurisdictions. The main similarities are discussed below. 2.4.1 Transfer of insurance risk Both insurance and reinsurance contracts allow for the indemnification of an insured (or reinsured) in the event of loss in consideration of a premium. The key features of the business cycle involved in both cases are very similar, through underwriting, investment, claims, control over expenses, and the reinsurance (and for reinsurers, retrocession) programme. Both the insurance 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, for example, occurrence of claims events, timing and quantum of claims, severity, development, and specifically for life business, mortality, morbidity and longevity. Reinsurers are subject to the same sources of risk, for example, the random occurrence of major claims events and fluctuations in the number and size of claims. Because the transfer of risk is a common feature, it could be assumed that the reasons for purchasing insurance and reinsurance protection are also similar. Insurance provides protection for policyholders; reinsurance also provides protection, to primary insurers. However, there are a 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 the insurer's results; ■ reinsurers can provide experience and expertise in new lines of business or new geographical markets; ■ reinsurers can provide a financing role. Primary insurers are dependent, to a varying extent, upon the reinsurance industry. A key feature of reinsurance is the need to diversify risk. The spreading of insurance risk around the market through the use of reinsurance creates a highly inter-related marketplace in which a major 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 their policyholders. The special case of financial reinsurance is described in section 2.4.2 Credit risk (exposure to bad debts) Among the risks faced by both insurers and reinsurers is the possibility of exposure to bad debts. For insurers, whilst bad debts can arise from a variety of sources (including intermediaries), 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 major issue 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 support insurance and reinsurance liabilities. Investment return is usually a key component of total profits generated by such operations. Both insurers and reinsurers need to manage their investment risks, balancing the need to maintain a prudent spread of investments, whose risk is appropriate to the 7
  8. 8. risk profile of the insurance and reinsurance liabilities, with the need for adequate investment returns. Whilst some in the industry argue that investment activities are managed separately from the underwriting activities, there is a trend towards the view that investment activities are an integral part of the management of insurance or reinsurance business. In either case, reliance on investment returns is a major feature of insurance and reinsurance, and exposure to the variability of stock market performance and interest rate movements is common. In the case of non-life insurers and reinsurers, investment in equities is generally less common, although shareholders' assets can be significantly affected by changes in values of equities and, to a lesser extent, bonds. From a supervisory point of view, it is important to be able to distinguish between the underwriting results and the results of investment activities. It is difficult to assess real trends in underwriting performance if the results are obscured by investment returns. Also, it is important to be able to assess the additional strains on capital arising from investment losses. This applies to 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 of intermediaries. In recent years, various insurance companies have set up direct selling operations 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 the point of sale. It also creates potential for greater understanding of their policyholders and increased opportunities for marketing their products. However, the traditional involvement of brokers continues to be important. A similar trend has occurred in the reinsurance industry, where a number of companies have started to deal directly with their customers in the primary insurance market. The reasons cited include the potential for developing direct long term relationships as well as savings in commissions paid to brokers. Nevertheless, brokers in the reinsurance markets continue to have an 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, the transfer of risk), the types of contract involved are usually different. Broadly, insurance usually involves the use of standardised policies. This is certainly the case in personal lines business (such as private motor and household). For commercial lines (including industrial 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 the particular requirements of the cedant. Reinsurance contracts may include limitations and exceptions that are not common or permitted for direct insurance contracts. These contractual provisions 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 treaty basis. Whilst facultative reinsurance involves an individual risk, treaty business covers a portfolio of insurance contracts over a specified period. Appendix 1 provides examples of the common types of arrangement. These differences should be of importance to supervisors because the population of risks in a reinsurer's portfolio is usually more complex. Reinsurers not only underwrite contracts with primary insurers, but also other reinsurers, as retrocessionaires. These factors mean that a deep understanding of the business is required in order to be in a position to make sensible assessments of a reinsurer's true financial position. 2.5.2 Volatility Reinsurance business tends to be more volatile than primary insurance. There are a number of reasons for this: ■ for insurers involved in conventional personal and commercial lines business, the book of business usually consists of a greater number of policies, each of which has relatively small exposure. Reinsurers tend to write business on a treaty basis, and are exposed to the accumulation of losses and greater likelihood of significant losses; 8
  9. 9. ■ primary insurers generally tend to have lower retentions than reinsurers; the outward reinsurance programme offloads risk and reduces uncertainty at the level of the primary insurer; ■ 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 single catastrophic event will usually lead to claims on numerous reinsurers, as risks are typically spread 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 upon the individual situation; volatility, whilst still present, will be lesser for a reinsurer which allows for better diversification and pooling of individual risks within a larger or well structured portfolio. 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 the risk of direct insurance companies. 2.5.3 Globalised portfolios Reinsurance is normally a global business. Companies tend to reinsure risks from a number of insurers located in many jurisdictions. Therefore, reinsurers usually have a broad range of geographical 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 are some global insurance companies, they usually operate with local subsidiaries in different territories. The reinsurance industry is far more concentrated in the hands of a small number of major global participants, combining international risks within one portfolio. Due to the nature of reinsurance business, diversification in the portfolio is an essential feature in the risk management 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 the basis 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 is inherently difficult. For example, global knowledge of major claims events in markets in which the reinsurer has exposure can be of critical importance in assessing the impact on the financial position of a company. 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 receipt of information about contracts entered into. Reinsurance is at least one additional stage removed from the underlying insured event. There are various reasons for delays: ■ insurers need to process policies and claims first before passing on information, which in turn may be passed via brokers; ■ reinsurance contracts often involve a number of different reinsurers taking lines; a reinsurer may lead or follow on a contract. Even with central processing and settlement systems, there can be time lags in the receipt of information; ■ insurance companies may also suffer from some time lags in receipt of information, but the position for reinsurers is usually worse as they rely on the submission of information from cedants. Reinsurers receive their premiums later than ceding companies, (due to procedures for settlement of accounts), but may on the other hand be required to make immediate cash payments when large losses occur. This can result in fewer opportunities to compensate underwriting 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 claims events until the claims have worked through the retentions and lower levels of cover. A reinsurer therefore needs to have effective processes to monitor exposures and the likely impacts of claims events in the markets. For example, the incidence of subsidence claims on household policies may take some time to accumulate to the point where insurers start to make recoveries on their excess of loss protections. From the supervisory perspective, these differences are important because they can make it more difficult to detect potential problems which may impact upon a reinsurer's financial position. 2.5.5 Reliance on others' knowledge 9
  10. 10. As a result of various intermediaries involved (insurers or lead reinsurers), the reinsurer may have a diluted understanding of the risk being transferred. Reinsurers therefore tend to be reliant on second-hand knowledge to obtain an understanding of the underlying risks. They also need to have sound management systems and controls in order to ensure that sufficient understanding of the book of business being reinsured is obtained. This applies both to underwriting and claims management. In proportional treaties, for example, the reinsurer follows the fortunes of the reinsured and, in order to make accurate assessments about the risk involved in writing a treaty, needs to know not only the type of business being written, but also the risks posed by the insurer's own internal arrangements, the quality and track record of its management, its systems and controls over acceptance 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 the underlying risks, which has ultimately led to financial difficulties for reinsurers. For example European reinsurers, writing employers and environmental liability policies in the United States faced a subsequent surge in claims, particularly relating to asbestosis. The larger reinsurers tend to be in a better position to cope with such problems, having resources to acquire deeper technical expertise in the markets and lines of business in which they are involved. The relative remoteness of reinsurers from the underlying risks, and the consequent reliance on information supplied by insurers and intermediaries, combined with the ways in which reinsurance contracts operate, results in the possibility for sudden impacts upon claims provisions as information becomes available to the reinsurer. This tendency is important in understanding the financial position of a reinsurer and is therefore relevant to prudential supervisors. 2.5.6 Profit commissions and premium adjustments Due to the generally higher uncertainty and less detailed knowledge of reinsurers of the underlying 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 of commercial lines, especially for larger risks, rather than personal lines business. This feature of the contract gives the reinsurer more scope to collect further premiums should the business turn out to be less profitable than expected. Profit commissions, reinstatement premiums and premium adjustments are incorporated in contracts as a way of sharing the risks and rewards with the cedant as well as minimising the costs of reinsurance. The risk exposure in the case of reinsurance contracts with adjustable pricing arrangements tends to be lower than that in the case of those with fixed price arrangements. Accordingly, an understanding of the types of contract written is important in making an assessment of a reinsurer's overall risk profile. 2.5.7 Professional counterparties Reinsurance business takes place in the professional marketplace. Whether directly with primary insurers, or through intermediaries, reinsurers deal in virtually all cases with professional counterparties. Whilst this would be relevant in the context of conduct of business issues, the question arises as to the relevance from the viewpoint of prudential supervision. The point is relevant because it can be argued that the inter-professional market place is to some extent 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 a significant reliance on the ratings provided by rating agencies. The largest reinsurance companies all have ratings from the main agencies. Credit ratings are also important in the context of primary insurance companies, but tend not to be used extensively where private consumers are concerned, due to the protection afforded by guarantee schemes in many territories. From a supervisory perspective, this difference is of relevance because there may be scope for supervisory authorities to make greater use of the market mechanisms which exist in relation to credit ratings. Also, downgradings in credit ratings will act as signals to supervisors, particularly as financial difficulties of reinsurers may in turn result in difficulties for insurers, with consequent implications for the protection of policyholders. 2.6 Other methods of risk transfer 10
  11. 11. 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 no generally accepted definition of ART. ART arrangements usually include a substantial retention level by the reinsured, with only a partial transfer of risk that includes elements of a traditional reinsurance contract. Some ART products are essentially a form of deferred lending, and most include a financing element of some 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 contracting market for retrocession and the increasing involvement of investment banks in alternative solutions. ART solutions are driven by a number of factors and often some form of arbitrage may be involved, whether connected with accounting, taxation or regulation, or a combination of factors. There is generally little transparency in the accounting of ART products, and this can make it difficult for regulators to understand the true effects of transactions and the motivational factors underlying them. It is essential for supervisors to understand the commercial effects and substance of transactions. Understanding the amount of credit risk assumed by the reinsurer is also important. 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" to the 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 from underwriting with enhanced interest rates. Commonly, the SPV is established in an offshore location, and this in itself may be a source of regulatory arbitrage. A number of investment banks have established reinsurance vehicles in such locations, particularly Bermuda. Reinsurers themselves have begun to invest in bonds issued by such vehicles as a means of increasing investment returns, and this results in insurance risk appearing on the assets side of the reinsurers' balance sheet, in addition to its liabilities.3 Financial reinsurance Pure financial reinsurance contracts, with little or no transfer of insurance risk, have ceased to be 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 become more common. Products which combine underwriting risk transfer with financial elements can provide direct insurers 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 of package it is also possible for insurers to include risks which have traditionally been considered uninsurable (such as political and financial markets risks). Such products may have an impact upon cyclical trends in the insurance markets, by tying in rates for a number of years and establishing long term relationships between reinsurers and their clients, facilitating insurers' access to the capital of reinsurers. 11
  12. 12. Financial reinsurance is sometimes seen as an effective means of "regulatory arbitrage". An example can be a financial guarantee contract involving risk transfer, which in its purest form is a 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 financial guarantee insurance contracts, is the relative advantage in regulatory assessment for solvency calculations under insurance contracts rather than banking contracts. As "Reinsurance" magazine, in its September 2000 edition, pointed out, "in recent times there has been a marked increase in financial guarantee insurances that compete directly with the bank guarantees and standby letters of credit that have been a substantial area of business for banks. The likelihood is that increasing market share will pass to insurance companies because of 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 not adequately pricing these risks. In particular, some are of the view that the models used by insurers 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 what extent the competitive advantage gained by insurers is as a result of potentially lower costs of regulatory capital. Derivatives 3 The Tillinghast report provides details of the special features of the regulatory aspects of securitisations Derivatives in themselves are "derived" from a particular product and provide protection against adverse movements in the product exposure. Examples of derivative products, which are similar to products offered by the insurance industry, include "weather derivatives" which provide protection against possible climate changes that could result in natural calamities. These products are primarily offered by Banks. Like securitisations, derivatives can be obtained by reinsurers in connection with their investment and underwriting activities in order to increase investment income. Derivative transactions can result in assets and /or liabilities, and the important point is that the risk profile of 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 of insurance risk in return for a premium. Although the objectives are the same, there are some key differences 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 direct relationship with policyholders of insurers. The broad similarities between reinsurance and insurance lead to common regulatory approaches in many territories, but the differences are significant. In particular, the greater potential for volatility in reinsurance business (especially higher levels of excess of loss business) leads to greater uncertainty in the outcome of contracts and, ultimately, the potential for reinsurers to encounter financial difficulties and insolvency might be greater. Volatility will be lesser for a reinsurer which allows for better diversification and pooling of individual risks within a larger or well structured portfolio. Reinsurance companies are professional market players. There is usually no direct link between reinsurance companies and the policyholders. 12
  13. 13. Primary insurers are usually able to pursue marketing and risk selection strategies that enable them to obtain homogeneity of risks in their portfolios of business. They are able to maximise the pooling effect of a large portfolio of risks, reducing the risk of random deviations from the mean value. For reinsurers, this effect is usually present to a lesser extent and the risk of random deviation is usually more significant. However, the reinsurance marketplace is a professional one, in which ceding companies generally 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 reinsurance companies to face financial difficulties, or for insolvencies to occur. 3 Reinsurance and risk 3.1 Scope In accordance with the Terms of Reference, the objective of this chapter is to "identify the main types of risks that a reinsurance undertaking is exposed to (including systematic risks in the reinsurance 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 the weighting and importance of the various risks impacting on an individual reinsurer depend on many factors, including: ■ classes of business underwritten and geographical coverage, which will affect the nature and severity of losses and the length of tail for claims development; ■ types of contract underwritten (for example "losses occurring" contracts compared to "risks incepting" 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. Underwriting risk The fundamental risk associated with reinsurance business is that the actual cost of claims arising from reinsurance contracts will differ from the amounts expected to arise when the contracts were priced and entered into. The key risk is that the reinsurer has either received too little premium for the risks it has agreed to underwrite and hence has not enough funds to invest and pay claims, or that claims are in excess of those projected4. This could occur for the following reasons: 1. Risk of mis-estimation: the expectations regarding losses are based on an inadequate knowledge of the loss distribution, or the underlying assumptions are erroneous. This can be due, for example, to 13 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.
  14. 14. 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 in the 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 experience triggers other events (for example, contagious diseases in health insurance or a fire which affects neighbouring industrial properties leading to business interruption claims). The significance of this type of risk in a portfolio depends on various factors, such as the number of risks involved, the distribution of probabilities of incurrence of claims and probable maximum losses. This risk is systematically decreased by the pooling approach, that is, assembling as many homogenous and independent risks as possible in the portfolio (pool). 3. Risk of change: adverse deviation of expected losses due to the unpredictable changes in risk factors that have brought about an increase in the frequency and/or severity of losses or payment patterns (for example, changing legislation, changing technology, changing social and demographic factors, changes in climate and weather patterns). Again, diversification of the reinsurer's portfolio of business may contribute to the mitigation of this type of risk. 4. Reserving (provisioning) risk: In addition to the insured risk itself, there is a derived risk caused by the reserving process of the insurer. This is the risk that technical provisions are insufficient to meet the liabilities of the reinsurance undertaking (reserve risk). If sufficient data on historical claims development is available, this risk may, to a limited extent, be mitigated by proper actuarial estimation of the provisions for claims incurred but not reported (IBNR) and those incurred but not enough reported (IBNER). The risk can rarely be completely extinguished, even where sophisticated actuarial estimation methods are used, due to the inherent uncertainties of insurance (and reinsurance) business. As reinsurance is essentially a form of "insurance" the key risk facing reinsurers is driven by the quality 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 risks suitable to the company. Poor underwriting from a lack of knowledge of the underlying risks could have severe impacts on the resulting claims profile. This can be a particular problem when entering 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 can impact 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 charge premiums 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 risk resulting from the use of false information obtained from fraudulent cedants. The correctness of the reinsurer's risk assessments depends significantly on information provided by cedants. However, since reinsurance is a professional market with relatively few reinsurance companies involved, fraudulent behaviour of one cedant, when detected, will rapidly be known within the industry and result in the exclusion of this cedant from the market. On the other hand, the higher the underwriting risk the more careful reinsurers will be in assessing information received by cedants. Nevertheless, fraudulent actions of cedants is a risk that in principle exists in the reinsurance market. Underwriting risk is unique to insurance and reinsurance business. Reinsurers tend to manage risk by pooling and, for unique risks, diversification. Pooling is easier to achieve for a larger reinsurer than a smaller one. However, reinsurers do tend to accumulate risks, and it is quite possible, even for a large 14
  15. 15. reinsurer, to build up accumulations of exposure in particular geographical regions, with consequential significant exposure to catastrophes in those regions. The reinsurers' approach of managing risk by pooling, and diversification, is in contrast to the traditional approach to risk in banking, banks tend to manage risk by hedging. This has implications for reinsurers as they begin to enter into an increasing number of ART transactions with investment banks. Retrocessions The risk management techniques employed by the reinsurer itself play a critical role in the sustainability and solvency of the business. A key part of this process includes the purchase of adequate reinsurance protection (known as retrocession). The extent and quality of retrocession purchased will establish the level of protection available to the reinsurer. The purchase of insufficient cover can lead to financial difficulties in the event of major unexpected claims. Accordingly, the risk of an inadequate retrocession programme should be recognised as a key risk. It is typical for reinsurance to split up large and unique risks and to distribute the risks on the international reinsurance market. This allows cover to be obtained even for risks which are too large for the largest individual reinsurers. Such risks are shared by many reinsurers. Credit risk The use of retrocession as a key part of the reinsurer's risk management process creates a significant level of credit risk that amounts due under a retrocession contract are not fully collectible owing to insolvency. Underlying the process of retrocession is the essential need for the financial stability of the retrocessionaires. In particular, the reinsurer usually makes a significant 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 be significant, particularly where long tail business is concerned. Consequently, the management of credit risk is of critical importance, particularly in placing retrocession cover. In addition, there is also some risk that the failure of intermediaries could result in bad debts. Investment risk Investment risks affect the assets of a reinsurance undertaking. A major element of investment risk is market risk. This includes the risks of asset and liability value changes associated with systematic (market) factors. Some forms of market risk relating to investment risk are, for example, variations in the general level of interest rates and basis risk (the risk that yields on instruments 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 are the default risk / credit risk, call risk, prepayment risk, extension risk, convertibility, real estate risk and equity risk. Investment risks can result in: ■ lower investment yields than expected when pricing insurance contracts due to a changing capital market environment (for example, changing interest rates, changing currency rates, adverse development of borrowers credit rating with respect to interest payments on a bond); ■ asset losses (for example, due to a decrease in the value of equity investments as a result of systematic 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 receive clustered claims due to natural catastrophes. Their assets, however, are sometimes less liquid, particularly where they invest in private placements and real estate). The area of investment risk will be investigated further in the insurance solvency study 5. 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 undertaking from the perspective of prudential supervision" (2002). Globalised risk portfolios 15
  16. 16. As described in chapter 2, reinsurance is a globalised market whereby reinsurers accept risks from 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, many reinsurers can be exposed to a "high profile disaster" irrespective of their geographical origin. Currency risk Strongly related to the globalised portfolio is currency risk. Most reinsurers write business in a number of currencies. As a result of an international risk portfolio, reinsurers usually need to invest in equivalent currency assets to match the liabilities. Reinsurers are therefore exposed to a 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 the influence of accounting principles and practices. Also, it may not always be desirable to hold assets in certain currencies, where the currency of liabilities is weak. In addition, foreign exchange control restrictions may limit the extent to which liabilities in certain currencies can be matched by assets in the same currency. Timing Risk Timing risk is interrelated with both underwriting risk and investment risk. The extent to which investment returns contribute to the profitability of an insurance portfolio depends both on the investment yield (influenced by investment risk) and the speed of settlement (which can be affected by underwriting risk, especially by unpredictable changes in risk factors). An increase in the speed of claims settlement reduces return on investment6. Investments need to be matched, in terms of their maturity, with the expected settlement of claims liabilities. Timing risk can be fundamental in financial contracts. Some financial contracts involve limited transfer 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 the risks is given below. 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 catastrophe reinsurance is strongly influenced by the laws of supply and demand. However, when market conditions are soft (rates are low and reinsurers do not have the power to obtain the increases they 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 to retain clients and maintain market share. Low price cycles can be very damaging to the industry as they leave smaller reinsurance players with the exposure of meeting claims with inadequate premium flow. In these circumstances, a huge natural disaster could trigger potential insolvencies. Interaction of insurance and reinsurance markets As the reinsurance market is driven by claims development in the insurance sector, any significant developments in the insurance industry are likely to lead to losses in the reinsurance industry. In terms of claims development, an example is the sudden surge in asbestosis claims which has recently been recognised in the insurance industry and consequently the reinsurance industry. Other examples of insurance industry trends which have also affected the reinsurance industry include: ■ increasing costs of litigation; ■ legal rulings which affect large numbers of claims; ■ improvements in medical technology leading to better chances of surviving accidents but leading to higher incidence of "loss of earnings" claims; and ■ smaller players in the market following the actions of larger players. Failure of a major reinsurer The financial failure of a large reinsurance player may have consequences within the overall reinsurance and insurance sector, due to the sheer dominance of the global market by the largest reinsurers. As a result of 16
  17. 17. the complex spreading of risks around the market, failure of a large reinsurer to meet its obligations can have an impact across the market, both for other reinsurers and for primary insurers. In fact there have been until now no significant breakdowns of a reinsurance company. 3.4 Systemic risks In contrast to systematic risk which is limited to a particular industry, systemic risk is defined as the risk which arises in relation to the entire economy (local or global). It is a general risk affecting every market participant. Therefore, the insurance and reinsurance industry are affected as well. Relevant factors include: ■ economic cycles (for example, recessions lead to a downward cycle in the insurance industry as demand for insurance products, and consequently for reinsurance, falls, but higher unemployment leads to an increase in theft related claims); ■ political instability: the level of political stability affects the overall performance of the economy, which is an important factor in wealth creation. Insurance (and reinsurance) is likely to see higher demand under more wealthy economic conditions. Also, international business can be affected by capital transfer restrictions; ■ interest rate movements (affecting the returns gained from investments which are primarily bond based for reinsurance companies); and ■ collapse of the financial sector (due to insolvencies of large banks or insurance companies leading to a possible economic slowdown). Carter, R. / Lucas, L. / Ralph, N.: Reinsurance, 4th Ed., 2000, p. 735 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 the identified "activities" of a reinsurer. Against each activity, the relevant risks have been mentioned in order of importance. For the risks mentioned, further analysis is provided on the components 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 of sophisticated reinsurance strategies on risk profiles. Furthermore, this snapshot does not examine the impact of special market environments on the risk profile; traditional one year contracts 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 companies were forced to sell traditional one year contracts featuring multi-year characteristics. Reinsurance Risk Matrix Activities Reinsurance Non-life -proportional Risks Underwriting Credit Risk Non-life -nonproportional Underwriting Risk Component Random fluctuation (especially surplus treaty) Random fluctuation (natural peril losses) Erroneous assumptions made by cedant Cedant's credit rating Erroneous assumptions Factors triggering Risk Class of insurance, type of reinsurance treaty, limits on treaty capacity Class of insurance, limits in treaty capacity Lax underwriting by ceding company, cedant's experience in the respective market, market environment (competition), reinsurer's liability Payment patterns Mitigation Strategies Pooling; retrocession Exclusions or event or cession limits Adjustment of reinsurance commission (i.e. sliding scales), non-proportional cover, use of cession limits experience in the respective insurance market, diversification Monitoring of cedant, deposits Class of insurance, market Retrocession, diligent pricing experience, accumulation process, use of underwriting of losses, cedant's guidelines, diversification retention, reinsurer's liability, reinsurer's profit loading 17
  18. 18. Profit sharing Credit Risk Activities Reinsurance Life - Risks Underwriting Fluctuation in loss experience Cedant's credit rating Risk Component Changes in risk factors Class of business Use of adjustable premiums experience on the respective insurance market Pooling, retrocession Payment patterns Monitoring of cedant, deposits Factors triggering Risk Mitigation Strategies Mortality/morbidity experience, early Diversification, retrocession Erroneous cancellation/lapse probabilities Adverse selection by Quota share treaties assumptions ceding company, retrocession (esp. surplus accumulation of treaty) losses Random War Exclusion Contagious disease Pooling; retrocession proportional fluctuation in loss experience Random fluctuation in loss experience Investment Bonus declaration Reinsurer uses investment Risk risk, market details diversification strategies; risk, credit risk Life - nonproportional Interest rate Wide range of market factors Class of insurance, market experience, accumulation of losses Mortality experience matching assets and liabilities Underwriting Erroneous assumptions Changes in risk factors Random Support by health examination Diversification, retrocession War Exclusion Contagious disease Pooling, retrocession fluctuation on loss experience Random fluctuation on loss experience 18
  19. 19. Activities Risks ART/Fin Re Credit Risk Investment Risk Other Risk Investments Investment Risk Credit Risk All activities Exchange Rate Risk Country Related Risks 3.5.2 Risk Component Cedant's credit rating Interest risks on Long-Tail classes of business Business not admitted for tax or supervisory purposes Fluctuation in equity prices, fluctuation in interest rates Cedant's diligence/credit rating Debtor default Factors triggering Risk Payment patterns Mitigation Strategies Monitoring of cedant Diversified investment portfolio, asset-liability matching Delays in the accounting for and the remittance of premiums by cedant Debtor's financial rating Fluctuations in exchange rates Changing economic environment, legal, tax, and regulatory environment, declining growth, inflation, war Monitoring of cedant, established business relations with cedant Asset - Liability matching/Hedging Regional diversification, regional expertise underwriting guidelines Proportional versus non-proportional contracts Diversification The reinsurer is exposed to different risk profiles depending on the type of treaty reinsurance business it writes. In the case of proportional reinsurance contracts, the reinsurer essentially participates in the same risks as the ceding insurance company. Its risk profile is therefore very similar to the ceding company. In contrast, by writing a non-proportional contract the reinsurance company generally participates only in high exposure risks, in excess of the stated retention limits. However, whilst writing a non-proportional contract, the company is exposed to a higher risk of random deviation of loss occurrence from its mean that does not necessarily result in a higher mean risk exposure for the reinsurer, as compared to writing proportional contracts. This is due to the pooling effects from writing other non-proportional contracts. The overall exposure to fluctuations in the loss experience is likely to be reduced when looking at the overall portfolio compared to a single contract. Therefore, the risk profile of a reinsurer depends on the size of the total portfolio, with the risk of random fluctuations in loss experience likely to decrease with the increasing size of the reinsurance portfolio. Geographical and risk type diversification can also be achieved in addition to the pooling achieved within a portfolio of risks. Geographical diversification is more common in reinsurance companies, because reinsurance companies generally do business on a more international basis than insurance companies. Structure of contract The risk profile of a particular reinsurer will be significantly affected by the terms and conditions of the business it writes. In particular, the future claims profile is likely to be influenced by the retention levels, restrictions and exclusion clauses contained in a treaty. A proportional contract with a high retention by the cedant also exposes the reinsurer to high severity losses rather than to high volume losses, resulting in a potentially higher volatility of results compared to a contract with a lower retention. Premium Structure A reinsurer may write a contract with a high premium combined with a profit sharing agreement. In this situation it is more likely that the reinsurer is prepared for unexpected loss development compared to writing a contract without a profit sharing agreement (and therefore a relatively lower premium). Similar effects can be achieved by using sliding-scale commission rates. The reinsurer can reward a ceding company for ceding 19
  20. 20. profitable business and conversely penalise it for poor experience, giving the cedant an incentive to cede high quality business. Information asymmetry For non-proportional contracts the risk of mis-estimation might be considered to be more important than for proportional contracts, since information asymmetry is potentially more likely between the insurer and the reinsurer with respect to the characteristics of the original business written and past loss experience. Under proportional cover the reinsurer participates not only in the original losses but also in the original premium, and can rely to a greater extent on 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 in pricing, 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-life contracts. For the same reason and due to the savings component being more important than with non-life contracts, life contracts in general involve higher investment risk than non-life contracts. Additional risks for insurance and reinsurance companies can emerge from the privatisation of traditional social security systems, for example health insurance, workers' compensation and disability 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 pure volume. As a result, they may under-estimate the administration effort and policyholders expectations with respect to benefits related to this business (this reflects expense risk: the risk that expense levels associated with administering policies may in practice be different to those originally expected, in writing the business). Due to the longer term nature of the contracts, further risks arise for example from economic cycles. Economic downswings might trigger increased payments relating, for example, to disability insurance with employees preferring to try to qualify for disability benefits over unemployment benefits. Due to the reinsurer having to rely on the insurer to submit information on changing loss experiences and increases in payments and/or reserves, the risk for the reinsurer relating to all kinds of changes is more important than for the insurer, because in addition to the risk of change the reinsurer is exposed to the risk of untimely reporting by the insurer. Non-proportional life reassurance contracts are related mostly to coverage of low probability insured events such as death, with high sums assured. The reassurer relies heavily on the risk selection and health examination processes of the insurer but often has the ability to influence this. The reduction of risk of random deviation is normally achieved by pooling and retrocession of sums assured. Proportional reassurance in life business normally involves the transfer of the original insurance risk and a significant financing element, relieving the solvency and cash flow strains associated with the acquisition of new business by the primary insurer. Proportional treaties are also used where the reassurer effectively underwrites the business but uses the primary insurer in a territory where it is not licensed to write the direct business, or does not have the administrative capabilities to do so. In such cases insurance risk will be present, and life insurers may use proportional reinsurance to transfer unknown elements of risk (such as the emergence of dread disease). 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 with non-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. This risk increases in long-tail lines of business, where significant claims can emerge after a considerable lapse of time since the policy was originally underwritten (depending on the type of policy). For reinsurance companies this risk is exacerbated, because of the additional risk of untimely reporting by the insurance company. Reserve/provision risk can be particularly important for non-proportional contracts. Here the reinsurer 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 in an accurate manner, the reinsurance company is exposed to the risk of not receiving notice of a claim in a timely manner, especially if the contract covers new business, where extensive historical data on past loss experience is unavailable and the calculation of the IBNR/IBNER reserves is therefore difficult. 3.5.5 Alternative risk transfer (ART) products 20
  21. 21. 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 such contracts. A reinsurer could incur significant losses if the cedant is unable to repay the financing element of the contract. Underwriting risk tends to be less important in these contracts and in many cases the reinsurer is not exposed to significant risk. It should be noted that ART is still an emerging area. Although financial contracts have been present in the reinsurance and insurance industries for many years, new products have begun to emerge in recent years which are increasingly complex and involve a new approach to risk management for many reinsurers. Accordingly, some reinsurers view such developments with a degree 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 their different weighting is the main reason for the relative complexity of this industry. The size of the reinsurer can also play a part in determining the risk profile. Larger undertakings generally tend to be more diversified in their risk portfolio and are better placed to absorb unexpected fluctuations in claims. As a result, reinsurance supervisors are faced with a range of risk factors that they must be familiar with in order to appreciate the risk exposure of an individual company. It is clear that there are wider macro risks which affect the reinsurance industry as opposed to relatively micro risks affecting the insurance industry. A significant issue for supervisors is that, given the global nature of the business, there is a need for understanding of the macro issues and this requires international information sharing and a wider knowledge base than can be obtained by focussing on individual states alone. Due to the remoteness from the original insured risks, the risk of error in the recording of claims is of relatively greater importance for reinsurers than for insurers. This is the risk that claims provisions established initially may subsequently prove to be inadequate, and this has implications 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 risks can 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 relative to 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. 4 Description of the global reinsurance market 4.1 Scope In accordance with the Terms of Reference, this chapter provides "a description of the global reinsurance 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 the market and developments in products, the trend from proportional to non-proportional business, the advent of ART ("alternative risk transfer") and securitisation, convergence between reinsurance and investment banking activities, the competitive position of EU reinsurers from a global perspective. The study should also identify possible discriminations in some countries concerning reinsurers based in certain other countries, as well as analyse existing 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 further followed up by discussions with market participants where necessary; and ■ Review and analysis of existing published material. 21
  22. 22. 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 to various factors, including consolidation in the primary insurance industry and the general low inflationary environment. Soft conditions in the market have also limited growth, as reinsurers have lacked the power to increase rates. In such conditions, an increased use of proportional cover has been noted over the past two years, as reinsurers have sacrificed quality in underwriting in order to retain their key clients, whose portfolios may be under performing the market.7 A study prepared by "Reinsurance" magazine (August 2000) of 1999's top 100 reinsurance companies showed that in 1999 the reinsurance companies made an average underwriting loss of 11% on their net written premiums. Reinsurance business is relying on substantial returns from investments rather than underwriting income to contribute to profits. Although of the 87 companies reporting underwriting results, 72 made an underwriting loss, only 18 out of 85 (that provided 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 reinsurance companies 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 Big companies, despite underwriting losses, continue to dominate the reinsurance market. The top ten reinsurance groups, as identified by market share (ranked by net written premiums) are as follows: Reinsurer Primary jurisdiction Munich Re Swiss Re Berkshire Hathaway ERC Gerling Group Lloyd's ASS Generali Allianz Re SCOR Re Hannover Re Germany Switzerland USA USA Germany United Kingdom Italy Germany France Germany Total Net premiums written (US $ million) 13,566 12,839 9,453 6,921 3,938 3,799 3,533 3,299 2,721 2,564 Combined ratio (%) 118.9 116.0 116.3 114.0 114.0 N/A 113.5 107.4 109.7 95.9 Source: Standard & Poor's Global Reinsurance Highlights (2000 edition) The trend towards concentration is frequently noted, but it has become more accentuated since the mid 1990s. The effect of concentration is that reinsurers themselves are obliged to grow through the absorption of some of their competitors. Also, as risks are becoming increasingly sophisticated, smaller or medium sized reinsurers are not always able to meet the increasingly complex 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 Global Reinsurance 9, "General Re acquired Cologne Re and ERC bid for Munich based Frankona. The following 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. For its part, XL added the property-catastrophe reinsurer, Global Capital Re, to its portfolio, and later took control of Mid Ocean Re." "In 1997 and 1998, the process continued. The largest of the Bermuda property-catastrophe reinsurers, 8 9 Source: As noted in Global Reinsurance, September 2000 "The French reinsurance market 1999" Source: Global reinsurance — Dec 1999 "Ten years in Reinsurance" PartnerRe bought France's SAFR, and another Bermudian, Terra Nova, bought Corifrance. 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, plus the UK's Eagle Star Re. Further moves followed in 22
  23. 23. 1999, XL, now XL Capital, took over the US 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 business has become significantly more concentrated. For example, between 1990 and 1996 the number of US professional reinsurers fell from 130 to 41. In 1990, the five largest reinsurers were estimated to control 21% of the world non-life reinsurance market estimated at $90 billion a year; by the end of 1998, the five largest controlled 37% of the global market (Source: Global Reinsurance). 4.4 The major reinsurance products 1999 saw the first year of growth in the global reinsurance market following three years of contraction. According to a study by Swiss Re, reinsurance business was split 83% non-life and 17% 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 still protection against mortality. Other main components include guaranteeing of investment income and protection against morbidity and medical expenses. The growth in life and health reinsurance is a relatively recent trend. Unlike the volatile nature of catastrophe reinsurance business, life and health reinsurance provides much steadier cash flow and more stable results. The life sector is thought to be growing by at least 15% per annum. Some experts estimate the growth to be in the region of 30%10. Various factors lie behind the growth in life reinsurance. First, direct life assurance is increasing globally. The reason for this is that the world economy has experienced high growth rates in the past few years and people are investing their increased wealth in life insurance and investment products. Also, social security systems in highly advanced, 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 not only for capital adequacy reasons, but also because they are focussing increasingly on their core strengths of distribution and asset management. By doing so, they rely on the reinsurers' risk assessment expertise and innovative skills. Life assurance and reinsurance are highly technical and actuary-dominated. In consequence, life assurers tend to outsource their risks through reinsurance (that is, they outsource the management of mortality). 10 Source: Baylis Mark, Global Reinsurance, appendix 4, pages 1-3 An analysis by Swiss Re, shown below, illustrates the breakdown of ceded premiums in the life and health sector in 1997. Regional breakdown of ceded life & health premiums 1997 Ceded premiums In US$ billion North America Western Europe Asia/Pacific Japan Latin America Eastern Europe Total world Source: Sigma 9/98 As a % of the total 10.6 9.1 0.6 0.6 0.6 0.2 21.7 49.1 42.1 2.6 2.8 2.8 0.6 100.0 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 opportunities restricted. The market shares of the major market players in 1997, according to Swiss Re, are shown below. 23
  24. 24. Market shares in the life and health reinsurance market 1997 Swiss Re Munich Re Employers Re/Frankona Cologne Re Lincoln Re Hannover Re Transamerica RGA Manulife Other Total Source: Sigma 9/98 19% 9% 7% 6% 5% 5% 3% 3% 2% 41% 100% 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 estimate in Global Reinsurance11, 75%-80% of reinsurance is sold via quota treaties (proportional), although there are some significant territorial variations. 4.4.2 11 Non-life reinsurance Source: Baylis, Mark, Global reinsurance, appendix 4, page 1-3 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-life reinsurance market. Regional breakdown of ceded non-life premiums 1997 Ceded premiums US$ billion As a % of the total 39.9 36.1 12.4 4.3 3.3 1.7 5.0 102.7 38.9 35.1 12.1 4.2 3.2 1.6 4.9 100.0 North America Western Europe Asia/Pacific Japan Latin America Eastern Europe Rest of the World Total world Source: Sigma 9/98 The table below provides further illustration of the domination of the global market by a small number of major reinsurers. Market shares in the non-life reinsurance market 1997 Munich Re Swiss Re General Re Employers Re Hannover Re Gerling Globale Re SCOR Zurich Re AXA Re Generali Other Total 10% 8% 5% 5% 3% 2% 2% 2% 1% 1% 61% 100% 24
  25. 25. Source: Sigma 9/98 Within the EU, non-life business is dominated by motor, accident and health, and property business. Factors which influence the proportion of business reinsured include the pricing and availability of reinsurance cover, the volatility inherent in the underlying business, and the degree of uncertainty involved in predicting underwriting results. Longer tail classes of business, and those which can be subject to catastrophic losses, are in general likely to attract greater levels of reinsurance protection. The table below illustrates this, with higher percentages reinsured in property, liability and MAT classes. 25
  26. 26. Breakdown of non-life business in EU and percentage of business reinsured Type of non-life business Motor Accident & Health Property Liability Insurance Marine, aviation & transport Others Total Source: EU Commission, Report: Undertakings, 1999 4.4.3 As % of all non-life 34% 24% 21% 6% 7% 8% 100% Results of Questionnaire on Percentage reinsured 12% 7% 31% 25% 36% 14% the Supervision of Reinsurance Alternative risk transfer (ART) products Boundaries between traditional and alternative risk financing tend to blur. This, together with the frequent invisibility of ART products in financial statements, makes it extremely difficult to make quantitative statements about the market volume of the ART products. Also, a common basis for the business volume of ART products seems to be difficult to identify. However, a study 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/multiline products, multi-trigger cover, contingent capital as well as insurance bonds and derivatives are still insignificant in terms of volume. (Source: Sigma 2/1999). The reinsurance industry tends to offer ART products, multi-line or multi-year contracts directly to the company that demands the insurance protection. The construction works legally either via fronting through the books of a direct insurer, or if possible directly with the demanding company. The size of the ART market by different product categories in 1998 has been estimated in a study prepared by Tillinghast Towers-Perrin. Their findings are summarized below: US$ billion Estimated size of worldwide ART market* Estimated size of World Reinsurance Market Estimated size of World Insurance Market Estimated size of European Insurance Market 13 125 2,129 669 *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 the business written), Bermuda, London, Zurich, Dublin and Luxembourg. However specialist companies in this market also operate in other countries, such as Hannover Re in Germany. Estimated market size The success of ART products has continued to attract further entrants to the ART market. In the last five or six years, many new operations have been established and there are continuing signs of increasing competition in this area. A sub-segment of the ART market is risk transfer using capital markets. Risk transference through capital markets is still a narrow segment compared with traditional reinsurance or insurance. 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 and securitisation have been the major mechanisms for insurance risk transfer using capital markets. 26
  27. 27. Trading of insurance derivatives on commodities exchanges has only been modest, even though the instruments have been adapted and refined to meet client needs many times since they were first introduced. The use of insurance derivatives as protection against previously uninsured threats to the earnings of an industrial or service company offers a lot of potential. Weather is only one example. 4.4.4 The Internet as a distribution channel In 1999 and 2000 reinsurers' margins were under pressure. The reinsurance industry considered two ways of tackling the problem: higher rates and lower transaction costs. Internet based reinsurance trading systems are promising lower transaction costs and faster and easier access to business than the traditional distribution channels. However, internet business is likely to put pressure on margins as well12. Based on internet technology there are currently two major systems used by reinsurance markets: "Reway" and "Inreon". Reway was set up by Gothaer Re of Germany. Inreon is backed by the world's two biggest reinsurers, Swiss Re and Munich Re together with Internet Capital Group (US based internet holding company and Accenture)13. Inreon provides insurance companies, brokers and professional reinsurers with transaction capabilities for standardised reinsurance covers. Inreon's standardised reinsurance trading is initially 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 facultative proportional property cover and both non-proportional and proportional covers for casualty and other lines of business. 14 Reway as well as Inreon offer insurance companies, brokers and professional reinsurers an opportunity to use the internet platform to enter into reinsurance treaties online. Reway is focusing initially on the European market. Reinsurance, October 2000 Bloomberg, L.P.: Munich Re, Swiss Re ; Accenture set up internet site, 18.12.2000 Lloyd's of London Press Limited: Two top reinsurers team up to form web-based exchange, 19.12.2000 12 13 4.5 The role of offshore locations Offshore insurance and reinsurance is often, but not always, driven by taxation and regulatory considerations. Whilst early offshore insurance and reinsurance companies faced few regulations, more recently most locations have adopted relatively comprehensive systems of insurance supervision and regulation. As the international significance of off-shore insurance and 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 of information. Nevertheless, the generally simpler offshore legislation makes it easier to evolve new types of product. The favourable regulatory and taxation environment encourages innovation and development. Almost all of the new insurance and reinsurance approaches that have broadened the practical concepts of insurance have been developed offshore. Hence, offshore insurance and reinsurance markets in the past grew with new approaches to covering risk, such as financial insurance and reinsurance and the securitisation of reinsurance risks. However, growth in more traditional areas of insurance and reinsurance, particularly in catastrophe reinsurance and excess liability insurance, has also been seen in these offshore locations. Aside from regulatory considerations, other factors may be involved in the formation of insurance or reinsurance companies offshore. For example: ■ the use of independent territories to manage global insurance and reinsurance programmes neutrally; ■ cost effective insurance and reinsurance management by specialist companies; and 14 27
  28. 28. ■ reducing taxation costs. Reasons for using an offshore location include: ■ the capability to co-ordinate global insurance programmes between reinsurance companies from 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 domestic regulatory limitations; and ■ involvement in the reinsurance or coinsurance of captive and other offshore insurers through local presence. Recently the distinction between onshore and offshore domiciles has become somewhat blurred, because onshore captive locations continue to introduce legislation aimed at attracting new business. 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, many domiciles have recently tightened up their insurance (and reinsurance) regulations in the face of accusations that their regulation is somewhat lax. Nevertheless, compared with setting up in the parent territory of the captive, the regulatory environment can still be favourable. The electronic revolution removes most of the remaining barriers between the onshore and offshore markets. Reinsurance/insurance can therefore be transacted anywhere that has physical capabilities (digital communications etc) and where insurance expertise exists. This in turn creates a threat to traditional geographical centres of the reinsurance market15. Perhaps the most significant development in offshore locations was the development of Bermuda as a location for reinsurance companies. Whilst the Bermudian companies have continued to remain strong, and have themselves seen significant consolidation, they have also seen the attraction of location in major onshore centres, such as the US and Europe. For example, 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 underwrites or reinsures primarily or exclusively the risks of firms belonging to the respective group. In 1998, there were about 3,800 captives worldwide, creating a premium volume of approximately USD 21 billion 16, equivalent to a share of roughly 6% of all premiums written in commercial lines of business. One-third of the captives were domiciled in Bermuda. More than half of all captives worldwide belong to industrial and service companies in the US. The captive market is highly competitive in terms of captive domiciles and the competition is set to continue to be fierce in the future. More than 80% of the estimated total number of captives worldwide are located in eight major domiciles.17: 1. 2. 3. 4. 5. 6. 7. 8. Bermuda The Cayman Islands Guernsey Vermont Luxembourg Barbados The Isle of Man 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 net growth of around 200 captives each year, this growth has slowed slightly in recent years. 15 16 17 The Role of offshore insurance, Jim Bannister Developments Limited 2000 Source: Tillinghast Towers-Perrin, Swiss Re Economic Research The Role of offshore insurance, Jim Bannister Developments Limited 2000 28
  29. 29. 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-proportional business with quantitative data covering the whole industry. Industry wide statistics do not generally provide analysis of treaty business in this way. However, the trend is reasonably well documented. The advent of Bermudan capacity, for example, was principally in the area of excess of loss reinsurance. The following quote comes from Global Reinsurance18: "Coupled with the shrinkage in the population, market leadership also took over, where it became more important for cedants to focus on doing business with a small number of large and well-capitalised reinsurers, rather than the other way around as it had been pre-1984. Because of this, reinsurance underwriters were able to have their way, imposing a risk-excess model on the market more broadly, in place of the proportional form that had been prevalent, thereby gaining more 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 in the worldwide reinsurance markets. One result of this gap in the global market, especially in relation to high level catastrophe cover, was the formation, backed by major financial institutions, of the highly capitalised Bermudian catastrophe excess of loss reinsurers, such as XL, and Mid Ocean, among others. With rising rates for catastrophe cover and the increasing tendency for reinsurers to monitor aggregate exposures, another result was that investment banks began to develop alternative solutions to provide ways for reinsurers to offset their residual catastrophe exposures, using the large cash reserves of the capital markets as a means of raising additional capital in case of major losses. Various ART solutions have been developed, including catastrophe options and bonds, and the launching in 1995 by the Chicago Board of Trade of an insurance derivative option based on indexed case estimates. The latter met with limited success, and some bonds have not reached the market (such as the California Earthquake Authority deal of 1996). However, a number of significant transactions were successfully completed in the late 1990s, including a ten year securitisation by St Paul Re, using a special purpose vehicle in the Cayman Islands to enable it to underwrite catastrophe business in the USA and the Caribbean. Such deals involve a high amount of investment in time and transaction costs. They also involve significant modelling input. A number of investment banks are actively marketing the concept of 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 and reinsurance. Transactions are often complex and this presents an issue for regulators. They need to understand the underlying motivation for such transactions, their effects and regulatory impact, in order to assess whether their regulatory approach is appropriate. 18 4.8 Global reinsurance - September 2000 "Look! They've killed reinsurance" Competitive position of EU reinsurers from a global perspective Despite the international nature of the reinsurance market, obstacles to cross-border business still exist. In terms of regulatory barriers, there are several areas where regulatory issues could have an impact on competition between EU and non-EU reinsurers. First, there is a possibility that capital requirements could influence decisions regarding where a reinsurer is located. However, in practice the capital required in order to meet the requirements of 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 often irrelevant in the case of reinsurance companies, as the requirement imposed by the market is far greater. Moreover, the question of location is arguably less important, given the international nature 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 where more regulatory costs are 29
  30. 30. passed on to the reinsurance industry in one territory compared to another, 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 statements according to local GAAP (generally accepted accounted principles) for the whole group. Certain EU countries also make use of systems where assets of the reinsurer must be pledged in order to cover outstanding claims provisions. According to the OECD and the CEA other obstacles exist. In some countries there is still a monopolistic 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 a state company or to identified national reinsurers. Supervisory restrictions, such as requirements to register in the host country or limits to cessions, can also exist. Furthermore excise taxes can be required 19. As an answer to this, the CEA proposes the introduction of a "Single Passport", which does not necessarily mean a harmonisation of the supervision of reinsurers. 19 Source: EU Commission, Discussion Paper to the IC reinsurance Subgroup "Approaches to Reinsurance Supervision", 2000 30
  31. 31. Description of the different types of supervision approaches currently used in the EU as well as other major Non-EU countries 5.1 Scope In accordance with the Terms of Reference, this chapter provides "a description of the different types 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 or leading jurisdictions, with the aim of clarifying the rationale underlying the adopted supervisory approach. It should indicate whether the same supervision regimes are used for insurance 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 supplement information gathered from local offices. 5.3 Introduction: reasons for supervision The major common objective of prudential supervision of reinsurance, in those jurisdictions where it is supervised, is the need for protection of the interests of the policyholders. Prudential supervision aims to minimise the instances of insolvencies of reinsurers. Whilst this overall objective is generally valid for the supervision of both insurance and reinsurance business, in some jurisdictions reinsurance supervision is organised with a 'lighter touch' than insurance supervision because reinsurance companies conduct their business predominantly in an inter-professional marketplace. A further consideration is the perception in other territories that, due to the special characteristics of the reinsurance market, without supervision the market in the long term would not work properly (for example in soft markets reinsurance companies offer reinsurance cover at uneconomic prices). Thus supervision may be in the best interests of economic policy objectives. 31