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

Contents

1 Introduction 4

1.1 Summary 41.2 GeneralApproach 5

2 Similarities and differences between insurance, reinsuranceand other risk transfer methods 6

2.1 Scope 62.2 Approach 62.3 Definitions 62.4 Similarities between insurance and reinsurance 72.5 Differences between insurance and reinsurance 92.6 Other methods of risk transfer 132.7 Preliminary conclusions 15

3 Reinsurance and risk 163.1 Scope 163.2 Approach 163.3 Risks 163.4 Systemic risks 213.5 Assessing the importance of different risks 223.6 Conclusion 27

4 Description of the global reinsurance market 284.1 Scope 284.2 Approach 284.3 The global reinsurance market 284.4 The major reinsurance products 304.5 The role of offshore locations 354.6 Captives 364.7 The future evolution of the market and developments in products 374.8 Competitive position of EU reinsurers from a global perspective 38

5 Description of the different types of supervisionapproaches currently used in the EU as well as other majorNon-EU countries 39

5.1 Scope 395.2 Approach 395.3 Introduction: reasons for supervision 395.4 Supervising authority 405.5 Forms of supervision 415.6 Supervision of reinsurance in the EU 425.7 Supervision of reinsurance in major non-EU countries 61

6 The rationale with regard to supervisory parameters 716.1 Scope 716.2 Approach 716.3 Extent of supervision 716.4 Overview of supervisory parameters 746.5 Parameters relating to direct supervision 766.6 Parameters relating to indirect supervision 97

7 The arguments for and against reinsurance supervision and

a broad cost-benefit analysis 1067.1 Scope 1067.2 Approach 1067.3 Arguments for reinsurance supervision 1067.4 Arguments against reinsurance supervision 1097.5 Impacts on the different approaches to supervision 1127.6 Cost-benefit analysis 112

8 Summary of reinsurance market practice for assessing riskand establishing technical provisions 117

8.1 Scope 1178.2 Approach 1178.3 Market practice for assessing risk 1178.4 Establishing adequate technical provisions 1188.5 Management of underwriting risks 1238.6 Monitoring credit risk 1328.7 Management of investment risks 1338.8 Management of foreign currency risks 1348.9 The role of securitisation 1368.10 Financial condition reporting 1408.11 Summary 141

Appendix I - Description of certain reinsurance arrangements 142Appendix II - Overview of other important captive domiciles 146Appendix III - Lloyd's: summary of the regulatory approach 147Appendix IV - Detailed description of actuarial reserving methods used 151

Appendix V - Main sources 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.

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: MARKT-C2@cec.eu.int.

Please also note that the Insurance Unit of the Commission has a website, where other documents of interest can be found:

http://europa.eu.int/comm/internal market/en/finances/insur/index.htm Brussels,

January 2002

Jean-Claude ThebaultDirector

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

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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 Reinsurance1 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.

51 Reinsurance and reinsurers: relevant issues for establishing general supervisory principles, standards and

practices, February 2000

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

2.3.2 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".

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2 Draft Statement of Principles (DSOP); Insurance Steering Committee, IASC, June 2001

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 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 2.6.1.2.

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

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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 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.

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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;

■ 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

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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

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

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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

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.

2.6.1.1 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

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insurance risk appearing on the assets side of the reinsurers' balance sheet, in addition to its liabilities.3

2.6.1.2 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.

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.

2.6.1.3 Derivatives

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.

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3 The Tillinghast report provides details of the special features of the regulatory aspects of securitisations

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.

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

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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.

3.3.1.1 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 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.

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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.

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 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.

3.3.1.2 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.

3.3.1.3 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.

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3.3.1.4 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 study5.

3.3.1.5 Globalised risk portfolios

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.

3.3.1.6 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.

3.3.1.7 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.

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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).

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.

3.3.2.1 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.

3.3.2.2 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. 3.3.2.3 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 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

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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 Risks Risk Component

Factors triggering Risk Mitigation Strategies

Reinsurance Non-life -proportional

Underwriting Random fluctuation (especially surplus treaty)

Class of insurance, type of reinsurance treaty, limits on treaty capacity

Pooling; retrocession

Random fluctuation (natural peril losses)

Class of insurance, limits in treaty capacity

Exclusions or event or cession limits

Erroneous assumptions made by cedant

Lax underwriting by ceding company, cedant's experience in the respective market, market environment (competition), reinsurer's liability

Adjustment of reinsurance commission (i.e. sliding scales), non-proportional cover, use of cession limits experience in the respective insurance market, diversification

Credit Risk Cedant's credit rating

Payment patterns Monitoring of cedant, deposits

Non-life -non-proportional

Underwriting Erroneous assumptions

Class of insurance, market experience, accumulation of losses, cedant's retention, reinsurer's liability, reinsurer's profit loading

Retrocession, diligent pricing process, use of underwriting guidelines, diversification

Profit sharing Use of adjustable premiums experience on the respective insurance market

Fluctuation in loss experience

Class of business Pooling, retrocession

Credit Risk Cedant's credit rating

Payment patterns Monitoring of cedant, deposits

Activities Risks Risk Component

Factors triggering Risk Mitigation Strategies

Reinsurance Underwriting Changes in risk Mortality/morbidity Diversification,Life - factors experience, early retrocession

proportional cancellation/lapse probabilities

Erroneous Adverse selection by Quota share treaties

assumptions ceding company, retrocession

(esp. surplus accumulation of

treaty) losses

Random War Exclusion

fluctuation in

loss experience

Random Contagious disease Pooling; retrocession

fluctuation in

loss experience

Investment Interest rate Bonus declaration Reinsurer uses investment

Risk risk, market details diversification strategies;

risk, credit risk Wide range of market factors

matching assets and liabilities

Life - non- Underwriting Erroneous Class of insurance, Support by health

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proportional assumptions market experience, accumulation of losses

examination

Changes in risk Mortality experience Diversification,

factors retrocession

Random War Exclusion

fluctuation on

loss experience

Random Contagious disease Pooling, retrocession

fluctuation on

loss experience

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Activities Risks Risk Component

Factors triggering Risk Mitigation Strategies

ART/Fin Re Credit Risk Cedant's credit rating

Payment patterns Monitoring of cedant

Investment Risk Interest risks on Long-Tail classes of business

Other Risk Business not admitted for tax or supervisory purposes

Investments Investment Risk Fluctuation in equity prices, fluctuation in interest rates

Diversified investment portfolio, asset-liability matching

Credit Risk Cedant'sdiligence/creditrating

Delays in the accounting for and the remittance of premiums by cedant

Monitoring of cedant, established business relations with cedant

Debtor default Debtor's financial rating

All activities Exchange Rate Risk

Fluctuations in exchange rates

Asset - Liability matching/Hedging

Country Related Risks

Changingeconomicenvironment,legal, tax, andregulatoryenvironment,declininggrowth,inflation, war

Regional diversification, regional expertise underwriting guidelines

3.5.2 Proportional versus non-proportional contracts

3.5.2.1 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.

3.5.2.2 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.

3.5.2.3 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

20

effects can be achieved by using sliding-scale commission rates. The reinsurer can reward a ceding company for ceding profitable business and conversely penalise it for poor experience, giving the cedant an incentive to cede high quality business.

3.5.2.4 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

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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

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■ Review and analysis of existing published material.

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.

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 Total Net premiums written (US $ million)

Combined ratio (%)

Munich Re Germany 13,566 118.9Swiss Re Switzerland 12,839 116.0Berkshire Hathaway USA 9,453 116.3ERC USA 6,921 114.0Gerling Group Germany 3,938 114.0Lloyd's United Kingdom 3,799 N/AASS Generali Italy 3,533 113.5Allianz Re Germany 3,299 107.4SCOR Re France 2,721 109.7Hannover Re Germany 2,564 95.9Source: 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."

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7 Noted by Standard & Poor's in their Global Reinsurance Highlights 2000 edition

8 Source: As noted in Global Reinsurance, September 2000 "The French reinsurance market 1999"9 Source: Global reinsurance — Dec 1999 "Ten years in Reinsurance"

"In 1997 and 1998, the process continued. The largest of the Bermuda property-catastrophe reinsurers, 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 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).

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 As a % of the total

North America 10.6 49.1Western Europe 9.1 42.1Asia/Pacific 0.6 2.6Japan 0.6 2.8Latin America 0.6 2.8Eastern Europe 0.2 0.6Total world 21.7 100.0

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10 Source: Baylis Mark, Global Reinsurance, appendix 4, pages 1-3

Source: Sigma 9/98

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.

Market shares in the life and health reinsurance market 1997

Swiss Re 19%Munich Re 9%Employers Re/Frankona 7%Cologne Re 6%Lincoln Re 5%Hannover Re 5%Transamerica 3%RGA 3%Manulife 2%Other 41%Total 100%Source: Sigma 9/98

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 Non-life reinsurance

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

North America 39.9 38.9Western Europe 36.1 35.1Asia/Pacific 12.4 12.1Japan 4.3 4.2Latin America 3.3 3.2Eastern Europe 1.7 1.6Rest of the World 5.0 4.9Total world 102.7 100.0Source: 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 10%Swiss Re 8%General Re 5%Employers Re 5%Hannover Re 3%Gerling Globale Re 2%

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11 Source: Baylis, Mark, Global reinsurance, appendix 4, page 1-3

SCOR 2%Zurich Re 2%AXA Re 1%Generali 1%Other 61%Total 100%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.

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Breakdown of non-life business in EU and percentage of business reinsured

4.4.3 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:

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.

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

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US$ billion

Estimated size of worldwide ART market* 13Estimated size of World Reinsurance Market 125Estimated size of World Insurance Market 2,129Estimated size of European Insurance Market 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.

14

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.

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

■ 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.

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Reinsurance, October 2000Bloomberg, 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

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. Bermuda2. The Cayman Islands3. Guernsey4. Vermont5. Luxembourg6. Barbados7. The Isle of Man8. 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.

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:

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14

15 The Role of offshore insurance, Jim Bannister Developments Limited 200016 Source: Tillinghast Towers-Perrin, Swiss Re Economic Research17 The Role of offshore insurance, Jim Bannister Developments Limited 2000

"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.

4.8 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 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

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18 Global reinsurance - September 2000 "Look! They've killed reinsurance"

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 required19.

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.

31

14

19 Source: EU Commission, Discussion Paper to the IC reinsurance Subgroup "Approaches to Reinsurance Supervision", 2000

5

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.

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Types of supervision can be classified in a number of ways. The IAIS identifies five main approaches20:

(i) no supervision at all;

(ii) supervision of reinsurance is restricted to ceded reinsurance of primary insurers only;

(iii) the supervisor is authorised to request non-public information about a domesticreinsurer;

(iv) every reinsurer doing business with a domestic reinsurer is licensed;

(v) uniform licensing being extended with additional requirements for the insurer or thereinsurer.

5.4 Supervising authority

Supervision of reinsurance can be provided by general public authorities or a special insurance department. A further possible form of reinsurance supervision is self-regulation through the market, and this is mainly achieved by rating agencies or by cedants' assessments of reinsurers' financial position in deciding whether to place cover. Due to the fact that reinsurance companies do business with professionals as described above, self-regulation (principally by the use of market mechanisms) might be a viable alternative to other forms of supervision.

The role of the rating agencies has become more significant in recent years. Rating agencies are not only relevant for potential shareholders of the reinsurance companies, but also for other stakeholders (such as policyholders). The information provided by the rating agencies can be useful in assessing the security of reinsurers, especially their claims paying abilities.

Rating and regulation are becoming closely connected. They have different agendas, but in certain areas they can be complementary to each other. Reinsurance Magazine (August 2000) notes that increasing co-operation between the world's regulatory authorities and the major rating agencies is a likely future trend.

Reinsurance companies are regulated in different ways in terms of which legislation is applied to regulating the business. A reinsurance company can be subject to legislation either of the country where business is written or of the country of origin.

A licence in the country of origin is, according to the European Directives, a precondition for starting direct insurance activities in a Member State. If the licence is withdrawn, the insurance undertaking must stop writing new business. Many EU states also require a licence for reinsurance business. The licence has to be obtained in every single country where the company wants to write reinsurance business, and where there is a requirement to obtain a licence. However, not all countries require a licence from a non-domestic reinsurer.

Within the EU there is an attempt to provide European reinsurers with a common form of certification, taking the form of a statement from the supervisor (Single Passport). In a single passport solution the reinsurer, providing it complies with certain criteria and requirements, receives an official recognition (passport) to undertake reinsurance business in the EEA, without further approval or registration procedures. If at any time a reinsurer fails to meet these requirements, the passport can be withdrawn.

5.5 Forms of supervision

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20 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles, standards and practices, February 2000

5

The key features of the supervisory approaches are:

■ licensing requirements;

■ solvency requirements (or an equivalent measure);

■ monitoring (including scrutiny of various aspects of the business, site visits, etc).

5.5.1 Licensing criteria

Licensing allows supervisors to impose minimum capital and management requirements. Additionally, supervisors obtain direct and established access to any information concerning the reinsurance business. Licensing criteria vary from country to country. The core requirements proposed by the CEA are: acceptable legal form, fit and proper requirements for management, prudential solvency requirements, adequacy of technical provisions, approval of controllers (shareholders) and at least annual reporting to the regulator.

As a by-product of the licensing requirement, supervisors can obtain crucial information about the reinsurance market in the country.

5.5.2 Financial Supervision

Financial supervision can include the review of a company's financial statements and/or additional information, the review of technical provisions for their adequacy and solvency requirements. Financial supervision can also include investment regulations. The question of whether the special character of reinsurance business (for example, reinsurance business being more international than insurance business) warrants differences between investment regulations for insurance and reinsurance business will need to be addressed.

5.5.2.1 Direct versus indirect supervision

The current situation in reinsurance supervision demonstrates that there is no commonly accepted single method of reinsurance supervision. A European Commission questionnaire on the supervision of reinsurance undertakings showed that almost all Member States supervise reinsurers either directly or indirectly or they have a mixture of both direct and indirect supervision.

Direct supervision means that any reinsurer conducting business within an EU member state is required to be authorised in some way by the supervisor. Direct supervision includes other requirements, for example, managers must be fit and proper, adequacy of technical provisions, minimum solvency margins, and submission of financial statements.

34

Indirect supervision is conducted via the full supervision of direct insurers. A reinsurer is examined as a result of the supervisor's scrutiny of the primary insurer's outward reinsurance programme.

5.6 Supervision of reinsurance in the EU

Direct insurance activities in the EU are regulated and supervised in accordance with EU directives. There are currently no prudential directives dealing with reinsurance. The only directive which does deal with reinsurance is 64/225/EEC on the abolition of restrictions on freedom of establishment and freedom to provide services in respect of reinsurance and retrocession.

The actual supervision of reinsurers is based on national legislation. This has led to a considerable variety in terms of regulation and levels of reinsurance supervision, which arguably hinders the further development of the internal reinsurance market.

Domestic professional reinsurers are not subject to any reinsurance supervision in Belgium, Ireland and Greece. Germany, France and the Netherlands apply elements of their direct insurance supervisory regime to reinsurers while a reduced licensing regime exists in Austria, Italy, Spain and Sweden where only the latter two impose solvency margin requirements.

Only in the UK, Denmark, Finland and Portugal are reinsurers subject to the comprehensive regulation and supervision applied to direct insurers under the single market regime, including licensing and thorough on-going financial supervision.

The following sections highlight areas of differences in the approach towards reinsurance, compared to insurance, in various European member states while the table below summarises the approaches in the main EU member states.

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Supervision Germany France UK Netherlands Italy Denmark Sweden Spain LuxembourgLicence is required in order to practice reinsurance

* domestic reinsurers X X X

* non-domestic reinsurers X X ✓ X ✓ ✓ X X XReinsurers are subject to supervision ■/

Reinsurers are supervised directly ■/ X X

Reinsurers are supervised indirectly X X

Reinsurers are a subject to on-site inspections

* domestic

* non-domestic X X X X X X X

Management must be "fit and proper"

* domestic X X

* non-domestic X X ✓ X ✓ X X X XChanges in management must be reported

*domestic X X X

* non-domestic X X ✓ X ✓ X X X XSufficiency of technical provisions is examined

* domestic ✓ ✓ X

*non-domestic X X X X X X X

Solvency margin requirement exists X X X X

Supervision Germany France UK Netherlands Italy Denmark Sweden Spain Luxembourg

Financial statements must be submitted

* domestic ■/ ■/ ■/ ■/ ■/ ■/ ■/ ■/ ■/

* non-domestic X X ■/ X ■/ X X X X

Annual Submission

* domestic ■/ ■/ ■/ ■/ ■/ ■/ ■/ ■/ ■/

*non-domestic X X ■/ X ■/ X X X X

Quarterly Submission ✓ (a) ■/

* domestic X X X X X X X* non-domestic X X ■/ X X X X X X

Assets are examined

* domestic X X ■/ X ■/ ✓ ✓ ✓ ✓

* non-domestic X X X X X X X

Sanctions: licence can be withdrawn

* domestic X X X ■/ ■/ ■/ ■/

* non-domestic X X X X X X X

Sanctions: fines may be imposed

* domestic ■/ ■/ X ■/ ■/ ■/ ■/

* non-domestic X X X X X X X

a) only report on development of investments

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5.6.1 Denmark

Reinsurance business is regulated in Denmark in the same way as direct insurance business and based mainly on rules implementing EU directives. This includes accounting, investment, solvency, and fit and proper rules.

The main objectives of the regulation of reinsurance business are, we understand, to minimise the possibility of credit loss on reinsurance for the ceding direct insurers. This is directly related to the protection of the financial position of the primary insurers and therefore to the protection of policyholders.

Licensing requirements

A licence is required by incorporated Danish companies to practise reinsurance in Denmark. As of 1 April 2000 branches of foreign reinsurance companies (permanent establishments) also need a licence. Having a permanent representative will constitute a permanent residence. Foreign reinsurance companies, without having a permanent residence or a permanent representative in Denmark, can sell reinsurance to Danish direct insurers without having a licence in Denmark.

The rules regarding licensing are the same as for direct insurers. To obtain and maintain a licence in Denmark, a reinsurer has to make a standard application to the supervisory authority, make the required statutory filings and maintain a level of assets sufficient to service the level of liabilities it reinsures. The Board of Directors in Danish insurance companies has to determine the sufficiency of the security of the used reinsurers and therefore normally only uses reinsurers with good security. The requirements are checked regularly by the regulator. The regulator can withdraw the licence if the regulations are broken.

Reinsurers are subject to regular on-site inspection visits by the regulator in the same way as direct insurers.

The board of management and members of the board of directors are required to meet the fit and proper criteria, based on EU rules. Changes in management have to be reported to the regulator who can withdraw the licence if the management does not meet the fit and proper criteria. These criteria are checked at the time of the original submission by the company and are normally not checked on an ongoing basis. Normally the regulator will not check the criteria if a member of management has already been approved by the regulator in another EU or EEU member country.

Reporting requirements

The financial reporting requirements are the same as for direct insurers. Audited annual financial statements (based on the EU Insurance Accounts Directive) and regulatory returns are required. The regulatory returns are in the same form and level of detail as for direct insurers.

Direct insurers as well as reinsurers have to prepare and file audited annual financial statements and regulatory returns within 5 months after the year-end. In the near future this time limit will be changed to 4 months.

Once a year the non-domestic reinsurers (branches) submit a report on their activities to the regulator. The report contains information about capacity utilisation and about business in general. The branch report has to be certified by a state authorised or registered public accountant. A branch of a foreign reinsurer must each year file with the regulator a specification of the contracts entered into, analysed by country, and a specification of the ten largest ceding companies. General agents have to file two copies of the annual accounts for the company with the Danish regulators. A non-domestic reinsurance subsidiary must comply with the rules of the domestic reinsurers, i.e. direct insurers.

There are no written rules regarding probable maximum losses and maximum exposures but the supervisor is very focused on how direct insurers and reinsurers manage their capacity.

Solvency requirements

As for direct insurers a solvency requirement calculation has to be prepared. The non-life solvency provision is largely derived from amounts in the audited financial statements. The life solvency calculations are prepared by and signed off by the appointed actuary. A reinsurance company that conducts life reinsurance needs to have an appointed actuary.

Use of rating agencies

mk/nb/552 37

The Danish Supervisory Authority has implemented a rating model (called REMOS-reinsurance monitoring system) to determine the risk profile of the reinsurance cover of the insurance companies. The reinsurance programmes of all larger direct insurers are registered in REMOS including treaties, cover and security. This system rates companies by reference to a number of financial ratios, but also takes into account the level of exposure that companies assume when rating the security of a buyer's entire reinsurance programme. However, the information is not available to the public.

5.6.2 Germany

Reinsurance companies are subject to limited supervision compared to direct insurance companies. The rationale for the difference between insurance and reinsurance companies with respect to supervision is that insurance companies are business professionals that do not need the same level of protection as individuals. Another argument for the different treatment mentioned in the literature is that the models for supervision which are appropriate for insurance companies do not fit the special character of reinsurance business, especially as reinsurance business is more international than insurance business.

Consideration is being given to revising the existing regulation for professional reinsurers in Germany.

Reporting requirements

Although reinsurance companies are subject to limited supervision compared to direct insurance companies, they have to comply with requirements regarding accounting and reporting to the supervisory authority similar to direct insurance supervision. Furthermore, reinsurance companies are obliged to submit a quarterly report on the development of investments.

Solvency requirements

The German solvency requirements are based on the European Directives. There is no statutory solvency margin requirement for reinsurers. However, the supervisor tries to ensure that reinsurers have a minimum capital at the level required for direct insurers.

Insurer's procedures for monitoring reinsurer security

The German supervisory authority has published guidance for direct insurers on how to assess the performance and capacity of reinsurers on the basis of data from financial statements and other available information. Following this guidance, it is necessary for direct insurers to review the annual results of the reinsurer in comparison to the previous year. Other available information has to be taken into account such as information from brokers or rating agencies. If the assessment by rating agencies is considered, it is necessary to obtain comparative ratings from different rating agencies. Assessments of third parties have to be closely checked before being taken into consideration.

The following information, concerning the company's outwards reinsurance programme, must be submitted by direct insurers to the supervisory authority:

■ The name of the reinsurance and insurance company or the name of the reinsurance broker;

■ The ceded premiums have to be analysed between direct insurance business and the assumed reinsurance business. The amount of the ceded premiums has to include the premiums paid to the reinsurer as well as portfolio entries;

■ The reinsurer's share of the gross technical provisions has to be analysed between direct insurance business and the assumed insurance business;

■ The liabilities from deposits of reinsurers.

In addition, the supervisory authority obtains the audit report through indirect submission which must contain information about results from reinsurance contracts (inwards and outwards) overall and separately for certain lines of business. Also, the auditor has to comment on the creditworthiness of reinsurance receivables.

On the basis of the submitted information mentioned above the supervisory authority has the ability to directly assess the reinsurance programme of direct insurers.

The supervisor does not consider the solvency position of a particular reinsurer when assessing the quality of a company's reinsurance recoverables since in Germany there are no solvency requirements for professional reinsurers.

mk/nb/552 38

The supervisor takes into account the fact that insurance groups often manage their reinsurance programme on a group basis in order to manage it more efficiently and to prevent over exposure to particular reinsurers.

Adequacy of assets

Reinsurance is not subject to the investment regulations in force for direct insurers.

For investments valued in accordance with the historical cost principle, the market value must be disclosed in the notes.

There are no restrictions placed on the recognition of assets arising from outwards reinsurance contracts.

Many insurance companies use stress tests in order to quantify their investment risks. Reinsurers tend to have more professional knowledge and therefore more sophisticated systems. Asset/liability management techniques are still at an early stage of practical use. Some insurance companies already use a stochastic model concerning investments.

Use of rating agencies

In Germany, the largest insurance companies are usually rated by one of the leading rating agencies. Rating is not obligatory. Insurers use ratings for marketing and to improve their credit standing. Market trust in ratings is high. More than 700 direct insurers and over 40 reinsurers exist, of which 169 are rated by Standard & Poor's, 12 by Moody's and 17 by Assekurata a German rating agency. The use by the regulator of these ratings is very limited and consists merely in suggesting their use to direct insurers when assessing the performance capacity of reinsurers.

5.6.3 Ireland

Traditionally the Irish reinsurance industry has not received the same degree of scrutiny as the direct insurance sector. This area is now in the process of being tightened with the foundations for further regulation having been laid recently by the Insurance Act 2000.

The Irish regulator does not operate a formal authorisation process but is able to exert control over the establishment of new entrants through an arrangement with the Irish companies registry. Under the new Act there will be further requirements in relation to authorisation.

There is currently no formal supervision of reinsurance companies but the reinsurance market is relatively young, and a supervisory approach is expected to be introduced within the next five years.

5.6.4 Italy

According to a 1959 Act, Italian undertakings and branches of foreign (EU and non-EU) undertakings operating exclusively as professional reinsurers are subject to Isvap's direct supervision.

Undertakings which intend to pursue only reinsurance business in Italy must be granted authorisation by Isvap. In this case, as in the case of transfer of controlling interests in a reinsurance undertaking, the same regulations in force in direct insurance apply as regards the requirements of good repute and financial soundness of shareholders.

Isvap tends to substantially extend the more complex regulations applying to direct insurance; this is why it has introduced a routine procedure under which an ad-hoc scheme of operations is required in order to verify, apart from the good repute and professional qualifications of administrators and internal auditors, if an undertaking has sufficient technical and financial resources to ensure its technical, economic and financial stability during its first three years of existence. More specifically, Isvap requires estimates of the balance sheet, and the qualitative and quantitative composition of assets and liabilities, as well as the profit and loss accounts with the expected amounts of premiums, loss burden and production and administration costs.

The 1959 Act envisages minimum capital requirements that are nowadays insufficient: this is why they are calculated on the basis of the needs shown in the scheme of operations, with special reference to the nature of the risks that the undertaking intends to cover, the financial balance and the need to represent technical commitments.

No quantitative or qualitative limits are envisaged for assets representing technical provisions in reinsurance business (done by a professional reinsurer or by an undertaking which also pursues direct insurance); however, undertakings' balance sheets must "show real or easily realisable financial resources for an amount not lower than the existing technical provisions".

mk/nb/552 39

Professional reinsurers are not subject to present regulations on direct insurance as regards the solvency margin; nonetheless composites must take reinsurance business into account when calculating the solvency margin.

Like direct insurers, reinsurers must submit a report on the first half year, annual accounts and supervisory forms, except for a number of attachments and supervisory forms which are not technically applicable. In this regard these undertakings - although they are not obliged to do so - have the report and the balance sheet audited on a voluntary basis.

The balance sheet must be approved before 30 June of the year following the financial year to which it refers, and can be postponed until 30 September, but in this case the relevant reasons must be explained in the notes on the accounts.

The chart of accounts that companies must adopt applies to both insurance and reinsurance undertakings.

The said 1959 Act establishes that reinsurance undertakings must keep, apart from the books envisaged by the Italian civil code according to the type of company, the register of contracts, the list of claims reported and the register of premiums, although reinsurance premiums are exempted from taxes if the latter have already been paid on the direct premium. According to the same code reinsurance contracts must be proved in writing.

Isvap has the same supervisory and sanctionary powers as those envisaged for insurance undertakings and - based on the examination of the yearly balance sheet of reinsurance undertakings or on any other evidence - may require information and documents, express criticism, raise objections and conduct inspections on the reinsurance premises and on all aspects of their activity.

In case of business crisis, Isvap also has the same powers as those envisaged for undertakings pursuing direct insurance business even as regards the appointment of the ad acta manager, the special management and the company's compulsory liquidation.

Finally, on the basis of the valuation of the solvency of a reinsurer not based in a EU country, Isvap may not allow any technical provisions of a direct insurer to be covered by claims against him.

5.6.5 The Netherlands

Licensing requirements

Few reinsurance companies are based in the Netherlands and overseas reinsurers play an important role in the Dutch market. Pure reinsurance companies wishing to operate in the Netherlands do not require a licence. However, if a company also offers direct insurance it is considered to be an insurance company and as a result, all business written by it (including the inward reinsurance) falls under the supervision of the Dutch regulator, according to EU rules.

Contrary to the practice with insurance companies, reinsurers do not need regulatory approval for their (non-)executive directors. However, when establishing a N.V. the company will need ministerial approval. The approval process includes the assessment of future directors, although this is generally a formality.

Reinsurance companies cannot (directly or indirectly) obtain an ownership interest of 5% or more in a bank or insurance company without the consent of the regulator. Other than this, there are no compulsory guidelines on the investment policy of reinsurers.

Reporting requirements

Reinsurance companies are obliged to file two copies of their annual accounts and directors' report with the insurance regulator. The accounts must comply with Dutch GAAP. The accounting principles (including the valuation principles relating to technical provisions) are consistent with those for insurance companies. Reinsurance companies are not required to file returns with the insurance regulator.

In addition to being required to file their annual financial statements, reinsurance companies must provide any information the regulator may need to fulfil its supervisory obligations. The regulator has the power to approach the management and supervisory board of the reinsurance company when required.

Solvency requirements

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There are no specific solvency requirements for reinsurance companies. However, reinsurance companies founded as a public limited liability company have to adhere to general requirements. Reinsurance companies belonging to an insurance conglomerate must adhere to the EU directive on solvency requirements for insurance groups that has been implemented under Dutch law as of calendar year 2001.

Insurer's procedures for monitoring reinsurer security

According to a study published by Pension and Insurance Supervision Board (PVK) the following instruments are used to monitor the reinsurance practice of Dutch insurance companies:

■ Analysis of annual financial statements of Dutch reinsurance companies. All available information is stored in a database and used as reference when reviewing the returns of Dutch insurers and assessing the credit risk of the companies' reinsurance recoverables;

■ Review of annual returns;

■ On-site investigations, which include interviews with management and a review of a sample of reinsurance contract and transactions. During the interview, the supervisory authority discusses the nature and magnitude of the risks ceded, the policy on net retention, measures taken concerning catastrophe risks and accumulation of risks, the chosen types of reinsurance, the exposure to individual reinsurers, and the selection criteria used to identify appropriate reinsurers. During the sample testing, the conditions of the reinsurance contracts are reviewed and the internal control procedures are tested;

■ Reinsurance is one of the topics addressed during the annual meeting that the PVK has with management.

The reinsurance review in the annual returns of a non-life insurance company includes:

■ A description of the reinsurance strategy by line of business (cover obtained, net retention, type of reinsurance, measures taken regarding catastrophe risks);

■ A list of all reinsurers with whom the insurer has signed a non-proportional reinsurance contract (excess of loss, stop loss);

■ A list of all reinsurers with whom a proportional reinsurance contract has been signed that transfers more than 10% of the gross premium (quota share, surplus);

■ For each reinsurer an overview is provided of any outstanding balances, the reinsurance premiums ceded, the reinsurer's share in claims incurred and in the technical provisions;

■ Collateral or deposits placed with the company are disclosed if they exceed 10% of the reinsurer's share in the technical provisions.

The reinsurance review in the annual returns of a life insurance company include:

■ A description of the reinsurance strategy by type of reinsurance;

■ Information on the net retention (per incident);

■ A list of all reinsurers including the reinsurer's share in the technical provisions and the amount reinsured by type of reinsurance;

■ Collateral or deposits placed with the company are disclosed if they exceed 10% of the reinsurer's share in the technical provisions.

Insurance companies are concentrating the management of their reinsurance programmes at a group level. Generally speaking, the net retention is maximised for the group as a whole. Off-shore captives can be established.

In 2000, the PVK drafted new actuarial principles which proposed to link the safety margins that an individual insurer should apply to the effectiveness of its risk management policies. Indirectly this would also affect the way that the PVK monitors outwards reinsurance arrangements. The draft was revised based on comments received from local insurance companies and other parties involved. The final report was delivered in September 2001. This report is referred to as the "basic principles for a financial assessment framework". On the basis of these principles, the PVK has started to elaborate practical policy rules for financial testing. However, it will take a few years before the new policy rules become effective.

Adequacy of assets

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Both in shareholders accounts and in the annual returns, investments (financial instruments and real estate) may be valued at historical cost or market value. Fixed interest investments may be valued at redemption price.

In May 2001 a specialist group appointed to review the accounting principles applied by insurance companies issued a report with recommendations to improve the comparability of the financial statements of insurers. The report will result in new directives that are intended as an interim standard, awaiting the IASB standard on the accounting for insurance contracts among others. The recommendations include:

■ valuation of equities at market value and fixed interest securities at amortised costs or market value;

■ the immediate inclusion of realised gains and losses on investments in net profit or inclusion of realised and unrealised gains and losses on investments in net profit; spreading these over time is not allowed;

■ life insurance provision: disclosure of the quantitative result of a statistically accentuated adequacy test of the technical provision for life insurance, based on modern, realistic principles.

■ non-life insurance provisions: disclosure of the run-off of the claims provision for underwriting years already closed. A breakdown of the nature and value of developments of the provisions for catastrophes.

Dutch insurance companies disagree strongly with the immediate inclusion of realised gains and losses in net profit. The outcome of the political debate on the new directives is as yet unclear.

The annual returns include an overview in which the insurance company must specify its assets and liabilities that are held in foreign currencies.

The regulator can challenge the valuation of an asset arising from an outwards reinsurance contract.

In the light of IAS 32 that has been implemented in the Netherlands, companies are required to provide disclosure in the financial statements on the risks related to their financial instruments.

In life-insurance business, models based on the calculation of the embedded value are used for asset-liability management and scenario analysis. The models applied focus on asset-liability mismatches.

Use of rating agencies

In the Netherlands, insurance companies can apply for a rating by one of the internationally acknowledged rating companies, who typically publish the ratings on their websites. There is no publicly available rating system designed specifically for the Dutch insurance market. The regulator does not disclose any regulatory rating that could be used as an indication of the companies' risks. However, some information in the annual returns must be made publicly available. Several parties analyse this information to identify developments in the Dutch market and publish "top-10" lists of insurance companies.

5.6.6 Spain

In general, reinsurance is regulated in the same way as direct insurance, although there are minor differences. There is no legal requirement for reinsurance companies to maintain a solvency margin.

Licensing requirements

Spanish reinsurers and foreign reinsurance entities or business associations which set up branches in Spain require authorisation from the "Ministry of Economy". If a company which is registered in an EEA country wishes to establish a branch in Spain a procedure similar to that applicable to direct insurers (European passport) is followed.

Foreign insurance or reinsurance companies or business associations operating in their own countries, with or without Spanish branches, may also accept reinsurance operations through their registered offices. In the case of entities registered in the EEA, such operations may be accepted through branches established in any member state. These entities do not require an authorisation.

Requirements for obtaining an authorisation are the same as those established for direct insurance companies and include restriction of statutory activity, submission of a programme of activities, forecasts for the first three years, minimum share capital, shareholders requirements and effectiveness of management. Ongoing compliance with requirements is mandatory for obtaining

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and maintaining the State authorisation, which will be revoked if any non-compliance is detected. Any breaches of the regulation may result in the authorisation to underwrite new or to renew reinsurance contracts being revoked or suspended, depending on the degree of the breaches.

Reinsurance companies, like direct insurance companies, are subject to a regular on-site inspection visit by the regulator.

All members of the executive management must be individuals of proven integrity and with appropriate qualifications, as established for direct insurance. These individuals should figure in the administrative register of senior management. They must satisfy certain requirements before assuming such positions. The regulator monitors the requirement generally through inspection of new and existing companies.

Reporting requirements

There are certain differences between the documentation to be presented by insurers and reinsurers, as follows.

■ In the statistical documentation of balance sheet items, reinsurers should distinguish between group, associated and other companies with regard to creditors and debtors for accepted reinsurance. Details should also be given to the amount provided for bad debts on reinsurance accepted;

■ Model 12 requires a breakdown of technical provisions and deposits (actuarial provisions, provisions for outstanding claims and other technical provisions), giving details of the amounts for the single line of business;

■ Model 19 requires details of premiums and claims settled by country, analysed between EEA member states, Switzerland, the USA and other countries.

The Spanish supervisory board requires annual accounts, director's report, statistical information and, where applicable, general and supplementary audit reports. The deadline for insurance companies is the 10 July of the following year. Reinsurance companies have to deliver by the 10 October.

The regulator considers probable maximum losses and maximum exposures to the extent necessary to grant operating licences.

Solvency requirements

Entities carrying out reinsurance operations are required to create, calculate, record and invest provisions in the same way as direct insurance companies. There are no differences between reinsurance and direct insurance in regard to the calculation of solvency margins or the items covered thereby.

Legislation regulating reinsurance tends to favour specialisation, requiring that newly created entities carry out reinsurance activities exclusively. Additionally, and here there are no differences with direct insurance, the controlling body favours specialisation by line of business and risk concentration policies.

We understand that the regulator is principally concerned with the following areas:

■ complexity of the reinsurance business;

■ the risk of insolvency of reinsurance entities which affects both the cedant and its insured parties (the protection of the primary insurer's policyholders);

■ the principle of diversifying risk culminates in the reinsurance business and, consequently, the concentration of risks on these should be avoided, given the increased impact this could have on direct insurance;

■ a perceived need to regulate the continuous innovations in the sector, especially given the international scope involved. (It should be borne in mind that almost half of the insurance companies operating in Spain are foreign-based).

Insurer's procedures for monitoring reinsurer security

Spanish legislation only refers to the retention programme as follows: insurance and reinsurance companies must arrange their reinsurance programmes so that their net retention is appropriate, given their economic capacity, to maintain the company's financial and technical stability.

Information on reinsurance has to be submitted to the regulator. Life insurance companies (when accepted reinsurance premiums represent more than 10% of total premiums) must submit details of premiums analysed by individual and group policies, and by periodic and single premiums, by with and without profit

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participation, and where the investment risk is borne by the policyholder. Non-life insurance companies are required to submit a breakdown of technical income and expenses between direct insurance and assumed reinsurance (where premiums accepted exceed 10% of total premiums).

The following details must be submitted by insurers to the insurance authorities about ceded business: type of reinsurance contracts, retention/priority and limit of the contracts (for each class of business representing more than 20% of direct business); listing of reinsurers representing more than 5% of the ceded business and details of year end balances with these reinsurers.

In addition, insurance companies must keep, inter alia, a register of accepted and outwards reinsurance contracts with identification data for each individual reinsurance contract. The information has to be distinguished between treaties and facultative contracts. The information for each contract should include characteristics of the risks reinsured, conditions of reinsurance coverage and all other matters with an economic impact.

The documentation to be submitted annually to the regulator requires a breakdown of reinsurance by country.

No specific programmes have been set up by the Spanish regulator to monitor insurance companies' risk management procedures, either generally or in particular in relation to the reinsurance programme.

Adequacy of assets

Historical cost accounting rules are applied in accounting. However, for solvency purposes, hidden reserves arising from the difference between the cost and market value of investments are taken into account.

The currency in which the investments are realisable must be matched with the currency in which the insurance liability will be settled, when the assets in other currencies exceed 7% of the total and when they exceed 20% of liabilities in the currency. There is an exception when the liabilities are payable in non EEA currencies. As a rule, financial investments must be issued in or subject to the control mechanisms of the OECD or the EEA, and deposited in the EEA. Similarly, real estate investments must be located within the EEA. Exceptions must be approved by the regulator.

The use of asset-liability management techniques for the management of expected payments for life insurance has increased. This enables insurance companies to guarantee technical interest rates on the basis of allocated investments, provided that they comply with certain requirements regarding maturities, financial duration and sensitivity of the current value to variations in interest rates at specified future dates.

Use of rating agencies

In Spain, only a few insurance entities have been rated by an external agency (generally Standard & Poor's, Moody's and Fitch IBCA) as there is no significant market pressure to obtain a rating. The regulations assume the use of credit rating in the following cases: use of appropriate assets for the coverage of life insurance provisions ; in the case of use of derivatives traded in OTC markets, both parties must have received a favourable credit rating; accounting legislation also takes into consideration the credit rating of the issuer when valuing fixed income securities.

5.6.7 Sweden

Reinsurance is in most aspects regulated in the same way as direct insurance. Some differences however exist, but not concerning solvency requirements.

Licensing requirements

A licence is required in order to practise reinsurance. However, this only concerns Swedish companies. Non-Swedish reinsurers can practise their business in Sweden on a cross-border or establishment basis without a licence. Branches from other countries than EEA or Switzerland have to apply for a licence. The same rules apply for direct insurance and reinsurance.

It is necessary to file an operating/business plan before obtaining a licence. Licensed entities are checked on a regular basis. If the requirements are not met the licence may be withdrawn.

Reinsurers (companies and foreign branches) can be subject to on-site visits by the regulator in the same way as for direct insurers.

The same fit and proper requirements for controllers, directors and managers apply for reinsurers as for direct insurers, including a need to report changes in the management. An approval is not required when there are changes in management.

Reporting requirements

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Reporting requirements are almost the same as those established for direct insurance companies and the same deadlines are imposed depending on the size of the business.

Branches from EEA companies have to prepare a balance sheet and profit and loss accounts. The requirements are the same as for direct insurance. Subsidiaries have to present an annual report.

Regarding probable maximum losses and maximum exposures, the supervisor usually does not monitor this area.

Solvency requirements

Reinsurance companies have to file an annual solvency declaration to the supervisory authority, and also report the level of technical provisions.

The solvency calculations are based on the EU directives. No major changes have been made.

Use of rating agencies

Most of the largest Swedish companies are rated by Standard and Poor's based on public information. At present there is no mechanism that gives an insurance company a regulatory rating or grading. However, the regulators are currently working on an international grading system to ensure stability within financial institutes including insurance companies.

5.6.8 France

5.6.8.1 Future revised regulations

A new law was adopted by parliament in May 2001 imposing specific regulation on reinsurers which is more extensive compared to existing regulation. This new law will soon be complemented by detailed regulatory rules. The new rules would subject reinsurers to an authorisation procedure similar to that for direct insurance companies. It would include adequate financial and technical means for the business to be written, quality of shareholders, procedures for financial recovery, and comparable sanctions (including withdrawal of the authorisation). Solvency requirements (including technical provisions, their coverage by admitted assets, and the solvency margin) will be implemented in the future, and will differ from those applied to direct insurance companies to take account of the special features of reinsurance business.

5.6.8.2 Regulations currently in place

Licensing requirements

There is no need for a license for assumed reinsurance. There are no specific rules for reinsurance companies, but French reinsurers have to file some of the direct insurer information with the French supervisor, the "Commission de Controle des Assurances", who also has the right to control French reinsurers.

French reinsurers can be subject to on-site inspections like direct insurance companies. The same fit and proper requirements apply to reinsurers as to direct insurers.

Reporting requirements

French reinsurers have to file with the supervisor in a format derived from the direct insurer's format. Financial statements must be approved by the shareholders no later than 6 months after the year-end.

Reinsurance subsidiaries are treated as a special category of domestic reinsurers. There are no supervisory requirements for branches of foreign reinsurers. Only reinsurers incorporated in France are supervised and considered supervisable.

Newly established reinsurers must send specified details to the supervisor including the statutes of the company and names of the directors. Financial statements required by the supervisor are the same as for direct insurers.

Solvency requirements

French reinsurers are not required to cover their technical provisions by admitted assets or to comply with a solvency margin.

Insurer's procedures for monitoring reinsurer security

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As stated in the framework of the mission of permanent supervision of insurance companies, it is the French supervisor's responsibility to assess the adequacy of reinsurance programmes of direct insurers on a case by case basis.

In meeting this responsibility, the supervisor may examine in detail the reinsurance programme during on-site audits to insurance companies.

Regarding information required to be submitted to the supervisor, property and casualty insurance companies need to file two schedules every year that give summarized information on assumptions and cessions:

■ Schedule C3 which provides a breakdown of assumed and ceded reinsurance premiums, insurance liabilities, technical balance (premiums less loss expenses less acquisition expenses), and interest expense on cash deposits from reinsurers. This information is further analysed for group companies and non group companies, and for French and foreign reinsurers;

■ Schedule C13 which analyses operations by accident year for ceded paid losses, reinsurers' share of loss reserves at the beginning and at the end of the financial year, and for some categories, increase in reinsurers' share of earned premiums.

The technical provisions are assessed before reinsurance.

A company's reinsurance recoverables are admitted in coverage of these gross technical provisions only up to the amounts secured by collateral from the corresponding reinsurers (or cash deposits or letters of credit from banks under specific conditions). Insurance companies also have to check the financial heath of their reinsurers, as recommended bythe OECD.

The French insurance law provides prudential rules on the quality of collaterals.

The supervisor has two prospective tools in order to monitor risk management procedures in relation to the reinsurance programmes. He can examine the annual solvency report, which analyses the sufficiency of assets as regard liabilities and possible future solvency margin requirements; and the quarterly schedule called T3, which aims at assessing the effect of stress-testing on asset-liability management. Moreover, the supervisor can ask the company to provide any information deemed necessary and carry out on-site inspections.

So far the supervisor has controlled individual companies. The implementation of the 1998 insurance groups directive will change this by introducing a group approach.

Adequacy of assets

Assets are usually carried at cost except fixed income securities which are carried at amortised cost. Investments are to be individually written down if a decrease in market value is considered permanent. If the market value of the overall investment portfolio other than bonds is lower than the carrying value, then the value is written down to the market value.

Insurance liabilities have to be covered by assets in a currency which matches the currency of the insurance liability. Pending the entering into force of the new regulation, this requirement does not apply to reinsurers.

Regarding assets arising from outwards reinsurance contracts, cash deposits by reinsurers enable the insurance company, in principle, to have adequate assets in coverage of gross technical provisions. Reinsurance recoverables are admitted in coverage of gross technical provisions up to the amounts secured by collateral.

The supervisor has recently developed some schedules (quarterly report) to assess exposure to interest rates and capital market changes on the assets and liabilities of the companies.

Use of rating agencies

In France, only the major insurance groups have a rating provided by a rating agency (Standard & Poor's, Moody's or Fitch IBCA). They are automatically rated when listed on a US stock exchange, otherwise French insurance companies have to request rating agencies for a rating. No use of ratings is made by the supervisor.

5.6.9 United Kingdom

5.6.9.1 The company market

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In the UK, the legislative framework for supervision makes little distinction between insurance business and reinsurance. The main objective of the regulation of reinsurance business is the same as that for direct business, i.e. confirmation of the company's ongoing ability to meet its obligations to policyholders (in this case other insurers).

Licensing requirements

Reinsurance business is regulated in exactly the same way as direct insurance business, for which the requirements are derived from the appropriate EU Directives. In order to become authorised, an applicant is required to submit financial forecasts and other information required by the relevant legislation.

Reinsurers are subject to on-site inspections in the same way as direct insurers. Fit and proper requirements apply exactly as for direct business, as does the need for the regulator's approval of changes in management.

Reporting requirements

The reporting required by the regulator is the same as for that for direct business. A return is to be submitted normally annually, but in certain cases (e.g. new companies) quarterly. This is a standard form and includes calculation of the required solvency margin, balance sheet, revenue account, reinsurance arrangements and detailed analysis of revenue headings. All annual returns require a report by the auditor and in the case of life business an actuarial report on the adequacy of technical provisions is required also.

The UK branches of non EU-companies are supervised in the same way as UK companies. In addition returns with their global figures have to be submitted.

Solvency requirements

Reinsurers in the company market are subject to the same solvency requirements as direct insurers. However, there are differences in the approach taken by the regulator, recognising the different nature of reinsurance business.

In addition to the standard regulatory reporting and solvency tests to which all UK authorised insurance companies are subjected, the regulator carries out certain additional checks on insurance companies operating in the London Market. These involve principally looking at the reinsurer's solvency position under a number of different loss scenarios and estimating probable maximum losses, in order to assess the degree of risk inherent in the liability side of the balance sheet. Also, an attempt is made to rank reinsurers according to risk assessments made by the regulator based on its loss scenario testing.

This type of approach represents an attempt to recognise the additional risks posed by a reinsurer, as a result of the complexity of its business and the volatility inherent in its reinsurance liabilities. With regard to the solvency position, there are two principal risks posed by claims provisions: first, the possibility that future claims events in respect of contracts already entered into may exceed expected levels, and second, that claims already incurred but not settled may exceed amounts provided within liabilities. Interestingly, neither of these possibilities are explicitly dealt with by the current solvency margin methodology.

For professional reinsurers writing life business, the solvency margin calculation applies a different rate (0.1% rather than 0.3%) to capital at risk. Other differences apply to reinsurance business rather than to reinsurance companies. The matching and localisation requirements do not apply to reinsurance business. Non-life reinsurance business is analysed separately in the regulatory returns and is accounted for on an underwriting year basis rather than an accident year basis. Most fundamentally, the authorisation of non-UK reinsurers applies to their worldwide operations, not just to business carried on in the UK.

5.6.9.2 The Lloyd's market

The supervisory approach within the Lloyd's market is somewhat different to the company market in the UK. In particular, Lloyd's operates a risk based system and focuses its regulatory efforts on perceived high risk areas. Whilst the approach encompasses both insurance and reinsurance business, the emphasis on risk means that reinsurance business may be monitored more closely; syndicates are required, for example, to produce Realistic Disaster Scenarios, identifying their potential exposure to major losses.

In addition, Lloyd's has on occasion undertaken reviews into the market-wide use of specific reinsurers, in attempts to identify potential problems.

Further details of the regulatory approach adopted by Lloyd's is included in Appendix 3.

5.7 Supervision of reinsurance in major non-EU countries

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The varied approach to supervision of reinsurance across the EU is reflected elsewhere in the world. However, where reinsurance is regulated, the approach usually differs little from the approach to regulation of insurance business. Solvency or equivalent requirements are usually based on the same rationale, and although there may be higher requirements for reinsurers writing significant amounts of catastrophe business, the overall approach to supervision is usually similar.

5.7.1 Canada

Reinsurance is explicitly defined and included within the overall business of insurance. The main objective of the regulation of reinsurance business is to minimize the possibility of credit loss on reinsurance for the ceding direct insurers.

Licensing requirements

Whilst reinsurance can be bought from unlicensed reinsurers, the ceding company, in order to obtain reinsurance credit for its own statutory reporting purposes, would typically require the reinsurer to post a letter of credit.

To obtain and maintain a licence in Canada, a reinsurer would make a standard application to the federal regulator, make the required statutory filings and maintain a level of assets in Canada sufficient to service the level of liabilities it reinsures, as prescribed in the regulator's rules.

The Canadian regulator operates a licensing system, and supervises reinsurance business in essentially the same way as direct insurance business, except that reinsurers do not deal with the public and accordingly do not have market conduct regulation to comply with.

There are a number of subjective matters to be considered by regulators in deciding whether to grant a licence including, adequate financial resources to provide minimum capital; providing a sound written business plan for the review of the regulator; a record of successful business operations by the owners of at least five years; management team with proven experience; compatibility of the proposal with the best interests of the Canadian financial system; equally favourable treatment accorded to Canadian companies in the countries in which the foreign insurer principally conducts business; ability to comply with all relevant Canadian legal requirements.

Minimum initial capital requirements are higher for reinsurers than for direct writers, reflecting the perceived greater inherent risks in reinsurance. Ongoing capital requirements are also calculated based on the actual risks undertaken by the insurer, on the same basis for both direct insurers and reinsurers.

Initial and ongoing governance requirements are the same for reinsurers as for other insurers, appropriate books and records must be maintained in accordance with GAAP; generally accepted actuarial standards must be used; appropriate systems of internal control must be maintained; directors and officers, as well as the auditor and appointed actuary, have duties to remedy breaches of law and regulation, and to report to the regulator any breach that is not remedied on a timely basis, as well as any condition threatening the "well being" of the insurer.

Once an insurer (whether a direct insurer or a reinsurer) is initially licensed, it is subject to ongoing supervision. This monitoring is done by the regulator through review of annual audited financial returns and actuarial opinions, unaudited quarterly financial returns, and an annual contact or visit from regulatory staff.

The regulator can place restrictions on a licence (e.g. limiting or prohibiting new business, limiting renewals) unless conditions such as inadequate capitalisation are remedied. Withdrawal of a licence would prevent an insurer from carrying on business. These sanctions, together with monetary fines, can be used to compel insurers to remedy a wide range of problems, such as poor market conduct, poor governance procedures or other breaches of the legislation or regulation. In extreme cases, the regulator can take control of an insurer and place it in liquidation, ordinarily to protect policyholders and claimants when an insurer is insolvent.

Reinsurance companies can be subject to regular on-site inspection visits by the regulator as for direct insurance companies.

Directors and certain officers, including the chief executive officer, secretary, treasurer, controller, actuary and any other officer reporting to the board of the CEO, are required to meet the fit and proper criteria. Changes in senior management are ordinarily reported to the regulator as a courtesy. There are no requirements for management and no regulatory approval is required.

The financial reporting requirements are essentially the same as for direct insurers, audited financial statements and regulatory returns are required, together with an appointed actuary's report on the technical provisions for policy liabilities. The regulatory returns are in the same form and level of details as for direct insurers.

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All reinsurers are required to report on a GAAP basis, regardless of whether they are foreign-owned or domestic, and regardless of whether they are organised as a company or a branch.

Reinsurers have adapted to shorter reporting deadlines by the use of estimates and more actuarial analysis. This has been made necessary both by earlier deadlines for regulatory reporting, and also by accelerating reporting deadlines of their parent companies, some of which are publicly listed.

Solvency requirements

Technical provisions are based on accepted actuarial standards. Equalisation provisions are forbidden as they are contrary to both GAAP and actuarial standards. An appointed actuary's report is required on the technical provisions for policy liabilities. The non-life solvency provision is largely derived from amounts in the audited financial statements, while the life solvency provision is subject to annual audit by the external auditors.

Reinsurers are subject to risk-based minimum solvency requirements - a minimum asset test (MAT) for non-life, and minimum continuing capital and surplus requirement (MCCSR) for life. These requirements are the same as those that apply to insurers.

Insurer's procedure for monitoring reinsurers security

The regulator reviews the general details of the reinsurance programme. An outline of the reinsurance programme of a non-life insurer is typically included in the annual appointed actuary's report. In addition, the regulator has specified more detailed requirements for earthquake exposures, including studies estimating the insurer's probable maximum loss in a given geographic area. These are used to monitor the preparedness of an insurer, including its reinsurance arrangements, to survive such a loss.

The annual statutory return schedules referred to above requires a list of reinsurers (identifying which are affiliates) and the premiums and claims ceded to each company. Separate schedules provide details of reinsurance ceded to unregistered reinsurers, so that the impact on the solvency margin can be calculated. Schedules in the statutory return require details of any collateral or deposits placed by the reinsurer.

The regulator places emphasis on the assets maintained in Canada, and the solvency ratios of the Canadian operation of the reinsurer.

Regarding the monitoring of risk management procedures in relation to the reinsurance programme, the regulator is beginning to see the results of life insurer companies' risk self-assessments, and the review of those self-assessments in the course of annual inspection visits. All insurers are expected to monitor the credit worthiness of their reinsurers.

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Reporting requirements

Larger multinational insurers have increasingly coordinated reinsurance within their groups, with the result that the coordination often occurs outside the country, and frequently involves affiliated company reinsurers. The regulator must usually deal with the information available within Canada.

The regulator is not currently reviewing the treatment of reinsurance ceded for regulatory purposes.

Adequacy of assets

In non-life business, a cost basis is used in both the shareholder accounts and regulatory returns. Investments are set at market value for solvency testing purposes.

In life business, cost basis is used in both the shareholder accounts and regulatory returns, except for investments in equities and real estate, which are marked to market at 15% and 10% per year respectively. Similarly, realised gains on equities and real estate are deferred and amortised to income at 15% and 10% per year respectively.

There are no specific foreign exchange regulatory requirements. However, mismatched currency risks could give rise to higher actuarial liabilities and higher risk-based capital requirements.

Explicit asset-liability matching techniques are used in life business. Future cash flows are modelled to develop life insurance actuarial liabilities, and specifically to develop a provision for asset-liability mismatches. Portfolio management practices are reasonably sophisticated for life insurers. Non-life insurers commonly manage liquidity in more basic ways, and are most likely to deal with diversification in terms of concentration limits or similar approaches.

Use of rating agencies

In Canada, the publicly quoted stock companies for the most part have a rating provided by a rating agency. Most smaller companies do not engage a rating agency. Where the insurer does not request a rating, one rating agency (AM Best) may publish a "provisional" rating based on published financial information. Standard & Poor's, AM Best and Canadian Bond Rating Service are the main rating agencies. Ratings generally include both capital instruments and claims paying ability. There is no explicit use by the regulator.

5.7.2 The USA

The regulation of reinsurance in the USA closely follows that of direct insurance business. Licensing follows the same structure and solvency requirements follow a risk based capital approach as required for insurers.

Reinsurance is generally covered by the broad definition of insurance in most states, but all states have specific reinsurance statutes under their insurance law.

Foreign companies can establish themselves as either an Authorised (licensed) or Accredited reinsurer. Each state has unique licensing requirements. The requirements to become an Accredited Reinsurer is mandated by the NAIC's "Model Law on Credit for Reinsurance". Certain provisions of the Accredited Reinsurer provision are unique to reinsurers.

To be accredited there are accounting/financial reporting and requests for information and on site inspection criteria. Sanctions which may be imposed are withdrawing the licence or accreditation or possibly requiring more stringent reporting.

Generally, key management and financial reporting personnel and members of the board of directors are required to meet the criteria of "integrity and competence of management".

Reporting requirements

For reporting purposes, reinsurance is generally subject to less detailed reporting in regulatory filings. Statutory filing requirements are guided by the filing company's state of domicile. For authorised reinsurers, annual statements are due to the NAIC. Non-domestic companies have the same filing requirements as domestic companies.

For regulatory filings, non-life insurance companies include the following based on relevance:

■ A description of the reinsurance strategy (cover obtained, net retention, type of reinsurance, measures taken regarding catastrophic risks);

■ A list of reinsurers with whom the insurer has amounts due;

■ Collateral or deposits placed with the company are disclosed if they exceed 10% of the reinsurer's share in the technical provisions.

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Solvency requirements

Solvency requirements follow a risk based capital approach, as for direct insurers. This approach, based on a model established by the NAIC, measures the various risks in the business, including investment risks, and calculates a score relative to the insurer's stated capital. In the event of deficiencies, certain actions are taken. The models are relatively complex and cover a broad range of risks. Since the underlying accounting model has changed with effect from 1 January 2001, these models will need to be revisited to ensure proper calculations. In addition, an older more traditional model still exists but generally has little impact.

Supervision is subject to the rules and regulations of individual states. Most states have adopted the NAIC's capital models, but in some cases the local rules are more or less restrictive, by requiring a minimum or larger capital requirement.

Insurer's procedure for monitoring reinsurers security

One interesting feature of the US approach is the extensive information required by regulators in respect of a cedant's outwards reinsurance programme:

■ The review of outwards reinsurance is based on periodic state regulatory examinations of cedants. Furthermore, significant contracts are likely to be discussed and agreed with regulators in advance. There are a number of credit related requirements to help minimise potential losses on outwards reinsurance. For example, the reinsurer may have to post letters of credit or trust accounts in order for receivables to be allowed to be counted for regulatory capital requirements.

■ Cedants are required to continually monitor the credit worthiness of their reinsurers. Statutory requirements stipulate such monitoring, as well as accounting and auditing literature.

■ In connection with the quarterly and annual reporting of financial results, insurers are required to provide comprehensive information, showing the reinsurers and their related balances. This information is fairly well scrutinized to monitor trouble situations. In addition, limited additional information is contained in notes to the financial statements filed by the company in February following the year-end.

Adequacy of assets

Invested assets are valued at amortised cost for fixed maturity investments and market value for equities.

Financial statements typically contain a number of disclosures relating to risk management and financial instruments used to manage risks. In addition, the SEC imposes a significant amount of disclosures on market risks relating to derivatives and financial instruments in the annual form 10-K.

Regulators impose significant financial and modelling requirements on companies, such as cash flow testing. The financial statements include many disclosures, but the filings with regulators contain much more detail.

Use of rating agencies

Several rating agencies exist in the US. AM Best is the most widely recognised rating agency for the insurance industry. While the rating agency information is important, insurance regulators generally do not rely significantly on this information, but prepare their own analysis and information to monitor companies. There are several types of ratings including, claims paying ability or capital instruments. The regulator does not use any internal ratings or market mechanisms in its regulatory process.

5.7.3 Bermuda

The approach to the regulation of reinsurance broadly follows direct insurance, and there is no difference in methodology in calculating solvency margins for insurance and reinsurance companies.

Licensing requirements

A licence is required in order to practise reinsurance in Bermuda. To obtain it a reinsurer would make an application to the regulator and be required to maintain the required amount of capital to support its licence application. The applicant must submit a business plan including information on its products, investments, capital, reinsurance, management and shareholders. The company must appoint a principal representative, a statutory auditor and a loss reserve specialist, all of which have statutory duties under the regulation.

The Bermuda regulator does not generally conduct site visits to reinsurance or insurance companies, although he has the power to perform them. All new applications of reinsurers are reviewed for fit and proper persons. Additional requirements for this criteria and routine on site inspections are scheduled to be introduced in the current year.

Reporting requirements

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Based on the above Classes, the solvency calculation is as follows:

Reporting requirements

All reinsurers are required to have an annual audit and must file an annual statutory return, which includes an audit opinion, a solvency certificate, and analysis of premiums, key operating ratios and an opinion from a loss reserve specialist (actuary).

Solvency requirements

Although the formula and principles are the same, different parameters are used in calculating the solvency margin, depending on the classification of the business. The classification could be one of four types:

■ Class 1 - Single parent captive insurer

■ Class 2 - Multi-owner captives

■ Class 3 - Insurers and reinsurers not included in Class 1,2 or 4 and normally including reinsurers writing third party business, insurers writing direct policies with third party insurers and finite risk insurers.

■ Class 4 - Insurers and reinsurers having the intention of underwriting direct excess liability and/or property catastrophe reinsurance risk.

As seen above, insurers and reinsurers are generally class 3. However, if there is excess liability or property catastrophe reinsurance risk i.e. the higher risk categories, then they are classified as Class 4.

Note 1: For Class 4 insurers, the test is 50% of net written premium with maximum deduction for reinsurance of 25% of GPW (Gross Premium Written).

The main objective of the regulation of the reinsurance business is to ensure that the reinsurer has sufficient solvency and liquidity to meet claim obligations.

5.7.4 Switzerland

Reinsurance business is covered in insurance regulation but most requirements for direct insurance companies do not apply to reinsurance companies.

The Swiss reinsurance market is of course unique, being home to some of the world's largest reinsurers. The concept of self-regulation by market forces is evident in the regulatory approach.

Licensing requirements

The supervisory legislation provides that all insurance companies constituted under civil law and carrying on business in Switzerland are subject to supervision unless exempted by it. Exemption from supervision applies to foreign insurance companies operating in Switzerland which write reinsurance business only.

Therefore foreign insurance companies which intend to carry on reinsurance business in Switzerland require no authorisation and are exempted from federal supervision. Authorisation and supervision is required for Swiss reinsurers.

In order to obtain a licence a company must submit a business plan. The business plan must contain information concerning business purpose and internal organisation; the planned business areas and geographic areas of activity; information necessary to assess solvency; the by-laws; the balance sheet and annual financial statements or, if applicable, the opening balance sheet and the budget; the tariffs requiring approval and other insurance materials to be used in Switzerland; details as to the technical reserves, reinsurance and, if applicable, amounts payable on settlement as well as participation in surpluses. Breaches of the regulations may lead to the withdrawal of the licence.

Reinsurers must complete an annual reporting package to the regulator. Disclosures per line of business are required for direct insurance and reinsurance. Reinsurers often used to report their underwriting results one year in arrears, but this practice is now uncommon.

Solvency requirements

Whilst there is no solvency requirement set out in legislation, the Swiss regulator does apply a benchmark of 20% of net premium as a minimum equity requirement. There are no fit and proper requirements and no consideration of probable maximum losses and maximum exposures by the regulator.

Insurer's procedures for monitoring reinsurer security

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Swiss reinsurance companies report the names of all relevant reinsurance partners to the regulator in the annual reporting package. In general Swiss companies reinsure their business with highly-rated global reinsurers. Therefore no special focus for the regulator has been needed in this area in the past.

The reinsurance programme is not an explicit part of the business plan during the licensing/authorisation process. It is common practice that the risk assessment is a key theme in the informal meetings between the regulator and management in the start-up phase.

No additional information on the reinsurance protection programme is collected by the regulator in the annual reporting package. At an interval of about four years, a team from the regulator visits the insurance company and discusses such subjects with management directly.

There is no requirement to provide the regulator with details of collateral or deposits.

Most Swiss insurance companies are part of a global group controlled by a foreign company or are global players themselves. As a tendency, more and more business is aggregated within the group and reinsurance coverage is placed with third-party reinsurers with a considerable retention limit. The treatment is supported by the fact that most direct insurance companies hold a license for assumed reinsurance as well.

The regulator is not currently reviewing the treatment of reinsurance ceded.

Adequacy of assets

Individual company financial statements and regulatory returns generally use lower of cost and market value for equities without writing up investments previously written down when the market value recovers. Fixed interest securities are normally valued at amortised cost. Market value is often used in consolidated financial statements. The difference between market value and cost may be taken into account in assessing solvency.

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Reporting requirements

There are requirements to hold "designated assets" to match the insurance liabilities and at most 30% of these assets may be foreign. However, there are no requirements as to where the securities must be deposited for a Swiss company. The "designated assets" must be held separately from the other assets of the company whether they are held by the company itself at its head office or by third parties. For obligations denominated in a foreign currency, the insurance institution has to invest at least 80% of the designated assets in valuables of the same currency. Foreign insurance institutions must have at their disposal in Switzerland assets in the amount of the solvency margin, computed on the basis of the Swiss business.

There are no restrictions on recognition of assets from outwards reinsurance except for those inherent in the EU calculation of the solvency margin.

Companies are beginning to calculate measures such as value at risk on their asset portfolio, but linkages between asset and liability risk is a theme being looked at by companies rather than something that is already in place.

Use of rating agencies

The major players in the Swiss market are rated by the major international agencies (Standard & Poor's analyses 36 Swiss insurance and reinsurance companies and AM Best analyses 37 companies). The regulator does not make any systematic use of ratings in the regulatory process, in practice little disclosure is given. There is no mechanism in Switzerland which feeds back to the market any regulatory grading either implicitly or explicitly.

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6 The rationale with regard to supervisory parameters

6.1 Scope

In accordance with the Terms of Reference, this chapter examines 'the rationale with regard to supervisory parameters such as:

- the examination of the adequacy and spread of reinsurance arrangements at the level of the primary insurer, the admissibility of reinsurance assets for the primary insurer, etc.;

- licensing or registration;

- fit and proper criteria, notification of managers and shareholders at specified levels, adequacy of technical provisions, assets, solvency margin, the importance of maximum exposure techniques for risk monitoring by the reinsurer, the possible use of rating agencies;

- on site inspections.

The study should examine the broad impact and relevance of different accounting practices, reporting and disclosure requirements (including nature and frequency). The study should comment on the relative importance and feasibility of supervising the parameters in question and its practical implementation with regard to EU and non-EU registered reinsurers".

6.2 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 number of interviews with reinsurers;

■ Reviews of existing published sources.

6.3 Extent of supervision

6.3.1 No supervision or self regulation

In a fully liberalised system with free reinsurance trade between domestic insurance companies and domestic/foreign reinsurers, insurers are free to choose their reinsurers and are responsible for their business.

A minimal control supplemented by self-regulation, in practice, means that reinsurers capable of self-regulation are allowed considerable freedom in carrying out their business, with a minimum of interference from the authorities. In self-regulation, the rules are drafted by market participants with an intimate knowledge of the market who are best placed to maximize the effectiveness of regulation while minimizing the business costs

Free reinsurance trade between insurers and reinsurers offers the advantage of high flexibility for the spreading of risk among reinsurers and makes it easier for participants to respond to market needs. Advocates of such a system argue that supervision can create an inequality in the market which may influence effective competition.

The absence of any supervision may lead to the use of low-quality reinsurers, affecting the solvency of insurance companies and may affect transparency of the market and overall stability. The majority of EU members support supervision since they do not want insurers to obtain poor quality reinsurance. In addition the reinsurance market is becoming more risky with for example the rising number of captive reinsurance undertakings or the growing concentration of risks, so greater protection seems to be required for reinsurers. As the global economy continues to grow, the need for stable and secure reinsurance will grow with it.

Some in the reinsurance industry state that there is no justification for detailed state supervision in a wholesale business such as reinsurance. Commercial insurers and reinsurers deal with other professional corporations, business to business. These

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corporations do not need special protection. The insurance companies are well equipped to distinguish honest and well-capitalised business partners from dubious and financially weak reinsurers.

They argue that the objective of reinsurance regulation is unclear. The objective of insurance policyholder protection would not be achieved by regulating reinsurance. The cases of insolvency of reinsurance companies are rare and no insurance company has become insolvent as a result of the insolvency of a reinsurer. Most reinsurance insolvencies have occurred in regulated markets. Reinsurance is an economic asset. It enables a wider spread of risk, which enables direct insurers to write more business. Any disruptive regulation that hampers the supply of reinsurance capacity would have a negative impact on insurance policyholders, as insurance companies will provide less capacity as a consequence. Any heavy-handed reinsurance regulation would be ineffective and disruptive. The reinsurance market has become very innovative in recent years, so that a special difficulty of regulation will be keeping regulators educated on the new types of products.

In summary, it can be said that opponents of the self regulated reinsurance market are driven by the fear of insolvencies of reinsurance companies, because of the complexity of the business. Unregulated markets have shown in the past that the inherent risk does not seem to be higher than in regulated markets. There is also no evidence that cedants all over the world consider risk in these markets higher. Our analysis did not show that self regulated companies have an inferior market position or have to accept lower premiums.

6.3.2 Limited or comprehensive supervision

A comprehensive direct supervision system generally involves financial supervision and on-going control.

Limited supervision involves the application of only some elements of the direct insurance supervisory system to reinsurers.

In a rapidly changing reinsurance world and reinsurance market dynamics, it may become increasingly difficult for a primary insurer to assess the reinsurer's security. If the reinsurers are directly supervised, the supervisor will be concerned about reinsurance in comparison with other innovative financial arrangements and will monitor the financial position of the reinsurer1. On the other hand, it may be difficult, if not impossible, for supervisors to take full responsibility for assessing the reinsurers' security. However, the supervisor faces the same difficulties of a rapidly changing market and is not even a market participant.

It is argued that reinsurance is becoming more prevalent while at the same time the scope of the risks covered is continuously growing and hence the potential for losses is rapidly increasing, and the number of captive reinsurance undertakings is rising. Such evolution means that more prudence is required and that indirect supervision may be insufficient. Others argue that direct supervision is too strict and should be reserved for new market players, for which evaluation is not yet established.

In a direct supervision system, the reinsurer has to submit financial information to the supervisory authorities. The supervisor may have more information and more capacity than a ceding insurer (in indirect supervision) to assess a reinsurer's security. Requirements set by the regulator on capital adequacy or admissibility of investments may be stricter and take into account fuller information than that provided to a ceding insurer, so that the regulator can make a broader and deeper assessment.

Many countries consider it an advantage that reinsurance supervision is done in the same form and detail as for direct insurers. Generally, at least some of the elements of insurance supervision are used for reinsurance companies. Another advantage is that it is relatively easy to implement a system based on the rules already applied to direct insurance.

However, some state that the current regulatory regime for direct insurers cannot simply be applied in its entirety to the reinsurance sector. There are key differences between the regulation of retail and wholesale markets.

Reinsurance is a business conducted between sophisticated parties of essentially equal bargaining power. Companies buying reinsurance policies do not need the same kind of protection as private

1 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles, standard and practices, February 2000

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policyholders. Models for supervision which are appropriate for insurance companies do not fit the special character of reinsurance business, especially as reinsurance business is more international than insurance business.

Some aspects require special consideration such as the correct level of technical reserves for a reinsurer and its calculation and accounting or the necessity of different solvency margins and separation of funds for entities carrying on both direct and reinsurance business.

Such an approach requires extra resources to enforce the rules which means the supervisory costs are higher than under a system of indirect supervision.

The IAIS notes that an insurance supervisor may encounter problems in exercising the supervision of both the insurer and the reinsurer in that it may have a conflict of interest concerning the confidentiality of information received.

In the United Kingdom, some associations, like the International Underwriting Association of London (IUA), argue that the information currently required is not as appropriate to the supervision of reinsurers as it is to the supervision of primary insurers. Less information could be demanded in terms of quantity than is required of the primary sector insurers. More appropriate key data could be provided by reinsurers earlier in the process than at the present time. The regulator could also aim to promote high standards and best practice by establishing benchmarks and issuing guidance notes on issues such as off-balance sheet items or reinsurance credit risk.

To conclude, advocates of regulation are motivated solely by the need to prevent insolvencies. If direct supervision is chosen as a general system, it can fulfil its objective only if the regulating authority has knowledge and capacity to follow the rapidly changing variety of products and can cover the whole (global) business of a professional reinsurer. The experience of the past has shown that insolvencies of reinsurance companies occurred infrequently and have been more common in regulated markets. Reliance on regulation can stop direct insurers from taking full responsibility for choosing the right partner for retrocession.

6.4 Overview of supervisory parameters

6.4.1 Direct and indirect supervision

There are two levels at which supervision can be applied to reinsurance business: direct supervision and indirect supervision. Indirect supervision, which focuses on the reinsurance arrangements of the direct insurer, is aimed at protecting policyholders against the risk of a direct insurer defaulting as a result of a failure in its reinsurance protection. The primary purpose of direct supervision of reinsurance companies is to maintain confidence in a country's reinsurance market. The fact that those jurisdictions which do regulate reinsurers do not prohibit direct insurers from placing cover with unregulated reinsurers indicates that they do not consider direct supervision of reinsurance to be a pre-requisite for the protection of policyholders, although clearly any rules which serve to promote the secure operation of reinsurers should in turn enhance the security of direct insurers and thereby indirectly improve the protection of individual policyholders.

Direct and indirect supervision therefore have distinct purposes. It follows that it is possible for a jurisdiction to have either or both direct and indirect supervision. Direct and indirect supervision are not alternatives to each other.

Indirect supervision was recommended by the OECD in 1998 in its "Recommendation of the Council on assessment of reinsurance companies".

6.4.2 Classification of parameters2

6.4.2.1 Parameters relating to direct supervision

The principal parameters relating to direct supervision, grouped by the IAIS insurance core principles, are as follows:

■ licensing:

2 This section mainly follows the IAIS Core Principles and the supervisory parameters associated with each principle. (cf. IAIS Insurance Core Principles, October 2000) The classification of the IAIS Core Principles has slightly been modified in some cases, e.g. derivatives have been considered together with assets.

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- fit and proper criteria for management;

- review of business plan;

■ passport systems:

■ changes in control;

■ corporate governance;

■ internal controls and risk management;

■ prudential rules on assets:

- diversification requirements;

- restrictions on asset types;

- asset valuation rules;

- matching rules;

■ prudential rules on liabilities:

- liability valuation rules and restrictions on discounting;

- rules on methods to be used;

- certification by loss reserving specialist;

■ capital adequacy and solvency:

- solvency margins;

- resilience and scenario testing;

- equalisation and catastrophe provisions;

■ financial reporting;

■ on-site inspection:

inspection by the supervisor;

inspection by third parties, such as auditors.

6.4.2.2 Parameters relating to indirect supervision

Principle 10 of the IAIS Core Principles relates to reinsurance which requires insurance supervisors to be "able to review reinsurance arrangements, to assess the degree of reliance placed on these arrangements and to determine the appropriateness of such reliance"23. In other words, this principle relates to indirect supervision. The principal parameters relating to indirect supervision are:

■ direct review of reinsurance programme;

■ limits on maximum exposures;

■ admissibility of reinsurance assets for the primary insurer;

■ collateral requirements;

■ diversification requirements;

■ use of rating agencies;

■ restrictions on use of non-regulated reinsurers;

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■ restrictions on use of "unapproved reinsurers".

6.5 Parameters relating to direct supervision

6.5.1 Licensing

6.5.1.1 General features of a licensing system

According to the IAIS Licensing Handbook the term "licence" is understood as the authority for a company to carry on insurance business, based on contracts between policyholders and the company, provided the company is subject to supervision by the competent authorities. In the Directives "authorisation" is used with the corresponding meaning.

It is clear that such a definition must be suitably adapted to reinsurance. Certain amendments would have to be made in order to reflect the fact that there is no direct link between the reinsurer and the policyholder.

23 ibid paragraph 21

By requiring the licensing of reinsurers, according to the IAIS, supervisors would obtain:

■ an overview of the companies engaged in reinsurance in a country (e.g. to control activities in money laundering);

■ assurance that minimum capital and management requirements are met;

■ direct access to any information regarding the reinsurance business.

A licensing system would have to be adapted for reinsurance companies wanting to do reinsurance business. Existing entities would need to fulfil licensing requirements in order to continue carrying on reinsurance business. Traditionally in direct insurance the granting of a licence means that the supervisor has performed a thorough examination of the insurance undertaking. If the licensing is not granted or is revoked the company can no longer carry on reinsurance business.

Licensing in general plays an important role in ensuring efficiency and stability in the market. Strict conditions governing the formal approval of insurance companies are necessary to protect insurance users. The licensing process may also help ensure that fair competition exists among companies in the market.

Requirements are preconditions for granting a licence and must be met at all times during the on-going business operations. It is necessary to consider the licensing requirements applied to insurance companies to see if they can be adapted to reinsurance companies. They are as follows (according to Supervisory Standard on Licensing from the IAIS):

■ legal form and head office of the company;

■ objective of the company;

■ minimum capital;

■ fit and proper criteria for directors and/or senior management;

■ control of shareholders;

■ affiliation contracts and outsourcing;

■ product control (general policy conditions, technical bases for the calculation of premium rates and provisions);

■ articles of incorporation;

■ actuaries and auditors.

The withdrawal of the licence creates a clear legal situation and improves transparency of the market. The supervisor needs to have at its disposal the right to withdraw the licence. As a legal

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consequence of this withdrawal, the reinsurance company is no longer permitted to carry on reinsurance business. It gives a clear mandate to the supervisor to remove unsuitable companies from the market.

In this system, cedants are better able to judge their reinsurers, as they are submitted to a minimum level of requirements. But on the other hand, there is the "moral hazard" that the cedant may place too much reliance on the fact that the reinsurer is licensed and controlled by the supervisor. Supervision of reinsurers by the regulator should not exempt the direct insurer from establishing its own controls over reinsurer's security.

It is also argued that licensing is not a standard in itself, but rather a sanction mechanism to enforce the standards. If direct insurers were obliged to do business only with reinsurers that fulfil certain standards, the objectives could also be achieved through indirect supervision.

Furthermore, introducing a licensing system in a previously non or less regulated sector could be difficult to implement. It might be difficult to require existing companies which do not meet the regulatory requirements to cease activities. A system of licensing brings additional costs of implementation and administration, such as the cost of the authorisation procedure.

In European countries where a licence is needed for reinsurance companies, generally the rules used are the same as for direct insurers. In some countries, in the case of life business there are minor differences between the solvency requirements for direct and reinsurance business.

The advantage of a licensing system is that it is the maximum protection for the insurance industry that regulation can provide. On the other hand, it represents the maximum intervention in the market. The question is, whether the aims of a licensing system can be achieved via a passport system without affecting the market mechanism. The market will probably punish companies without a passport, so that the effect strived for is reached in either case.

A licensing system within the EU may affect competition in the global reinsurance market and relations with Non-EU countries and off-shore locations have to be considered. If the licensing system is implemented this disadvantage will have to be compensated by additional benefits.

6.5.1.2 Fit and proper criteria for management and controllers

The main objective of such criteria is to assess whether reinsurance entities are soundly and prudently managed and directed and that their key functionaries (directors, managers, shareholders and other who exercise a material or controlling influence over the affairs of the reinsurance entity) do not pose a risk to the interests of present and future cedants of these entities3.

The criteria could cover the following persons, as proposed by the Australian Regulation Authority:

- directors, in the case of a locally incorporated reinsurer;

- senior management;

- the approved auditor;

- the approved valuation actuary, where relevant;

- the agent, in the case of a branch; and

- other key staff, who are responsible for important decisions.

The supervisor must monitor compliance with the standards on an ongoing basis. A person is fit and proper if that person has:

- never been convicted of an offence under national or foreign law in respect of conduct relating to a financial institution or conduct relating to dishonesty;

3 IAIS Fit and Proper Principles

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- never been bankrupt, applied to take the benefit of the law for the relief of bankrupt or insolvency debtors or compounded with the person's creditors;

- formal qualifications, including membership of professional associations and bodies and the nature of binding professional codes of conduct and enforcement of these within the professional body;

- no potential conflicts of interest;

- a business track record and appropriate experience;

- demonstrated competence in the conduct of business duties;

- demonstrated integrity in the conduct of business activities;

- a good reputation within the business and financial community.

Each reinsurer should provide the regulator with details of those persons acting in the key positions and notify immediately if a person to whom this standard applies no longer complies with the tests of fitness and propriety.

The demonstration of business competencies for management is a complex requirement, especially for reinsurance. The business is heterogeneous so it is necessary that, as a minimum, any head of a department has specialist knowledge of the segment. The international nature of the reinsurance business makes it even more complex. For example, the underwriting of life business differs totally from that of a typhoon risk in Japan.

Some of the EU members use these criteria in the supervision of reinsurers. Generally fit and proper requirements apply exactly as for direct business, including the need to report changes in the management. The same criteria for insurance companies seem to be appropriate for reinsurers.

Fraud prevention could be supported by developing fit and proper testing instruments. When reinsurers are subjected to direct supervision the same fit and proper requirements would apply. In the case of a non-licensed reinsurer, fit and proper testing would need special attention. It would be helpful to have more structured information available about the fitness and propriety of the management of reinsurers4.

From the IAIS point of view, fit and proper testing is important. The reinsurer's activity is essential in the comprehensive chain of risk spread and reduction sought by the insurer. Therefore, fit and proper testing should be applicable to all management activities in the risk spreading process beyond the primary insurance sector, including the reinsurance sector.

There is a wide agreement in the insurance industry that members of the board of directors in an insurance company, direct insurer or professional reinsurer, should have an appropriate qualification based on theoretical and practical knowledge and experience and be personally liable. This is based on recognition that failures of insurance companies can arise from bad management, criminal activities and lack of resistance to shareholders' pressures.

The first EU Council Directives provide that the home member state shall require every insurance company for which authorisation is sought to "be effectively run by persons of good repute with the appropriate professional qualifications or experience". These Directives only relate to direct insurers. However, there is a general acceptance that professional reinsurers should also be expected to meet such requirements.

Regarding the persons who have to meet these requirements, these might be any director, controller manager or main agent of the reinsurer, as provided by the UK Insurance Companies Act, or as proposed by the CEA restricted to the members of the board of management, since they manage the company and have the prime responsibility and power to do so.

Professional reinsurers cover the whole insurance market which is heterogeneous. It will always be necessary to have sufficient underwriting expertise in every area covered.

6.5.1.3 Review of business plan

4 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles, standards and practices, February 2000

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Before granting authorisation, insurance supervisors invariably obtain a business plan, in a specified format, from the entity applying for a licence to undertake insurance business. (This requirement in enshrined in the EU insurance directives and is applied by those jurisdictions which regulate reinsurance companies.) In the EU, the requirement to submit a business plan applies only prior to authorisation. Once authorisation is obtained there is no general requirement for an insurer to submit subsequent business plans although supervisors might require plans if there are special circumstances.

This information may help the regulator to:

■ form an initial assessment of the adequacy of the capital and reinsurance arrangements of the proposed operations;

■ monitor actual business volumes and profitability against what was envisaged at the point of authorisation;

■ identify particular risk areas, such as outsourcing arrangements.

Moreover, in discussing the plans with the applicant, the regulator can form a view of the extent to which management is aware of the company's regulatory obligations.

If subsequently business volumes are higher than those in the plan, the regulator can intervene to require the company to inject further capital.

It would be relatively easy to introduce such a requirement for reinsurance companies across the EU. The costs of complying with such a requirement would not be material. The value to the regulator of such a requirement is however to be questioned, because it could not assist in assessing the reinsurer's security.

6.5.2 Passport System

Instead of a licensing system, the CEA proposed in May 2000 a passport system. In this system, undertakings may choose to adhere to the system or to remain outside it.

It aims to establish an EU model for reinsurance supervision and to promote more efficient cross-border trade in the reinsurance sector through increased security and through the elimination of statutory trust fund requirements.

A passport system would replace supplementary supervision for reinsurance companies in the host country, or let their cedants enjoy certain benefits linked to the passported status of the reinsurer.

The CEA proposed a passport applied to professional reinsurers. The IAIS has produced a recommendation which stated that the passport could be applied to professional reinsurers, underwriting associations and direct insurers accepting reinsurance.

The existing entity must fulfil certain requirements to receive a single passport or in order to receive some advantages linked to the system. If the passport is not given or is revoked the entity can continue to do reinsurance business, but will not enjoy advantages linked to the system.

The passport could take the form of a standard document which would confirm that the company meets the requirements. The respective supervisors would have to be able to check these requirements, to pass on the results of the checks to the home market and other markets, and to withdraw the document if the requirements were no longer met.

The standards set must be adequate. Each country of origin would have to impose similar minimum core requirements before granting approval to companies seeking to do business in other participating countries. Major aspects that could be included in a possible EU framework for reinsurance supervision, which are proposed by the CEA or the IAIS; are as follows:

■ legal form requirement;

■ corporate governance issues: "fit and proper" requirement;

■ shareholder control;

■ operating/business plan, for authorisation; (IAIS only)

■ financial and supervisory reporting (on at least an annual basis);

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■ technical provisions appropriate and adequate;

■ prudent solvency requirements;

■ investment rules; (IAIS only)

■ powers of intervention for supervisors;

■ supervisory intervention in cases of reinsurers in difficulty - withdrawal.

Under a mutual recognition scheme, the regulator in each participating country recognises companies approved by the regulators from the other participating countries, which could enable reinsurers to trade freely in the geographical area of mutual recognition.

As argued by the IUA, the objective for a European passport could be to attain mutual recognition with the equivalent North-American system. Such a system would leave companies the choice of whether they would like to adhere to the system or not. But the position of the supervisor would be weaker as compared with a licensing system, as supervisors would not have the option of removing unsuitable companies from the reinsurance market. If a company did not fulfil the essential solvency requirements, the supervisor could revoke the passport but not stop the business. In practice, there would be probably no insurance company that would cede business to such a reinsurer.

If licensing systems are in place in certain countries, it would be seen illogical to replace them with a passport system, and some in the industry argue that such system could entail extensive additional requirements which would create additional costs. The system could also result in an obligation for foreign reinsurers to make security deposits for reinsurance companies which would not have the passport.

Many US reinsurance associations argue that a mutual recognition system between EU countries and the US is premature. For them the proposal would represent a decrease in the level of such security within the US, although it could represent an improvement with respect to the security of reinsurance recoverables as compared to the level where they currently exist in certain EU countries. As US reinsurers are not afforded a single passport within the US it would place them at a competitive disadvantage as compared to non-US reinsurers.

The US reinsurance industry disagrees that current practices such as trust fund requirements or tax restrictions constitute major obstacles in reinsurance and asserts that both requirements do nothing more than contribute to a level playing field among US reinsurers and non US reinsurers. Regarding excise tax, the US has entered into treaties with a number of countries (such as France, Italy, UK, Germany) waiving the collection of insurance excise tax. According to the US reinsurance industry, trust fund requirements are not imposed on a "compulsory basis". If a non-US reinsurer wants to do business in the US, without subjecting itself to the full scope of US regulatory laws imposed upon US reinsurers (creation of a licensed affiliate or licensing a branch), the non-US reinsurer must secure its obligation so that US regulators need not be concerned with its financial status or the level of regulation of its place of domicile, but remain confident that it will meet its US obligations while it is solvent or in the event that it becomes insolvent. This strong position is criticised in the European Union.

Some of the German interviewees mentioned that the US deposit requirements are only relevant for new reinsurers intending to enter into the market; the established reinsurers have already met the US requirements by establishing a US subsidiary which is subject to supervision in the US.

The major argument against a passport system is that regulation cannot displace companies from the market after the withdrawal of the passport. The reinsurance market is globally considered as a working market mechanism, so that a passport probably will be established as a standard, like ratings in the past. The withdrawal of a passport will therefore, even more than not applying for a passport, cause market reactions resulting in the possibility of reduced business volume.

The idea of the single passport system is already included in the proposal for a Directive of the European Parliament and the Council on the activities of institutions of occupational retirement provisions (COM(2000)507final) of 11 October 2000. National regulations on licensing and supervision remain unaffected by this directive.

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6.5.3 Changes in control

In insurance business, as defined by the IAIS, the insurance supervisor should require the purchaser or the licensed insurance company to provide notification of the change in control and/or seek approval of the proposed change; the supervisor should establish criteria to assess the appropriateness of the change, which could include the assessment of the suitability of the new owners as well as any new directors and senior managers, and the soundness of any new business plan.

For many countries, where a licensing system exists, the rules applied for reinsurers are the same as for direct insurers. In some countries an approval is required when there are changes in management in reinsurance companies.

As pointed out by the CEA, there is an agreement within the industry that a reinsurer's group structure should be transparent, which means that major shareholders of the reinsurer should be disclosed. Shareholders who have controlling interests should be able and sufficiently qualified to promote a sound and prudent management of the reinsurer. The qualification of the shareholders is to be presumed if the managerial team meet the requirements of diligence as well as competence and personal qualification.

6.5.4 Corporate governance

EU insurers and reinsurers already have to operate within the corporate governance regimes that apply to the generality of companies and these vary from country to country. For example, some countries (for example Germany and the Netherlands) require two tier boards, one executive, one non-executive. In the UK, it is considered best practice for boards to consist of both executive and non-executive directors, although there is no binding requirement for companies to adopt such a structure.

In general, EU insurance regulators do not impose explicit corporate governance requirements although it is implicit in the fit and proper requirements that the board will contain individuals capable of carrying out all the necessary roles.

The fit and proper requirements could be bolstered by requiring companies to document the responsibilities of individual directors and senior managers and to provide the regulator with these details. The rationale for such a requirement is that it makes the individuals concerned pay greater regard to their regulatory responsibilities.

In addition, if not already a requirement of general corporate law, insurance supervisors could require boards to adopt explicit policies on the following5:

■ the corporate governance principles of the undertaking;

■ the company's strategic objectives;

■ the means of attaining those objectives and evaluating progress towards those objectives;

■ board structure and appointment procedures;

■ division of responsibilities;

■ risk management functions;

■ external audit and internal control procedures.

Given the existing variety of corporate governance regimes, it would be difficult to introduce a set of comprehensive harmonised rules on corporate governance for reinsurance companies. However, a requirement for reinsurers to document senior management responsibilities could be introduced without involving significant effort by companies.

6.5.5 Internal controls and risk management

The need for reinsurance companies to operate adequate systems of internal control is self-evident. There are a number of approaches that supervisors can take to monitoring the adequacy of internal controls systems:

5 These areas are based on the IAIS's Core Principles Methodology approved in October 2000.

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■ requiring directors to produce a certificate that internal controls are adequate;

■ issuing guidance notes on the adequacy of controls and requiring directors to report any areas of non-compliance with the guidance notes;

■ requiring external auditors routinely to report on the adequacy of internal controls;

■ using external accountants to carry out specific internal control reviews;

■ carrying out audits of internal controls themselves.

The objective of all these parameters is to ensure that companies have adequate controls in place and that the controls are properly operated.

A requirement for directors to produce a certificate on control adequacy could readily be applied to reinsurers and, given that reinsurers should already have adequate controls in place, should not introduce any additional regulatory burden. However, such certificates give only limited comfort to supervisors.

Reinsurance is a complex business with exposure to a wide range of operational and financial risks. The reinsurance market is international with a great deal of cross-border activity. Risks assumed are more complex due to the diversity of reinsurance contracts. There is rapid product innovation with the growth of more novel form of risk transfer. Reinsurance assumes large exposures to catastrophes. Reinsurance being a global business, exposures may arise in many jurisdictions increasing the degree of legal risk to the reinsurer.

In these conditions, it is essential for reinsurance to have appropriate administrative systems and adequate internal control.

The risk management and internal control systems have to be adequate and appropriate for monitoring and limiting risk. This includes, in particular, the development, implementation and maintenance of adequate and appropriate policies and procedures for monitoring and managing:

Underwriting riskRetrocessionsCredit risk

✓ Investment risk✓ Globalised risk portfolio✓ Currency risk✓ Timing risk

New approaches to risk management include stress testing and dynamic financial analysis. These new approaches take an integrated view of market and reinsurance risks. Alternative risk transfer is also being increasingly used as a risk management tool and should be taken into account by regulators in understanding the implications and formulating appropriate regulations.

Annual dynamic analysis reports (used in the US) model the impact on future financial condition of various adverse developments with regard to both assets and liabilities. The model takes account of factors such as investment losses or market value decreases, falls in the level of investment income, and a variety of other factors affecting profitability of the business such as claims, lapse rates and expense levels.

The internal model that many insurance and reinsurance companies are developing to manage risk exposure, to allocate their capital efficiently and to provide management with tools for business decisions, could be used by supervisors to analyse relevant information (Further developments are given in chapter 8).

If supervision is considered necessary, supervisors need to review the adequacy and appropriateness of reinsurers' risk management policies and procedures. Risk measurement methods, risk management processes and strategic asset allocation should be disclosed to the supervising authority.

Generally there is a trend towards improvement of risk management systems. This affects the reinsurance industry as well. We did not recognise any differences between markets where the supervisory authority monitors risk management and others.

6.5.6 Prudential rules on assets

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6.5.6.1 Diversification requirements

Diversification requirements can operate at two levels. One is to require companies to avoid a concentration in any one type of investment. Thus a company can be prohibited from investing more than a certain percentage of its investments admissible for solvency purposes in property or equities. The other is to prevent companies from investing more than a specified percentage of their investments in any one entity.

Reinsurance companies in jurisdictions which regulate reinsurers are already subject to such requirements. In general the investment strategies of reinsurance companies are not fundamentally different from those of direct insurers and it seems unlikely that reinsurance companies would have to change their investment approach to comply with the introduction of admissibility limits.

On the other hand, it is unclear whether it is necessary to have specific rules enshrined in legislation to ensure that reinsurance companies appropriately diversify their investments. A general requirement for companies to avoid undue concentrations, backed up by reporting requirements which enabled supervisors to identify high concentrations, would be simpler and could be equally effective.

6.5.6.2 Restrictions on asset types

The basic objective of restricting companies from investing in certain asset types is to prevent insurance undertakings from investing in illiquid or volatile assets. However, in the case of derivative instruments, there is the additional objective of preventing companies from taking on additional risks which may not be evident to the regulators.

As with admissibility limits, the rules could be extended to reinsurance companies but, as with diversification requirements, it is unclear whether detailed rules are strictly necessary. The reinsurance industry argues that reinsurers should have the freedom to manage their investments in accordance with their business and investment plans. Provided that investments are properly valued and disclosed, it is unclear that it is necessary to have such restrictions. Such rules can have the adverse consequence of preventing reinsurers from entering into innovative investment arrangements which may give a better return than conventional investments or provide a better matching of liabilities.

Regarding new risk transfer products, the supervisor should take into account their growing use. Disclosure of these products should be enhanced to achieve sufficient transparency. The accounting and valuation should properly reflect all possible commitments and rights. Solvency requirements should take the characteristics of these products fully into account.

6.5.6.3 Asset valuation rules

Reinsurance companies are, of course, already subject to the general accounting requirements, whether regulated or not. Basic valuation principles vary between EU countries, some stipulating the market value principle, others the historic cost principle. Where investments are shown at the lower of historic cost and market value in the financial statements, the market value has to be disclosed in the notes.

Supervisors can supplement the basic accounting rules by:

■ specifying more detailed valuation rules for particular asset classes;

■ eliminating optional treatments that are available under general accounting rules.

There are a number of reasons for imposing additional requirements:

■ more specific rules and fewer options mean that the balance sheets of reinsurance companies are more readily comparable with each other. This assists both supervisors and direct insurance companies in assessing the relative financial strength of different reinsurance companies.

■ it ensures that the assets are valued in a way consistent with the rationale behind any solvency margin requirements.

■ it reduces the risk that companies will place an inappropriately high valuation on assets where it is not easy to establish a market value.

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There is a strong case for subjecting reinsurance companies to more specific asset valuation rules regardless of whether reinsurers are subject to regulation. Indeed, if reinsurers are not regulated it is more important that direct insurers and their supervisors are able to assess accurately the financial strength of reinsurers.

Where there are harmonised solvency margin requirements, it is illogical to permit different asset valuation rules. For example, if the appropriate minimum solvency margin for a company which values its assets at historical cost is 20% of premium income, it will clearly be necessary for a company which values its assets at market value to be subject to a higher percentage of premium income.

Valuation rules are already applied to all direct EU insurers and regulated reinsurers and, since reinsurers' investment strategies are not different in principle from those of direct insurers, there is no reason why they should not be extended to reinsurance companies. Moreover, such a requirement could be introduced even if reinsurers were not subject to full regulation.

6.5.6.4 Matching rules

Supervisors can require insurers to reduce their mismatch risk by requiring them to match assets and liabilities. Examples of such requirements are:

■ requiring companies to match foreign currency liabilities with assets in that currency and to ensure the holding of sufficient assets of appropriate nature, term and liquidity to enable the company to meet insurance liabilities as they become due;

■ requiring life companies to match linked liabilities with the same assets as are used to determine the unit price.

Currency matching is a much more difficult issue for reinsurers since in many cases they will not be certain precisely in which currency a liability might arise and, in addition, will typically face liabilities in many more different currencies than a direct insurer.

In recent years, insurers and reinsurers have developed increasingly sophisticated techniques for matching assets and liabilities to reduce the overall level of risk. The introduction of rigid matching rules could adversely affect the development of these techniques.

An alternative approach might be to require reinsurers to disclose in their published financial statements the techniques they use to match their investments to their liabilities. Such an approach would be simple to implement and should not be onerous.

6.5.7 Prudential rules on liabilities

The rationale for prudential rules on liabilities is two-fold. In the first instance, the regulator wishes to ensure that insurers use appropriate techniques to determine accurately what their true liabilities are; and secondly to ensure that insurers retain sufficient funds to meet these liabilities.

6.5.7.1 Liability valuation rules and restrictions on discounting

In principle, it is possible for regulators to specify rules on:

■ the discount rate (if any) to be applied to liabilities to allow for the investment return on technical provisions;

■ the extent to which future expenses need to be taken into account;

■ the extent to which future premiums (or premium margins) can be taken into account;

■ the basis for recognising premium income (i.e. the basis for calculating unearned premiums and unexpired risks);

■ the extent to which acquisition costs should be deferred.

For life business the amount of uncertainty related to underwriting risk is relatively small and the existence of rules on such matters as the discount rate to be used, the extent to which future premiums can be taken into account, and the allowance to be made for

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future expenses can mean that technical provisions will be broadly comparable from company to company.

The position for non-life business is different in that the uncertainty surrounding the amount and timing of claims will often be significant, with the effect that differences in assumptions on discounting and expenses will have a relatively minor effect on the level of provisions.

The purpose of many valuation rules, such as the restriction on discounting non-life outstanding claims, is to ensure that the estimate of liabilities is conservative. These rules therefore act as a supplement to the solvency margin requirements.

Valuation rules could also be used to improve comparability between companies and to ensure that the basis of calculating liabilities is consistent with the rationale of the solvency margin calculation. At present, there are considerable disparities between companies in the strength of their provisions. In particular, there is a wide divergence of practice regarding the confidence level that should be aimed for when establishing non-life provisions. One approach is to set the provisions at a "best estimate", i.e. a provision where the probability that claims will be greater than estimated is the same as the probability that they will be less than estimated. Another approach is to make a provision which will be adequate in all reasonably foreseeable circumstances. It is unclear how this test could be quantified as a confidence level, but it might be equated with a 95% probability that the actual claims will be no greater than those estimated.

Although it may be difficult in practice to quantify the confidence level that can be attached to a particular level of provision, there is no reason why regulations should not seek to harmonise the level which reinsurers should aim at.

As with the asset valuation rules, any requirements imposed by the insurance supervisor will overlay the existing general accounting requirements. Moreover, like asset valuation rules, liability valuation rules could be introduced without necessarily subjecting reinsurers to further regulation.

6.5.7.2 Rules on methods to be used

An adequate level of technical provisions ensures that the company is able to meet its obligations at any time. All of the insurance industry agrees that an insurer's technical provisions should be appropriate and adequate. It should be the same for reinsurer's technical provisions.

As referred to in the European Directive for insurers, the amount of technical provisions must at all times be such that an undertaking can meet all liabilities arising out of insurance contracts as far as can reasonably be foreseen. Any assessment of the adequacy of a reinsurer's technical provisions should have this definition as a basis. In addition, the special features of reinsurance business could be taken into account in respect of:

■ underwriting risk;

■ credit risk;

■ currency risk;

■ investment risk;

■ timing risk;

■ globalised risk portfolio.

It should establish methods of control for ensuring the adequacy of technical provisions, based on the best actuarial methods used by reinsurers (see also chapter 9). Usually the methods are similar to those applied to direct insurance business and in some cases are identical, as in the case of proportional reinsurance.

Monitoring of technical provisions is an important point for supervision of reinsurers as information provided to the reinsurer is of lower quality than information available to direct insurers. The reinsurer depends on reports from the direct insurer which usually do not include the historical information related to the reinsurer's portfolio. For non-proportional business, provisions for IBNR claims might not be reported. Because of the international nature of the business, the reinsurer has to take into account the

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international different accounting policies for reserving, for example there are countries where claims provisions are discounted. Therefore, it is essential for a professional reinsurer to do a reserve analysis based on its own portfolio including a calculation for IBNR reserving.

Some associations, such as the CEA, consider that there should be an additional standard whereby the respective home supervisory authorities would be obliged to check the global adequacy of the technical provisions and would need to have the necessary powers to perform these checks.

Generally, the regulatory returns regarding the level of technical provisions required by supervision authorities are in the same form and level of detail as for direct insurers. However, in some cases, such as in Switzerland, the rules on calculation and evaluation of technical provisions for direct insurers do not apply to reinsurers.

Property and casualty provisions are in practice calculated using actuarial projection techniques using paid and incurred loss development triangles.

Life provisions are calculated using actuarial analysis under the policy premium method, whereby all anticipated future cash inflows and outflows from a policy are estimated and adjusted to present value, with appropriate margins for adverse deviation, to arrive at the provision for future policy benefits.

Regarding non-life provisions, in some countries reinsurers are required to provide disclosure of the variability in estimates from prior years claims, which many provide by showing data on the over and under provision adjustments made in the current year's income from prior year's reserves. In addition, schedules showing run-off by accident year are required in the statutory return filed with the regulator only. Reinsurers have tended to provide little or no explanation for run-off results.

The effects of significant changes in actuarial assumptions are required to be quantified and disclosed in the accounts. Examples of these include changes in the interest rate environment, and changes in the policy lapse rate or similar actuarial assumptions.

A possible approach is to give the supervisor the authority to prescribe standards for establishing technical provisions and to verify the sufficiency of these provisions and to require them to be increased if necessary. Another possible approach is for reserving to be checked by the supervisory authority independently.

Given the differences that exist between the books of business of different reinsurers, it would be unlikely to be practical or appropriate to set rules on the methods of estimation to be used. Moreover, the stipulation of particular methods might inhibit the development of better techniques for estimating liabilities.

However, it would be feasible, and not particularly onerous, to require companies to disclose in their annual reports the types of techniques it uses to determine the liabilities of its principal classes of non-life business.

6.5.7.3 Certification by loss reserving specialist

Virtually all countries have a requirement for the life provisions of a direct insurer to be certified by a qualified actuary and in countries where reinsurers are supervised this requirement is extended to reinsurers. In practice, life reinsurers will almost certainly already be obtaining a report on their provisions from an actuary and the introduction of a regulatory requirement for reinsurers would be a codification of existing practice.

For example, in the UK, USA, Canada and Australia life reserves both for direct and reinsurers have to be certified by an actuary. Non-life reserves and DAC have to be certified by an actuary in Canada at present and in Singapore, Australia and Ireland in the near future. However, the appointed actuary in Canada is not required to be as independent as an auditor and commonly is an employee of the insurer or reinsurer, and therefore the external auditor needs to assess the work of the actuary in forming an opinion on the financial statements. Lloyd's of London for solvency purposes require an actuarial sign-off which includes a review of reinsurance security based on ratings produced by the rating agencies.

For non-life business, it would in principle be possible for supervisors to require companies to obtain a report from a loss reserving specialist on the adequacy of reserves. The rationale for such a requirement would be, that it could help in reducing the risk that

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the provisions may be understated in the financial statements. However it is questionable, whether the potential benefits would compensate for the additional corresponding costs.

Furthermore, there would be practical difficulties in introducing such a requirement in the EU either for direct insurance or reinsurance. Unlike the USA and Canada, there is not a large and well established non-life actuarial profession and in the short and medium term there would not be sufficient people with a recognised loss-reserving qualification to carry out the certification.

6.5.8 Capital adequacy and solvency

6.5.8.1 Statutory minimum solvency margin requirements

The adequacy of financial resources is one of the most important elements in controlling an insurer's and reinsurer's security. It ensures its ability to fulfil its commitments at any time. The assessment of solvency is a key tool for many regulators. Failure by a company to meet minimum capital or solvency requirements is a primary warning indicator for most regulators.

Elements of the current solvency system in the EU Directives could be used for reinsurers. However, it should be borne in mind that some of the actual methods used may not be efficient due to the complexity and international nature of reinsurance business.

Solvency requirements focus on the financial statements and even for direct insurers may lead to stronger requirements for prudent companies. Generally companies with a prudent reserving policy will need more investments to meet solvency rules although the risks they have assumed may not differ from those assumed by a company which has less prudent reserves. The technical provision for life business, for example has to be covered with investments. As this provision is discounted the amount decreases with any increase in the interest rate used. The economic risk for the company increases with the increase of the interest rate so that the solvency requirements develop reciprocally to the risk of the company.

In many EU countries the solvency system is considered inadequate. A far reaching financial risk model which is based on a general solvency theory and which could guarantee the financial position of insurers is not yet available. Due to the fact that the financial indicators are calculated from financial statements the judgement about the present solvency system is based on past, not forward-looking, information. Furthermore, the present solvency system does not take into account the asset management risk of non-life insurers. For life insurers the asset management risk is only addressed through the amount of the total investments and without examination of the different types of risks associated with the assets.

Part of the industry argues that standardised solvency requirements are easy to implement and monitor, but ignore the individual risk profile and risk management approach, are retrospectively oriented and exaggerate capital requirements and are only for companies unable or unwilling to develop an internal risk model.

Additional solvency requirements may be proposed, such as those which would relate to the investments to compensate for the assets risks. In non-life business special attention would have to be given to the possible inadequacy of long-tail business provisions. To assess the real risk volatility of a business some model, such as a risk-based capital model may be used.

The solvency calculations in many countries are based on the EU directives. One approach would be for the reinsurer to perform the same solvency calculation as a direct insurer.

The following methods are used to calculate the solvency margin:

First the amount of equity required as a safety margin is calculated based on defined, risk-weighted margin factors set by the regulator for each asset and liability, including off-balance sheet exposures; then this total required is divided into the amount of capital actually available to arrive at a definite ratio. The regulator requires an overall margin above a 100% ratio, which has been escalating in recent years, and pays more attention to companies below 150%.

An alternative approach is to define required assets as the book value of liabilities, plus a specified safety margin for claims and unearned premiums (the margins are increased if claims experience

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has been relatively high), and divided into the adjusted assets for the regulators ratio. Adjusted assets include investments at market value and exclude certain assets such as computer equipment. The regulator expects a margin of adjusted assets over the required amount of at least 10%.

Some countries, such as the UK, argue that, although solvency problems in a reinsurer affect the ultimate consumers of insurance only indirectly, the greater potential for volatility in the results of reinsurance business (especially non-proportional) suggests that a degree of supervision at least equal to that of direct insurance is appropriate. The EU Commission's current proposals for reform of direct insurers' solvency margin requirements include a proposal that a 50% uplift be applied to marine, aviation and general liability business. It may be appropriate for this, or a higher percentage, to be applied also to proportional reinsurance business of these classes and all non-proportional reinsurance business. This would reflect the following factors in such business: greater volatility, the effect of catastrophes, the longer tail nature of the claims run-off and the uncertainly in establishing technical provisions. However, we believe that this view does not reflect the diversification potential and other risk mitigation techniques of reinsurers.

Generally, the regulatory returns regarding the solvency margin required by supervisory authorities are in the same form and level of detail as for direct insurers. In some cases, as in Switzerland, there is no solvency requirement required by law for reinsurers, but the regulator applies a benchmark of 20% of net premium as a minimum equity requirement. In other cases, as in France, reinsurers are not required to prove their solvency position to the regulator. In Germany, although there is no statutory solvency margin requirement, the supervisor tries to ensure that reinsurers have a minimum capital of 10 per cent of net premiums. In the UK, the basic system of regulation is the same for reinsurers and direct companies, but some detailed provisions are different.

Solvency requirements change nowadays from a single company view to a view of the whole insurance group. Further developments are shown in the "Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision".

Risk-based capital methods could be technically justifiable, but for the regulator these methods are difficult to apply since they presuppose a strong knowledge of management control and of the risk portfolio of the reinsurer. Risk-based capital methods are discussed in more detail in the "Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision". A possible approach to supervision could be the definition of standards that have to be covered by the risk-based capital method. If these standards are not met the supervised companies have to demonstrate their solvency by the common method based on ratios.

6.5.8.2 Resilience and scenario testing

Resilience testing is well established for direct life business where companies are required to consider the impact of sharp falls in investment values and interest rates. Jurisdictions which regulate reinsurance companies also apply such tests to life reinsurance companies.

To date supervisors have not generally extended the principle of resilience testing to other areas; for example it could require companies to disclose the impact of a 10% adverse deviation from expected loss ratios or to require that the solvency margin was sufficient to withstand an adverse deviation of this magnitude. Resilience testing may represent an alternative approach to calculating minimum solvency requirements which avoids the inflexibility of formula-based approaches.

6.5.8.3 Equalisation and catastrophe provisions

EU regulation requires non-life direct insurers to establish equalisation provisions for credit business. Some member states have extended these requirements to other classes of business that are inherently volatile such as frost and hail. Catastrophe reinsurance business is similar in nature to these classes of direct business in that there are expected to be occasional years of heavy losses balancing most years when profits are made.

Equalisation provisions should be extended to reinsurance business. Reinsurance business often tends to be more volatile than direct insurance business for the reasons given in chapter 2. However, it is not the objective of equalisation provisions to smooth out volatility in general rather than to depict fairly the equalisation process over time taking place in the insurance business. Therefore, there is no higher need for an equalisation provision for reinsurance business than for direct insurance business.

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By contrast, the concept of catastrophe provisions is important with respect to the reinsurance business. Reinsurers are to a significantly higher extent exposed to catastrophe risks than direct insurers. They tend to build in the ability to take a major shock periodically and the capital needs to be adequate for this.

Concerning catastrophe risks, it is unlikely or it may even not be possible at all to diversify the different risks within a portfolio of contracts during a single accounting period, especially when the likelihood of occurrence of such risks is relatively low, but the volume of the potential cost of each of these risks is individually high. For example for earthquakes, the relevant extreme losses have return periods of about 200 years and these losses can arise out of only about 10 scenarios of comparable size. As a result, the typical insurance principle to balance losses within a large portfolio cannot be applied here. In such cases, it must be the aim to diversify the different risks over a period of time, i.e. the time span for covering claims expenses with revenue extends beyond a single accounting period into an unlimited period in the future.

The necessary coverage of the insured risks over time can only be achieved, if the risk premiums which are not used for claim expenses are carried forward to later accounting periods. It must be deemed that the insurance enterprise has an obligation at the reporting date.

6.5.9 Market conduct

Countries which regulate reinsurance companies do not subject them to their market conduct rules since they do not deal directly with members of the public.

6.5.10 Financial reporting

Reinsurance companies are already subject to the general requirement to produce annual accounts. Supervisors may also require more detailed information or for the reporting to be more frequent and to tighter timescales. The basic rationale for applying more stringent reporting requirements to insurance and reinsurance companies than the generality of companies is two-fold:

■ to enable the supervisor to assess the financial strength of the companies supervised; and

■ to enable buyers of insurance and reinsurance to assess the financial strength of potential providers of cover.

In addition, reporting assists the supervisor in monitoring compliance with other parameters, such as conformity with business plans, and diversification of investments.

It would be possible to introduce additional harmonised reporting without subjecting reinsurers to full direct supervision. There would, however, need to be sanctions which could be imposed on companies which failed to comply with the reporting requirements.

The present lack of an international method for accounting for the insurance and reinsurance sector may hinder the supervision of parameters at an EU and/or international level. There are different bases under which the assets and liabilities arising from insurance and reinsurance contracts are measured and reported and the results of such transactions are calculated (an overview is given in chapter 5). Although, under European legislation, an effort has been made to ensure that the accounts of member insurers and groups are prepared on a consistent basis, limitations already exist due to the wide range of options available under the legislation and a lack of harmonised guidance on the policies. A harmonised framework of accounting practices could promote greater comparability and transparency and provide relevant and reliable information to supervision authorities.

Uniformity in assessing the reinsurer's security will be essential to a world-wide acceptance of a system of reinsurance supervision, with converging supervisory principles and standards. This objective can only be achieved with harmonisation of the information on reinsurers, namely by regulation of accounting standards. The use of future harmonised standards for supervisory issues is discussed in more detail in the "Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision". Usually, reporting requirements for reinsurance companies are not so detailed as for direct insurance companies.

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Generally reinsurance companies generate their financial information from data provided by cedant companies. Because of the international nature of the business there is always a delay in receiving the information or, if financial statements are prepared soon after the balance sheet date, there could be a lack of quality because a high degree of estimation is needed. In particular, the claims reserves are subject to estimates. This causes estimated amounts in reinsurance receivables and payables as well as in profit-sharing. For proportional business, premiums also have to be estimated. Finally, the profit for the year is influenced by estimates. There is a trend to producing financial statements more promptly as a result of pressure from the capital markets. Therefore the impact of estimations increases.

To keep the quality of the financial statements, in practice, sophisticated estimation systems are designed for the companies. To give a judgement of the quality of these estimates, these systems have to be analysed. However, even if the implemented estimation system meets the highest standards, misstatements caused by the lack of information are common and have to be reflected as an adjustment in the next period.

Supervision of reinsurance should take this aspect into account. Financial supervision of reinsurance companies may not need to be as extensive as for insurance companies.

6.5.11 On-site inspections

6.5.11.1 Inspection by the supervisor

On site inspection is not merely a supervisory parameter. It represents a distinct approach to supervision, one in which the regulator takes an active role in monitoring the activities of a company and its compliance with the regulations.

On site inspections enable supervisors to:

■ evaluate the management and internal control systems;

■ analyse the company's activities;

■ evaluate the technical conduct of the business being carried on, such as the organisation and management of the company, its commercial policy, and its reinsurance cover and security.

These activities are time-consuming and require a technical knowledge of a complex business. On the other hand, on-site expections allow the supervisory staff to extend its experiences which are necessary for an effective off-site supervision. The issue with on-site inspections is whether supervisors have sufficient resources to carry them out.

6.5.11.2 Inspection by third parties, such as auditors

In many cases, the objectives of on-site inspection can be achieved by requiring auditors or other third party experts to investigate and report on companies.

Auditors will already be considering the adequacy of controls and provisions as part of the statutory audit so that extending these requirements might be a more feasible and cost-effective approach than the extensive use of on-site inspection by the regulators themselves.

6.6 Parameters relating to indirect

supervision 6.6.1 Direct review of reinsurance

programme

As defined by the IAIS in the Insurance Core Principles, the insurance supervisor must be able to review reinsurance arrangements to assess the degree of reliance placed on these arrangements and to determine the appropriateness of such reliance. Insurance companies would be expected to assess the financial position of their reinsurers in determining an appropriate level of exposure to them. IAIS asks the insurance supervisor to set requirements with respect to reinsurance contracts or reinsurance companies addressing:

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- the amount of the credit taken for reinsurance ceded. The amount of credit taken should reflect an assessment of the ultimate collectability of the reinsurance recoverables and may take into account the supervisory control over the reinsurer; and

- the amount of reliance placed on the insurance supervisor of the reinsurance business of a company which is incorporated in another jurisdiction.

The supervisor has to ensure that the reinsurance programme is appropriate to the level of capital of the insurer and the profile of the risks it underwrites and that the reinsurer's protection is secure.

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The Australian Prudential Regulation Authority (APRA) also recommends a system based approach in supervising the reinsurance arrangements of insurers. This approach recognises primary responsibility for reinsurance management rests with the board and senior management of an insurer and focuses on the quality of the processes and controls adopted by that insurer. Reinsurance management is a critical component of an insurer's ability to meet policyholders obligations.

The objective of such an examination is for the cedant to make sure that the chosen reinsurance undertakings, the professional reinsurers as well as the direct insurers writing inward reinsurance, offer the best possible guarantee that they will be able to fulfil the obligations they have accepted.

The monitoring of these reinsurance programs is often less strict than supervision of direct business and in many cases simply requires copies of treaties and other contractual documents and the list of reinsurers to be submitted to the supervisory authority. Submission of these documents focuses on ensuring observance of technical and financial requirements rather than evaluating the market conditions of reinsurance contracts.

Requiring insurance companies to report details of their exposures and reinsurance arrangements may encourage management to be more rigorous in devising appropriate reinsurance programmes.

Such security analysis is not always successful, either because of the lack of necessary data to serve as a basis for assessment or because of the inability of the ceding company to use the available data to obtain an appropriate assessment of the reinsurers. In this respect, insurance supervisory authorities can play a role in exercising some control over the choice of reinsurers by the ceding companies to ensure the good security of chosen reinsurers.

If the ceding company does not obtain all the information necessary to get a comprehensive overview of the reinsurer, the examination cannot be appropriate. Also, the ceding insurer may not have the capacity to carry out a proper assessment of the reinsurer. However, examining the reinsurance protection of the direct insurer is useful when reinsurance companies are unable to provide information for reasons of client confidentiality and if foreign reinsurance companies and/or their branches are not supervised in their domestic country.

This parameter of indirect supervision has the advantage of reducing the scope of supervision. Such an approach can transfer the cost of monitoring the security of foreign companies to the foreign reinsurers interested in operating in the domestic market. But this indirect supervision parameter brings with it disadvantages such as administrative costs for cedant companies in providing the information.

A system in which it is the primary insurer's responsibility to assess the reinsurer's security may not be totally secure. The ceding insurer will be motivated by the desire to minimise cost as well as to maximise security. For financial reasons the ceding insurer may choose a secure reinsurer, but not necessarily the most secure 6.

The industry is of the opinion that the review of reinsurance programmes is a fundamental part of supervising the reinsurance market. Assessment of reinsurer security is a function of the direct insurer, and supervision authorities must monitor the appropriateness of the protection of the direct insurer by the reinsurer.

In some EU member states the techniques used to assess the reinsurance programme of an insurer are generally based on data from financial statements and other available information (e.g. Germany) or in some cases based on on-file and on-site audits (e.g. France), but in many cases there is no evidence that the regulator supervises the reinsurance programme beyond an analysis of the documentation which has to be submitted. In Switzerland no special focus is given to this area by the regulator.

In some countries, for example in France, the information required with respect to company's outwards reinsurance programme is quantitative and does not provide the regulator with a view on the quality of the reinsurance programme.

6.6.2 Limits on maximum exposures

6 Reinsurance and reinsurers: Relevant issues for establishing general supervisory principles, standard and practices, February 2000

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Assessments of the adequacy of an insurer's reinsurance protection need to be made in the context of an insurer's maximum exposure. For example, a company might have a working rule that it will not expose itself to a loss from a single event of more than 5% of its capital. Clearly such limits will vary greatly from company to company depending on the scale and diversity of the insurance business that they write. Any potential loss in excess of such a limit would need to be protected by reinsurance. In practice, many supervisors have informal internal guidance on what are appropriate maximum exposures. It may be possible to develop this guidance into harmonised rules on the maximum exposures that companies may accept relative to their capital.

6.6.3 Admissibility of reinsurance assets for the primary insurer

Reinsurance recoveries are hard to quantify as their estimation depends on the estimation of losses during any given period.

The Prudential Supervision of General Insurance Companies in Australia (APRA) proposed that the minimum statutory solvency requirement should take into account the relative riskiness and diversity of reinsurance, in deciding whether, and to what extent, these assets should be allowed to count towards an insurer's statutory solvency requirement. It recommended the consideration of a system of risk weighting the assets of insurers, reinsurance assets be risk weighted according to ratings assigned by rating agencies. More information was sought on how risk weights would be applied to reinsurance assets such as those relating to incurred but not reported claims liabilities where it was uncertain which reinsurer would be called upon.

The pool of reinsurance recoveries would be risk weighted according to the risk-weighted average of premiums ceded in the previous reporting period.

This proposal uses the same general principles in the risk weighting of reinsurance assets for insurers as those proposed in June 1999 by the Basel Committee on Banking Supervision7. The proposed reforms include the introduction of credit risk weights based on the ratings assigned by rating agencies.

Further developments will be shown in the "Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision".

6.6.4 Credit for reinsurance and collateral requirements

Credit for reinsurance concerns the deduction of reinsurance in the calculation of the solvency margin. The admissibility of reinsurance recoverables for the determination of required minimum regulatory capital has been addressed in the previous sub-section. Collateralisation concerns the reduction of the reinsurers' credit risk through security deposits. Collateral requirements may also affect the calculation of the solvency margin of the primary insurer. According to EU rules, the solvency margin allows just 50% of the receivables against reinsurers if there is no deposit.

Credit for reinsurance is given either by increasing the assets or reducing liabilities. To qualify for credit, ceding insurers must meet certain supervisory requirements. These may include the holding of collateral to secure the obligation or the constitution of a trust fund if reinsurance is not ceded to a reinsurer licensed in the home country of the insurer.

One disadvantage of credit for reinsurance with regard to the calculation of the solvency margin is that reinsurance recoverables are based on past claims while the solvency margin is supposed to put the reinsurer in the position to cover future claims. Therefore, it has to be noted that reinsurance recoverables can only be an approximation of risk reduction provided in the future.

Collateral requirements can enhance the domestic supervisor's comfort level with the reinsurer's ability to meet its financial obligations to ceding insurers and their requisite policyholders.

There are a number of disadvantages: collateral for the benefit of certain classes of policyholders may act to the detriment of other classes of policyholders. Collateral

7 Consultative Paper "A New Capital Adequacy Framework"

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requirements create classes of preferential creditors and can lead to capital withdrawn from the local markets. For many users these restrictions are seen to have the effect of dispersing a reinsurer's capacity and thereby hindering its freedom to trade. Finally, the rates of return on deposits held by ceding companies are often far lower than would actually be earned by reinsurers on these funds, and the practice of requiring deposits actually increases the cost of reinsurance (leading to higher premiums).

Part of the industry argues that with this mechanism of protection, no additional supervision is needed for reinsurers.

Some supervisory authorities have always held that gross reinsurance technical reserves must be covered by assets which meet strict criteria. In those cases, reinsurers must make appropriate deposits or pledges in favour of cedants to enable the direct insurers to meet regulatory liabilities coverage constraints, for example in France. According to the French authorities, this practice adequately protects cedants against default by their reinsurers and is the only available proof that the reinsurer agrees with the cedant's computation of reinsurance recoverables.

It is argued that, considering the difficulties in controlling reinsurance, this system is at the moment the only one which allows an efficient protection against reinsurer default. Abandoning such a system would only be possible if the new system could give the same level of protection for insurers. The system of control over reinsurers would need to be sufficiently harmonised and coordinated at an international level and would involve the exchange of confidential information about ceded business.

Within the EU, France, Belgium and Spain use indirect deposits by "gross reserving". In Belgium, exceptions have to be approved by authorities. In the US, trust funds are used or other collateral under State credit for reinsurance laws.

The US has developed a system whereby the reinsurance transaction is regulated through the mechanism of credit for reinsurance. The fundamental concept underlying the US regulatory view is that the reinsurer must either be licensed and subject to the full spectrum of reinsurance regulation or provide collateral to ensure the payment of the reinsurer's obligations to US ceding insurers (through a trust, letter of credit or other acceptable security)8.

The idea behind this approach is that the ceding insurer is allowed financial statement credit for cessions to non-US reinsurers, only if US regulators have the confidence that the non-US reinsurer is able and willing to pay its obligation to US ceding insurers as they become due. This is accomplished through the collateralisation of the reinsurers' obligations.

According to US authorities, collateralisation eliminates the regulator's need to assess the level of regulation in the non-US reinsurer's domiciliary jurisdiction or the financial strength of the particular reinsurer. Collateralisation ensures that funds are available to satisfy the non-US reinsurer's obligations whether it is solvent or not. Collateralisation also serves to ensure that funds are available in the event that the ceding insurer becomes insolvent. Cost and difficulties are mitigated or even eliminated if sufficient collateral is provided to satisfy the obligations of the reinsurer.

European reinsurers are pressing for a less stringent regulatory system in the US that would benefit them. They argue that US regulators have established deeper and broader working relationships with foreign insurance regulators and have a better understanding of the solvency regulation of many foreign countries. European reinsurers believe it would be appropriate to reassess the US credit for reinsurance rules, particularly as they relate to cessions of reinsurance by US reinsurers to non-US reinsurers. They believe that it would be appropriate to reduce the level of funding required for the multi-beneficiary reinsurance trusts maintained by a number of these reinsurers. Today European reinsurers operating in the US are highly-rated, professional reinsurers dealing with sophisticatedbuyers. A mutual recognition where reinsurers regulated in the EU are free to trade within the US and vice-versa, would facilitate free trade and competition at an international level. This would also reduce the bureaucracy involved in trading in the US and help to create a free and transparent market in reinsurance. The IUA has been working on a project with the objective of reducing trust fund requirements for overseas reinsurers. In March 2001 some progress had been made, when the NAIC agreed to the concept of irrevocable letters of credit being used as an allowable asset. This allows a system with greater flexibility and improves the reinsurer's cash flow, but it is only a small step forward.

8 Reinsurance Association of America, Alien Reinsurance in the U.S. Market 1996 Data

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Today most of the professional reinsurers handle the problem by establishing a subsidiary in the US which is subject to supervision, so that there are no obligations for non resident reinsurers.

6.6.5 Diversification requirements

Supervisors can reduce the reinsurer default risk by placing limits on the amount of credit that can be taken for reinsurance with any one reinsurer.

In general, EU regulators have not enshrined diversification requirements in legislation. This reflects the fact that there are great differences in the types and amount of cover obtained by direct insurers.

6.6.6 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. 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 and existing solvency supervision 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 mechanism which exists in relation to credit ratings. Also, downgraded 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.

At present, there is no explicit use of rating agencies by the regulator, except as general information. But many insurers use rating agency information in their selection of reinsurers. Insurers that select only highly rated reinsurers, in conjunction with other criteria, are less likely to have problems with uncollectable reinsurance and will spend less time and resources evaluating reinsurers 9.

Some argue that there will be an extension of their use in response to pressure by regulators who will try to upgrade the quality of companies by insisting that they get ratings from acceptable agencies.

The role of rating agencies is becoming more important. They have already had the effect of improving discipline in the reinsurance market. Although insurers cannot endorse the validity of these independent credit evaluations, they do provide a useful indication of the security of various reinsurers in the global market place.

The supervisor has to be careful in using ratings of reinsurance companies because rating agencies react slowly to market trends and, as stated by the Groupe Consultatif des Associations d'Actuaires, history shows that they do not provide timely early warning signals in case of reinsurance failure. However, it would make sense for supervisors to be aware of the external ratings.

Part of the industry is of the opinion that companies have to take precautions when using ratings. The main concern of rating agencies should be the recognition of risk; the risk cannot be assessed with poor proxies such as premiums, but refined exposure measures are required for adequate risk assessment. Some argue that solvency control through supervisory authorities would be preferred to ratings. Rating agencies are in the business for commercial reasons and any involvement in supervision would conflict with this. Where the regulator does have recourse to ratings, an acceptable rating level should be established (for instance BBB by Standard & Poor's).

From a rating agency point of view, reinsurance company ratings are used by brokers/intermediaries banks and equity analysts and are serving policyholders and the cedants. Rating agencies provide benefits to management control and to companies which can compare themselves with their peers. In their opinion, they are an early warning system for regulators by providing ratings on reinsurance recoveries and insurance companies. They point out that there could be a conflict of interest, when companies pay for ratings which the supervisor would be using to regulate them, similarly when insurance companies look at claims payment ratings of reinsurers (paid for by the reinsurer). At the moment this is a commercial decision. However, it could become more serious if regulators use rating agencies.

9 Principles of Reinsurance, Insurance Institute of America, p.201

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The main agencies on the market are A.M. Best Company, Standard & Poor's Corporation Moody's Investors Service and Fitch IBCA/Duff & Phelps Credit Rating Corp. They provide credit ratings for insurance companies worldwide and also rate the major reinsurers. They generally have their own models based primarily on historical financial analysis and capital adequacy statistics. A brief overview of the methods used by these agencies is presented below.

Best's ratings are based on a comprehensive evaluation of a company's financial strength, operating performance and market profile against A.M. Best's quantitative and qualitative standards. The quantitative evaluation is based on an analysis of each company's reported financial performance for at least the five past years, using over 100 key financial tests and supporting data. These tests, which vary in their importance depending on a company's characteristics, measure a company's absolute and relative performance in three critical areas: leverage/capitalisation, profitability and liquidity. A company's quantitative results are compared with standards of its peer composite as established by A.M. Best for property/casualty and life/health insurers. Peer standards are based on the performance of many insurance companies with comparable business mix and size. In addition, industry composite benchmarks are adjusted annually for underwriting, economic and regulatory market conditions to ensure the most effective and appropriateanalysis. The interpretation of these quantitative measurements involves incorporating more judgemental, qualitative considerations into the process 10.

A Standard & Poor's Insurer Financial Strength Rating is a current opinion of the financial security characteristics of an insurance organisation with respect to its ability to pay under its insurance policies and contracts in accordance with their terms. Standard & Poor's employs two approaches when rating the financial strength of insurer: interactive ratings, and "pi" ratings. The difference between the two reflects the amount and type of information the analysts are expected to receive. Interactive financial strength ratings are published only after a thorough review, which includes an extensive interview with the management. The "pi" subscript indicates that the insurer has not voluntarily subjected itself to Standard & Poor's most rigorous review. Therefore, the analysis is based on an insurer's published financial information and other data found in the public domain11.

A Moody's Insurance Financial Strength Rating assigned to an insurer measures the ability of that company to punctually repay senior policyholder obligations and claims. These ratings are based on industry analysis, regulatory trends, and an evaluation of a company's business fundamentals. Industry analysis examines the structure of competition within the company's operating environment and its competitive position within that structure. Analysis of regulatory trends attempts to develop an understanding of potential changes in a particular country's regulatory system, accounting system, and tax structure. The analysis of a company's business fundamentals focuses primarily on franchise value, management, organisational structure/ownership, and financial analysis. The financial analysis includes an assessment of capital adequacy, investment risk, asset/liability management, profitability, liquidity, underwriting, reserve adequacy, and financial leverage12.

A Fitch insurer financial strength rating (IFS rating) provides an assessment of the financial strength of an insurance organisation, and its capacity to meet senior obligations to policyholders and contract holders on a timely basis. Fitch's analyses incorporate an evaluation of the rated company's current financial position as well as an assessment of how the financial position may change in the future. Consequently, the rating methodology includes an assessment of both quantitative and qualitative factors based on in-depth discussions with senior management. Fitch's insurance ratings generally include an approximate 60% quantitative and 40% qualitative element through such weightings can vary drastically given unique circumstances. The company's ability to meet its obligation is evaluated under a variety of stress scenarios, not just the "most likely" scenario. Incorporated into the analysis is a review of the company specifically, as well as the macro trends affecting the industry in general. Rating methodology focuses on the industry review, operational review, organisational review, management review and financial review13.

10 Best's Key Rating Guide, Life and Health Edition

11 Standard & Poor's Property/Casualty Insurance Ratings Criteria

12 Moody's Rating Methodology Assessing Credit Risks of US Property and Casualty Insurers

13 Fitch Non-Life Insurance Ratings Criteria

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Analysis of reinsurance companies, as pointed out by Standard & Poor's, must be continually reinvented in order to be reflective of the expanding boundaries and innovative approaches of "non-traditional" reinsurance mechanisms, like the emergence of alternative market mechanisms; the gradual diminution of true risk transfer embodied in finite risk reinsurance; the connection of reinsurance with financial markets in the securitisation of various type of risks. The issue of reinsurance recoverables remains a significant one for the reinsurance industry and is focused on the ultimate collectability of retroceded liabilities.

Generally, the major players in the reinsurance market are rated by the major international agencies. Most smaller companies do not engage a rating agency. Generally, no use of ratings is made by the regulator.

For the implementation of a framework of supervision of reinsurers the reliance on rating agencies is a possible approach. On the one hand this approach does not give rise to high costs, but on the other hand the judgement of rating agencies is driven by subjective considerations. The reinsurer and the supervisory authority have no influence on the subjective elements of a rating.

6.6.7 Restrictions on use of non-regulated reinsurers

At present this issue is greatly influenced by the fact that many of the largest and strongest reinsurers are currently unregulated or only regulated to a relatively limited extent. The two largest reinsurers, Munich Re and Swiss Re, have some 20% of the reinsurance market between them, and both have the highest security ratings. Of the ten largest non-life reinsurers, five are regulated to a relatively limited extent only (Munich Re and Swiss Re plus Gerling, Allianz Re and Hannover Re). In such circumstances, it is impractical for supervisors to restrict the extent to which direct insurers place reinsurance cover with unregulated reinsurers.

However, if the EU introduced a regulation requirement for reinsurers, it could become possible for EU insurance supervisors to restrict the amount of credit given for reinsurance placed with unregulated reinsurers.

6.6.8 Restrictions on use of "unapproved reinsurers"

Another approach that supervisors could take would be to restrict credit for reinsurance to cover from "approved reinsurers" which could include all regulated reinsurers plus other unregulated reinsurers which were explicitly approved by the supervisor.

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7

The arguments for and against reinsurance supervision and a broad cost-benefit analysis

7.1 Scope

In accordance with the Terms of Reference, this chapter analyses "he arguments for and against reinsurance supervision (e.g. contribution towards strengthening the prudential supervision of primary insurers, access to global markets by European reinsurance companies, etc.)" and provides "a broad cost-benefit analysis of the public policy benefits achieved by supervising reinsurers relative to the costs of supervision".

7.2 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 number of interviews with reinsurers;

■ Discussions with regulators and use of public information where necessary, to supplement information gathered from local offices;

■ Reviews of existing published sources.

7.3 Arguments for reinsurance supervision

There is one single directive, adopted in 1964, which applies specifically to reinsurance; it was intended to abolish regulations which restricted freedom of establishment and freedom of services. In practice, its principal effect has been to facilitate the freedom of establishment for specialised reinsurers. However, the experience of these three decades shows that the freedom ratified by the directive of 1964 no longer satisfies all concerns of reinsurers. This directive had left national supervisory authorities the option to implement local reinsurance supervision regimes. This has led to a proliferation of national rules on reinsurance, often very disparate, which has hindered the creation of a single market. Differences in the regulation of reinsurers across EU member states has resulted in a distortion of competition of the single market. On the other hand, harmonised supervision can create distortion of competition with reinsurance providers from European third countries (e.g. US).

Growing pressure is coming from international discussions between central bankers and finance ministries for international reinsurance to be brought more under control. Generally, there is a consensus about more supervision. In fact major reinsurers are low-regulated or differentially regulated, but the main factor is that globalisation and e-commerce are creating an international flow of capital. But there has been no empirical evidence of any systemic risks (see section 3.4 for the definition of systemic risk) caused by or in connection with the reinsurance sector14.

Enhanced regulation of reinsurers is part of an inexorable trend towards regional and global coordination of the conduct of financial services business generally. Within Europe it is an anomaly that the direct insurance market should benefit from a level playing field while the reinsurance market, which serves it, remains subject to trading barriers within the EU, contrary to the principles of free movement of capital and services upon which it is based. However, reinsurance has historically always been international. Because of its international nature, a heterogeneous system of supervision within the EU or even world-wide may lead to impediments and distortion of competition.

A level playing field in the regulation of reinsurance in Europe is proposed by many associations such as the IUA or the CEA, which could be achieved by the implementation of a mutual recognition system such as a single passport. For the IUA the objective is for a European passport for insurance and reinsurance to attain mutual recognition with the equivalent North-American system.

Such a system would help to eliminate discriminatory treatment and trade obstacles (such as additional licensing procedures, reporting requirements, deposits or similar requirements). In a number of countries, the collateral system determines the reinsurance arrangements where local regulation focuses on the security of the primary insurer. These requirements have the disadvantage that they result in capital being withdrawn

14 Financial Stability Forum, Report of the Working Group on Offshore Centres, April 2000, p.15

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from the local market. From a reinsurer's point of view it is argued that such restrictions on the location of capital unduly hinder the freedom of trade.

Higher reinsurance costs caused by market barriers

Barriers to foreign reinsurers, such as exist at present, increase the cost of reinsurance to cedants and thus also the cost of insurance to policyholders. They reduce access to the competitive international reinsurance market which would offer not only lower cost, but also a better and broader range of services.

For instance the obligations involving letters of credit bring additional costs for reinsurers.

Indirect additional protection ofpolicyholders

Direct or indirect supervision of reinsurance does not only protect the direct insurer against failure of its reinsurer, but maintaining stability and confidence in reinsurance markets through the application of supervision parameters in turn also leads to a higher degree of policyholder protection.

Transparency of the market

The existence of harmonised supervision rules would also improve transparency in the European industry. Implementation of common accounting standards and practices and prudential ratios applicable to all is essential to enable operators to establish and terminate relationships based on a full knowledge of the facts. Transparency of information in the marketplace facilitates market discipline which in turn maintains standards of conduct and creates incentives for companies themselves to maintain standards. However, harmonised regulation can only work with adequate standards and similar core requirements imposed by each country, to permit free trade anywhere in the geographical area of mutual recognition.

Market performance

Moreover, supervision could help ensure a strong image and could possibly improve industry performance. As "unsuitable" reinsurers could be identified more easily and, if there were an authorisation or licensing system, could be removed from the market the overall reputation of the market would be enhanced. Regulation may help remove firms guilty of misconduct from the market that would otherwise contaminate the reputation of all firms in the market.

Reduction in insolvency risk

In recent years, the reinsurance market has shown a clear trend towards concentration and an abundance of risk-seeking capital supply. Fraud risks may occur in the complex markets of risk transfer products because of the insufficiently transparent retrocession processes. The combination of severe competition and continuous entry of new suppliers can lead, among other things, to bankruptcy.

Supervision may contribute to limit the risk of fraudulent bankruptcy or default. Even if a reinsurer's bankruptcy only rarely leads to insolvency of its cedants, it is important for the reputation of the reinsurance sector to avoid such occurrences.

Increase in market efficiency

Regulation that could enhance competition and overall efficiency in the market could create a market which overall works more efficiently and through which everyone could gain. Competition can result in a transfer from the less to the more efficient reinsurer which has the effect of increasing the overall efficiency of the market. In this respect, efficient reinsurers may possibly benefit from meaningful regulation. Regulation can make competition more effective in the market by requiring the disclosure of relevant information that can be used by insurers in making informed choices.

Bargaining power against non-EU countries

Supervision could lead to European insurance associations having increased bargaining power to oblige non-European countries to lower the constraints which still all too often hamper geographical expansion of reinsurance operations. A common European framework could also provide European reinsurers with a competitive advantage over unsupervised non-EEA reinsurers and could thus be used as a marketing tool. But this obviously depends on the nature and structure of the framework.

Many European associations believe harmonised supervision could give European reinsurers a strong image and a negotiating tool, vis a vis foreign regulators (e.g. US), for being considered adequately supervised. Restrictions placed by regulators on foreign reinsurers, such as having to keep trust funds in the US, are in fact protectionist in their effects.

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Cost savings by harmonised supervision

Harmonised supervision would reduce the scope for duplication, with only home supervision, which would reduce the costs at an EU level. A standard system will lead to a saving on the costs of compliance with different legal and regulatory regimes. A system built on mutual recognition (i.e. a passport system) in the country where the reinsurance undertaking is registered would mean that supervisors in host countries would not have to perform additional supervision or checks.

Capacities of direct insurance industry increase by harmonised supervision

A recognised harmonised system could mean that more credit could be given for reinsurance in the solvency margin calculation for business ceded to EU licensed reinsurers. This would mean that the maximum reduction of 50% today might be increased in order for direct insurers to rely to a large extent on their reinsurance arrangements with EU recognised reinsurers. AISAM strongly considers that the current maximum reductions for reinsurance are too low and should be increased to between 90% to 100% for all contracts, provided of course that the reinsurer was properly supervised. For the Groupe Consultatif, the amount of the solvency margin reduction should depend on both the standing and type of cover applied, given the insurer's portfolio and expected new business. Under these conditions regulation increases the capacity of direct insurers.

Harmonisation allows a lower level of regulation

Any harmonisation of reinsurance regulations should minimise such regulation as is already in place. Even the opponents of reinsurance supervision prefer harmonised supervision to the current situation because this would reduce the effort required to fulfil different local rules from supervisory authorities. In many countries, there are several reporting requirements for foreign reinsurers. The requirements differ from country to country, for example in relation to the accounting rules.

7.4 Arguments against reinsurance supervision

Generally, the reinsurance industry is of the opinion that there is no need for regulation, arguing that in several European countries there are low-level regulated markets which operate effectively.

The reinsurance industry also argues that the evaluation of adequate protection and security of reinsurance companies is the business of direct insurance. Companies are of the opinion that supervision should be based at this level, focusing on whether the reinsurance protection of the direct insurer is appropriate.

Reinsurance is a professional market. The customers of reinsurers are sophisticated companies who do not need the same protection as private consumers. In a wholesale business such as reinsurance, commercial insurers and reinsurers deal with other professional corporations, business to business, and do not need special protection like final consumers (policyholders). The view of the IUA is that, this situation means that reinsurers should be subject to a lower degree of regulation than insurers. For some professionals, this shows that there is no justification for detailed state supervision.

Practical implementation of supervision

Given the internationality of the reinsurance business and its dynamism and flexibility, which differs from direct insurance, the practical implementation of national supervision may be difficult. For example the types of contracts differ from region to region. In relation to the business which is highly heterogeneous, requirements for reinsurance supervision are also high.

Global market

Global reinsurance business needs more freedom of action than the direct insurance business which is usually regionally limited, so that the intensity of supervision should not be the same for the professional market of reinsurance as for the direct insurance market.

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Market barriers

Regulation, particularly state regulation, brings initial barriers to entry, and can introduce delays which conflict with business objectives. State regulation is necessary for the protection of consumers, but reinsurance is a business between sophisticated commercial undertakings, not consumers.

Impact on effective competition

Reinsurance supervision may have adverse effects on the functioning of the reinsurance market. Where legislation is deemed necessary it should not create an inequality which hinders fair and effective competition. Trying to harmonise supervision on a global basis may avoid discrimination between EU and non-EU reinsurers. Restriction in the EU that hinders reinsurers in their business relative to non-EU reinsurers may ultimately result in adverse pricing differences which subsequently impact adversely on the EU reinsurance industry.

EU harmonised market

Such regulation may introduce in Europe restrictions not previously thought to be necessary, which is contrary to the freedom of establishment and the freedom to provide cross-border services within the EU, as guaranteed by treaties. Under European law, these sort of restrictions have to be objectively justifiable in the public interest. Regulation may hamper the supply of reinsurance capacity provoking a negative effect for insurance policyholders, as insurance companies would provide less capacity as a consequence.

Experience in regulated markets

The reinsurance industry argues that most reinsurance insolvencies have occurred in regulated markets. There is no evidence that the financial collapse of a reinsurer would pose any systemic threat to the insurance market, although it could have a real negative effect for any particular insurance company.

Flight of capital

Regulation in Europe may encourage a flight of capital to more amenable jurisdictions, such as Channel Islands or Barbados (off-shore markets), as companies will find ways around regulation or even exploit it. Changing the supervisory system may create opportunities for those who wish to escape from regulation which can lead to an increased risk of default in the reinsurance market.

EU harmonisation versus global markets

Although there is an argument that regulation would enable the European authorities to negotiate reciprocal agreements of mutual recognition with other countries, notably the US, it seems unlikely that it would achieve such an objective, since American authorities (for protectionist reasons) would certainly resist such an opening up of the reinsurance market. The Reinsurance Association of America argues that the US reinsurance industry cannot support any proposal that would permit non-US reinsurers to assume reinsurance risks from US cedants on the basis of a single licence through mutual recognition while US reinsurers continue to be constrained by a 50-state regulatory system. Mutual recognition is not feasible until US reinsurers are permitted to do business in the US in a manner that will maintain a level playing field with non-US reinsurers.

According to the OECD and the CEA, obstacles still exist in some countries such as monopolies, compulsory cessions, supervisory restrictions, tax restrictions (e.g. USA with a Federal excise tax in reinsurance), compulsory deposits by reinsurers (as in France or USA) or administrative impediments.

A common system of supervision in Europe should take into account the systems existing in other countries, especially Switzerland. Also, supervisory practice should be taken into consideration. The existing bilateral agreements between the Swiss Confederation and the EU could probably be updated by a demand for local application of the same elements to Swiss reinsurance. A system with a "high" degree of supervision would be difficult to implement in Switzerland and other reinsurance markets.

Knowledge

Another difficulty in implementing reinsurance supervision arises from the limited availability of reinsurance specialists. Given the small number of experts, according to the Groupe Consultatif, it might be difficult for supervisory authorities to find appropriate human resources. It may not be feasible or cost-effective to expect each local supervisor to have the necessary skills to assess reinsurers' security as well as their products.

Harmonised supervision for the whole industry

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There is a network for reinsurance and direct insurance within all the EU market. If a supervision system is implemented it seems to be necessary to set up a uniform system for the industry as a whole, as the businesses of direct insurance and reinsurance are connected.

Costs

Regulation leads to on-going costs, direct and indirect. If regulatory authorities develop regulation with costs that outweigh their benefits, the market will become less efficient. Any regulation brings costs for the industry as a whole. Closer regulation increases the costs for the companies, arising from the additional time spent in preparing and providing information to the regulator.

Implementing or enforcing regulation leads to higher costs for regulatory authorities which will need more resources and in particular for specialists in the reinsurance market. Due to the current situation in the reinsurance market, the reinsurer may not be able to recoup the increase in costs through higher premiums.

7.5 Impacts on the different approaches to supervision

The extent of the impact of supervision will depend on the supervisory regime adopted and the extent to which it is more or less direct and detailed. A harmonisation of the system and of the requirements at an EU level is recommended by the majority of member states, whereby a model based on direct supervision is preferred.

If it is decided to introduce harmonised supervision, some operators consider that direct and detailed supervision of reinsurance undertakings will not necessarily be the only solution and may have restrictive effects. In the large majority of cases, the prudential supervision currently exercised in the reinsurance undertaking's head office country should suffice, whether exercised directly or not. Some argue that a stricter and closer supervision should be reserved for new players in the market. The Groupe Consultatif's view is that, if reinsurance is supervised, this should not be at as detailed a level as direct insurance.

The strength of the arguments for and against supervision presented above will depend on the level of supervision adopted. A more stringent level of supervision would increase the strength of the arguments.

For example, a supervision equal to the supervision of direct insurers leads to mainly high security against insolvencies but creates a very high level of costs and market barriers for the reinsurers.

7.6 Cost-benefit analysis

The arguments in favour of supervision need to be balanced against their cost. Closer supervision needs to be justified in terms of the value added for society. When there are alternatives for regulating an aspect, the most cost-effective regulatory practice should be the one which least impedes the ability of the market to respond to the consumer's needs.

Before undertaking important regulatory changes, the scale of the cost implications at all levels (supervised institutions, supervisory authority and possibly third parties) needs to be established and set against the anticipated benefits.

Regulations will bring benefits where there is a probability that they will reduce market imperfections and failures or eliminate them. The extent of benefits is equal to the reduction in damages caused by market imperfection and failures. But regulation also gives rise to costs.

The comparison of costs and benefits of regulation gives information about economic advantages. It has to be checked very carefully if the benefits of additional requirements of supervision are worth the costs of the impact on the reinsurance industry. Regulation should only be undertaken when the benefits outweigh the additional costs. An assessment of benefits should be oriented to regulatory objectives.

Regulatory intervention is only likely to be justified if the nature of the market imperfection (if any) is causing a problem, if there are solutions for the imperfections to deliver a net improvement and if the regulation does not cause any other greater disadvantages.

An analysis of the nature and degree of market failure should also involve an analysis of whether the benefits of regulation can ever exceed the costs. There are costs involved in pursuing regulation and, if pursued too far, the costs may come to exceed the benefits. Regulation can always be made

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more effective in terms of its defined objectives, but at the expense of higher costs. The aim is to balance the benefits of a higher degree of achievement of objectives against the costs.

The view of the FSA (Financial Services Authority) in the UK is that some regulation can be counter-productive if, for instance, it erects unwarranted entry barriers, restricts competition in other ways, controls prices, stifles innovation, restricts diversification by financial firms, impedes market disciplines on financial firms, etc. For these reasons, the FSA recommends that all regulatory requirements should be subject to some form of cost-benefit discipline though, in practice, such exercises encounter formidable methodological problems.

7.6.1 Description of supervision cost-impacts

The costs/benefits deriving from supervision can be classified into two categories: micro-economic which are more easily quantifiable and macro-economic which are not readily measurable.

7.6.1.1 Micro-economic impacts

Costs directly related to the supervisory regime

Designing, monitoring and enforcing regulations requires extra resources. These include administrative costs for the State, IT resources, human resources, training costs, control and supervision division costs and other administrative expenditures. This will be the case when no supervision already exists and a regulatory body has to be created. This situation will also occur when supervision already exists but must be extended into a new area which requires specialist knowledge of the reinsurance market.

In order to monitor the highly specialised market of reinsurance, a high level of training will be required in the supervisory organisation. Education of regulators will give rise to additional costs of supervision. Such costs are generally quite easy to measure as they consist of expenditure by regulatory bodies.

The regulatory body could recover part of these costs and implement a fee charged to regulated companies. In practice costs for current supervision are mainly transferred to the supervised entities. In Germany, for instance, the industry pays about 90% of the supervisory costs. As implementation of reinsurance supervision is complex, the cost of its implementation are probably not recoverable. In turn these fees charged to reinsurers may lead to an increase of premiums.

Costs of compliance

The regulated reinsurance companies must use extra resources, including time, to comply with new regulations. These costs may include allocating the resources internally, costs of training, management time, authorisation costs, costs arising from disclosure. Generally these costs could have an impact on the final price to the consumer (policyholder).

The use of extra resources can be significant. Global reinsurance companies estimate the cost being approximately four persons per year to comply with reporting obligations.

The cost of harmonising supervision at an EU level will result in direct costs and costs of compliance that will be different for each country, as they depend on the extent to which regulatory practices already exist. These costs will also vary regarding the extent of the requirements required for harmonised supervision.

Increase in premiums

An increase in costs for reinsurers, directly or by a possible fee charged by the regulator, may lead to an increase in premiums for policyholders as explained previously. Costs of reinsurance to cedants would increase and as a result the cost of insurance to policyholders would increase too.

At the moment the market situation of reinsurance companies would not permit an increase in premiums. In this case the costs have to be paid by the shareholders. The situation will possibly change in the future.

7.6.1.2 Macro-economic impacts

Besides the micro-economic impacts on the economy as a whole, regulation may also bring indirect costs or indirect benefits which are generally hard to measure.

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Negative market impacts

Negative market impacts include the costs of reduced competition arising from the loss associated with increased charges. Higher costs for reinsurers, brought by regulation, may reduce efficiency and lead to uncompetitiveness in the reinsurance market. The increase of costs for EU reinsurers could have a negative impact comparatively with non-EU reinsurers, and a consequence could be the flight to other countries as explained below.

Regulation may hamper the supply of reinsurance capacity producing a negative effect for insurance policyholders, as insurance companies will provide less capacity as a consequence.

The demand in the reinsurance market can decrease as a result of regulation costs. These costs may have a repercussion on the cost of reinsurance and indirectly on the cost of insurance for policyholders.

It is possible that the introduction of supervision would cause some companies to cease business, or that financial services would be transferred to less regulated areas. Indeed the enforcement of new regulations may create opportunities for those who wish to escape regulation (to amenable jurisdictions) which can lead to a weakening in the security of the reinsurance market. One possible impact would be the reduction in the choices of reinsurance products in the market. That situation also would mean higher costs which could also lead to a lack of competitiveness and job losses.

Regulation can have also an impact on the availability of the products in the market, in case of licensing system in which unsuitable reinsurers are removed from the market. This may reduce a cedant's scope for achieving an optimal allocation of capital.

Regulation may also have a negative effect on small businesses. If regulation imposes high fixed costs, it may hinder new small businesses entering the market which could reduce competition.

7.6.2 Description of supervision benefit-impacts

7.6.2.1 Micro-economic impacts

Reduction of costs

Harmonised supervision can also lead to a reduction of costs at an EU level, as it would reduce the scope for duplication and eliminate the costs associated with different legal and regulatory regimes.

Reinsurance companies doing business worldwide already have departments to serve the different supervisory regulations in different countries. This is highly cost intensive due to the existence of different disclosures required under different accounting principles.

A single administration would avoid duplication of compliance costs arguably without any reduction in benefit.

7.6.2.2 Macro-economic impacts

Positive market impacts

Regulation can have a significant effect on competition. As explained in the first part of this section, harmonised regulation would permit free access to the competitive international reinsurance market and may lead to lower cost of reinsurance and indirectly of insurance. This situation could create a benefit for the policyholder by reducing premiums.

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Under a European passport system, regulation would enhance competition and create a benefit by reducing the resources wasted competing for the market (e.g. high commissions). The value of this benefit would equal the value of the reduction in resources wasted, which in turn would equal the reduction in the costs of the firms competing for the market.

Efficient competition also leads to a better and broader range of services. This means an increase in quality that is brought about by regulation. Improved quality in the reinsurance products leads to more secure products in the market. The benefit is to allow insurers to select products more appropriate to their level of risk.

Confidence in the market, enhanced through regulation by setting minimum standard requirements, leads to increased demand for reinsurance products which is beneficial to the insurance industry as a whole (reinsurer, insurer, policyholder). As a general rule, an increase in choice creates a benefit.

Regulation which removes firms guilty of misconduct from the market that would otherwise contaminate the reputation of all firms in the market should increase overall security. Reinsurance regulation implies more security for insurers which indirectly leads to more security for policyholders. Greater security for insurers means less risk of failures in the insurance market, although in the past there have been no significant cases where an insolvency of a reinsurer did cause insolvency of direct insurer.

Finally, regulation that enhances market transparency for insurers due to a harmonised level of quality of reinsurers leads to costs savings in the process of reinsurer selection.

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Summary of reinsurance market practice for assessing risk and establishing technical provisions

8.1 Scope

In accordance with the Terms of Reference, this chapter provides " a summary of reinsurance market practice for assessing risk and establishing adequate technical provisions, the impact of securitisation and how reinsurers measure or take into account portfolio diversification in assessing their own capital requirements. Techniques for the calculation of probable maximum losses (PML) should be specifically addressed".

8.2 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 number of interviews with reinsurers;

■ Discussions with regulators and use of public information where necessary, to supplement information gathered from local offices;

■ Reviews of existing published sources.

8.3 Market practice for assessing risk

The risks for reinsurance companies are set out in chapter 3 of this report. The range of risks is diverse. Moreover, the amount of information available to the reinsurer depends on the cedant and will vary considerably, for example according to the segment of business, and the territory, as well as the individual cedant. Specific comments on foreign currency risk are included below, and reserving risk is covered in section 8.4. The assessment of other risks is highly dependant on the individual reinsurer.

Soundly managed reinsurers will undertake exposure analysis as part of their assessment of underwriting risk. Individual records of contracts written will capture the underlying exposures, sum insured limits, etc. Overall risk assessment depends on modelling based on this. Different reinsurers extend this to different degrees of depth. We describe below a modelling approach which attempts to model all aspects of the reinsurers risks across the whole enterprise. This description is comprehensive and some parts of the overall process are adopted in isolation by some companies.

Reinsurance companies face several categories of risks doing their business. The different risks are similar to those of direct insurers. The underwriting risk as an essential risk differs especially because the business written by a reinsurer is derivative. Usually, the spread of the business written by a reinsurer is much wider in terms of geography and type or line of business than that written by a direct insurer. This has a significant influence on the calculation of underwriting risk. The reinsurance industry deals with these higher risks by a diversification of its portfolio and pooling of individual risks.

For better risk management the reinsurance industry is working on internal risk models, especially relating to underwriting risk.

Underwriting risk is the key risk for reinsurers. There are several other risks facing reinsurance companies. These risks are discussed in chapter 3. The risks considered to be the most significant after underwriting risk are:

■ credit risk

■ investment risk

■ currency exchange risk

The reserve risk is part of the underwriting risk but is so significant that reinsurers consider it separately. There are risk management strategies established to handle the above mentioned risks. As the complexity of interdependencies and the interrelations between these risks differ significantly the risk management strategies differ for each risk.

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8.4 Establishing adequate technical provisions

8.4.1 General comments

Today most reinsurance companies use actuarial methods to assess the adequacy of reported reserves. Generally the reserves reported by the cedant are taken into the books of the reinsurer. The reinsurer receives claims reserves from all over the world and has to judge the quality of these reserves. Reserving quality is very different from country to country. For example, reported reserves on business written in the US tend to be very low. German business used to be reserved strongly at least in some lines of business (such as motor in the past) and has ultimately produced significant run-off profits.

Incurred but not reported (IBNR) claims in proportional business are, in principle, set up in accordance with the amounts reported by the cedant. In some cases the IBNRprovisions set up by the cedants are not included in the accounts of the reinsurer or they are not sufficient, e.g. in third party liability. This is common practice for non-proportional business. In these cases and in the case of differing accounting policies between countries it is important that the reinsurer does its own analysis of IBNR claims. IBNR claims reserves can only be assessed using statistical methods which are discussed for the reported claims reserve generally in the following sections. These methods are applied to both proportional and non-proportional business although assumptions in non-proportional business are much more uncertain because of the higher volatility of non-proportional business and respective historical data.

The actuarial calculation of the reserves in life and non-life business mainly addresses three major subjects

- adequacy of the reserves set up in the published accounts;

- adequacy of premium calculation;

- adequacy of the retrocession program. For

this analysis actuaries apply different tools.

Life actuaries tend to model or remodel the premium and reserve calculation of the cedants by applying (modified) assumptions received by the cedant or derived from their market databases. The accuracy of the results of the life actuaries mainly depend on the underlying assumptions. In life business significant uncertainties remain in those cases where either not enough data is available from the cedant or other sources or where no data records are available due to the missing history of new products (for example in current processes of privatisation of health insurance).

Non-life actuaries generally use triangulation methods for their work. In these models, the available data is divided into accident years and the related run-off years. If the earliest reliable accident year is not settled, it is necessary to set a so called tail factor to take the remaining run-off into account. Various kinds of models are used. Most of the models focus on the prognosis of the development factors that have to be used for the different development years. For these prognoses it is necessary to have as much homogeneous data as possible and, therefore, the underlying data is segmented. Large claims and cumulative claims are eliminated for a separate estimation. The quality of the non-life actuaries work heavily depends on the volatility of the development factors of the respective segment. The more homogeneous the underlying database is, the more reliable are the results of the actuarial analysis and vice versa. Because of the underlying business (i.e. environmental liability, US liability or catastrophe risks) there is a probability of significant uncertainties. The methods of reserve analysis for non-life business are discussed in the following section.

Overall it can be stated that a well organized and well diversified reinsurance company is able to monitor its reserve risks properly.

The impact of the reserve risks on the underwriting risks are obvious. Therefore this kind of analysis plays a significant part in the calculation of the underwriting risk of a reinsurance company. More details on that are discussed below.

8.4.2 Actuarial reserve analysis for non-life business

Actuarial reserve analysis can be regarded as a three step process: definition and obtaining of the required data, segmentation of the business, analysis of the segments.

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8.4.2.1 Required Data

Defining and obtaining the required data is the most crucial step for a reinsurance company.

For reinsurance companies it is difficult to obtain the data needed for the analysis. As mentioned in section 2.5.4. there is usually a delay in reporting claims. Another reason for the difficulties is that, depending on the complexity of reinsurance contract terms, cedants may want to evade a high effort of supplying the data or need more time to do so. In addition, a cedant may be interested in delaying the supply of data until the renewal of reinsurance contracts with advantageous contract terms. The problems of obtaining the required data from cedants could somewhat diminish in the future with the improvement of data systems. Systems which allow estimations of unearned premiums and claims provisions with an acceptable extent of reliability in an environment of constant delays in claims reporting do not exist yet and are currently being developed in practice.

For proportional business the figures are usually available on an accident year basis but there is no information on single claims. Even this information is not visible from the cedant's account. For non-proportional business it is even more difficult to obtain the requested data, especially for the layers written by the reinsurer. The historical data can only be taken as significant if the structure of the written layers is comparable over the years. Otherwise, claims information has to be adjusted for projection purposes. Data is only available for the gross business of the reinsurer. To calculate deficiencies with an impact on equity the calculation has to be done on a net business. The retro data is even more difficult to get, because generally the retro cover is not based on single treaties or segments of the incoming business, but is for example segmented differently or based on whole accounts for a line of business.

For the analysis of gross business payments, outstandings, earned premiums and commissions (brokerage) are essential. Usually the number of losses is taken into account but generally these numbers are not completely available to the reinsurer. To calculate an average loss size on the existing base would leave the analysed segments too small for a statistical analysis.

The claims data may be available in accident year or underwriting year cohorts depending on the type of business and the practices of the individual cedant. For each cohort, the claims for each development period need to be available.

Companies often book their losses on an underwriting year (UY) basis. Underwriting years may have a different duration which would distort the homogeneous behaviour of a segment. Moreover, if an insurance contract with a period of e.g. five years is part of a reinsurance treaty on underwriting year basis, any loss that is incurred in the second treaty year would be allocated to the second development year and therefore regarded as an IBNR loss which is not the case in strict terms. The problem with multiyear reinsurance contracts on an underwriting year basis is that it is simply not known for losses incurred in years following the underwriting year to what extent they are caused by increased claims expenses (corresponding to a run-off loss on an accident year basis), IBNR or claims incurred in years following the underwriting year. This makes an adequate analysis of data difficult.

Because of such difficulties, the split by accident year if available is in many ways preferable for analysis purposes.

Often the split by accident year is not available, and analysis has to be done on an underwriting year basis, or this may be necessary as the market has always been organised on an underwriting year basis (e.g. Lloyd's and many other London Market insurers and reinsurers).

For the analysis the actuary only takes business into account that has a bearing on the loss development. Clean cut business is not analysed using triangulation projection techniques.

Run off treaties should be available with their total history. If parts of the history of runoff treaties are not available there should be a separate analysis.

If at the date of the actuarial analysis the current calendar year is not totally reported, reinsurance actuaries may leave out the last diagonal and correct the total reserves which are the result of their analysis by the payments booked for the current calendar year. Alternatively, the current calendar year can be extended to a full year by pro-rata grossing up or, better, using monthly or quarterly development factors. For the estimation of the current year's reserve the Expected Loss Method may be utilised.

8.4.2.2 Segmentation of the Business

The analysed business has to be sub-divided. The aim is to get segments with a homogeneous development of the run-off. The segmentation has to leave a statistically usable group of claims for

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the analysis. As mentioned before, cumulative events like catastrophes and other special features have to be eliminated in advance.

Basically, the segmentation of the reinsurance business should be three-dimensional: line of business (LOB), type of reinsurance, region.

The different lines of business have to be divided into at least long-tail and short-tail business. It is very important that any liability business is kept separate. This is difficult for motor business because generally reinsurance does not divide motor liability and other damages. For statistical reasons lines of business may be accumulated for the analysis -for example the complete property business might be analysed as one LOB.

Within a LOB the business should be segmented by three types of reinsurance: proportional, non proportional and facultative business. Geographical segments have to be defined as well. Reinsurance business can be very different according to the region where it is written. The regional split can only be made according to the region where the business is written and data recorded. This does not necessarily mean that this segment only includes risks of this region.

8.4.2.3 Analysis of the Segments

The first step in an analysis is the definition of the data to be used. If all necessary data is available the analysis can be run based on payments or on incurred amounts (including reserves). Incurred amounts may be influenced by the cedants' accounting policy on reserves, but contains more information in the outstanding claims and reflects legal and other changes which may not work their way through to payments for some years. Thus, both the payments basis and the incurred basis should be considered.

For non proportional business an analysis based on payments is often not possible since the payments for these contracts begin in later development years. For those cases the use of the incurred values is necessary.

For the evaluation of the required reserves several actuarial methods are available, e.g.:

■ Chain Ladder Method

■ Bornhuetter-Ferguson Method

■ Cape Cod Method

■ Additive or Loss Ratio Step-by-Step Method

■ Expected Loss or Naive Loss Ratio Method

■ Berquist-Sherman Method

■ Benktander Method or Iterated Bornhuetter Ferguson Method

■ Separation Methods

■ Fisher-Lange Method

■ Salzmann Methods

Variations of the above methods are also available. Some methods require data which is usually not available to reinsurance companies.

The standard techniques applied by reinsurance actuaries are Chain Ladder (with variations), Cape Cod, Bornhuetter-Ferguson, Additive Method and Expected Loss Method. Detailed descriptions of the methods used are included in Appendix 4.15

The methods used most commonly in practice are based on a triangle of loss data. The only exception is the Expected Loss Method which only requires an estimation of the ultimate loss ratio.

These methods require homogeneous segments. Since large losses or catastrophe losses would distort the homogeneous development, they have to be treated separately. Ideally, the complete development of such

15 Examples of the Chain Ladder, Cape Cod, Bornhuetter-Ferguson and Separation method are contained in Swiss Re (2000) Late claim reserves in reinsurance, (Zurich).

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losses should be taken out of the triangles. A minimum requirement is to avoid applying the year-to-ultimate factors to those losses but to review their case reserve separately.

Which method will be chosen for a certain segment will depend on the actuarial analysis of the available data. For example, if there has been a clear trend in claims development in the past years, a Chain Ladder method would be appropriate. If there is a correlation between loss development and premiums, Cape Cod could be the appropriate method. Whatever method will be chosen, nobody can say for sure that it is in fact the correct one.

All methods require significant judgment in order to select the result to be adopted from the different methods, with the key issues being:

■ The company's philosophy regarding the degree of prudence will affect the provisions. There is no generally accepted level of prudence in the industry. The degree of judgement may be more or less limited by accounting principles. For example, if accounting rules require the use of best estimates, a provision is set up to the extent that the probability that claims will be greater than estimated is the same as the probability that they will be less than estimated.

■ Particular judgement has to be applied to the loss ratio adopted for the recent years which is blended in as part of the reserves in the Bornhuetter Ferguson method and forms the reserve for the loss ratio method. If this loss ratio is provided by underwriters there may be undue optimism about the business performance, and the loss reserving specialist must understand and if necessary challenge the loss ratio being included.

■ The tail on long term business is particularly important and if the business category has not been written that long then there will not be adequate data and curve fitting or judgment must be applied.

■ The degree to which large losses are regarded as exceptional and removed from the data is also important. If too readily removed, there may not be sufficient allowance for future large loss emergence.

■ New market issues have to be understood and the effect on the development data available allowed for in the projection process.

It is also relevant to note that for some classes development statistics in triangulation format are not appropriate. Examples of this are asbestos claims development; pollution claims development; health hazard claims development, and "spiral business" where business had been retroceded several times in the market. Also for complex pieces of business, specific modelling of the workings of the underlying business contracts is necessary. In all of these categories traditional methods are not applicable and are not likely to produce sensible results. The approach must be specifically tailored to the circumstances driving the loss development.

The degree to which different reinsurers model specific situations separately from the balance of the account varies considerably. Best practice is for the reinsurer to understand the loss development in their account sufficiently to be able to identify contracts or types of claim which should be analysed separately. Smaller reinsurers are less likely to have the resources or sophistication to do this to the same degree as larger reinsurers.

The ability to set adequate reserves is influenced by the degree to which actuarial analysis is undertaken, the independence of the loss reserving function from the underwriting and the degree to which the management takes a prudent stance on reserving issues. It is possible to consider past run-off to see if there is a pattern of setting reserves which had a favourable run-off, or whether the converse applies. Also it is possible to project future cash flows, and future loss emergence, and to monitor actual emergence against that anticipated.

8.5 Management of underwriting risks

Underwriting risk is the fundamental risk of the reinsurer. The risk that the actual costs of claims will exceed the premiums earned is determined by several factors, which makes the management of underwriting risk very complex. The management starts with the analysis of the profitability of every single contract and ends with the capacity of the whole company limited by the amount of equity. In practice management of underwriting risk is organized for segments of business via several steps that are connected. The following steps are taken:

■ for the business units the maximum amounts of liability with respect to premium that should be accepted are determined;

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■ underwriting guidelines are issued;

■ checks are installed by third parties or computer systems that ensure that the underwriting guidelines are followed;

■ retrocessions are defined that cover the incoming risk so that the retention rate is adequate in relation to the companies capacity.

Whilst the principles are basically the same the precise steps differ significantly from company to company.

Underwriting guidelines include the business segments and contract types that are permitted or not permitted to be written, respective minimum premium rates, the maximum risk exposure allowed (e.g. per segment, risk or treaty), maximum amounts allowed to be written by one or several underwriters and criteria to assess if and to what extent retrocession coverage is necessary. Usually, underwriting guidelines exist for business segments, which are quite detailed, but still leave a certain range of discretion to the underwriter. The process of preparation of underwriting guidelines is described in the following sections. Underwriting guidelines are prepared by one department of the reinsurer, e.g. the controlling department, approved by the board of directors and usually revised annually. Most importantly it has to be assured that they are being consistently applied in practice.

8.5.1 Fixing of capacities and premium rates

The underwriting requires an allocation of the capacity in advance of a renewal season. The company has to determine what degree of risk it is willing to take. For the calculation the existing portfolio and the renewal has to be taken into account.

The capacity is determined by the total amount of net equity available in the company or group. The net equity has to be allocated to the existing portfolio and to the different segments in order to come up with the maximum risk that the individual business units may write without jeopardizing the solvency of the company or group as a whole.

To achieve this the company has to analyse the amount of risk borne by writing different kinds of contracts in different kinds of segments or regions. The amount of equity required depends on the risks included in the different products as well as on the retrocession purchased.

These analyses lead to the process of fixing of capacities and the amount of net equity that the company is willing to risk within the individual selling units.

The result of the analysis is documented in the underwriting guidelines and is mandatory for underwriters. If the individual underwriter or the business unit want to exceed these guidelines explicit permission has to be granted.

In practice the process described above is applied by different methods. The methods used by the companies to derive their capacity and to allocate it differ significantly.

Basically one can distinguish between a ratio approach and a risk modelling approach.

Ratio approach

A well known ratio approach which is similar to the methods used in the industry is the Standard & Poor's model. The model is applied in the assessment of the financial strength of a company. The financial strength is measured in the long run by the ability to avoid insolvency. So the major aim of the Standard & Poor's rating is to identify capital risk that can lead to insolvencies by using the complete net equity of the company.

The Standard & Poor's approach defines the four major risks. There are risk factors calculated by using ratios on a defined basis. The major risks are the underwriting risk, the reserve risk, the credit risk and the investment risk. The basis for these ratios is easy to calculate from the balance sheet of the company. They are:

major risk basis

- underwriting risk - premium

- reserve risk - book value per segment

- credit risk - receivables

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- investment risk - book value per risk category

Also, reinsurance companies define ratios similar to the Standard & Poor's approach based on criteria like booked premium or liability taken. The concrete ratios are developed by historical analysis based on the segments extrapolated to the future. For high risk products like natural perils separate analysis is performed. The quality of this approach is as good as the factors that are applied. In particular, the historical analysis has to be done on special segments which have to be as homogeneous as possible. To achieve this, all events that are not of a regular statistical relevance (like cumulative claims events, catastrophes, and so on) have to be eliminated and analysed separately. There are often difficulties caused by data quality especially for the older data. The analysis of business needs to be done over the long term to see a significant development.

Risk modelling approach

A total enterprise risk model develops the risk categories discussed in chapter 3 of this study like underwriting, credit, investment and reserving taking into consideration their interactions.

A relatively new approach is the stochastic method for the analysis of risks based on segments or the total account like for example capital at risk or optimising the retrocession program. However, stochastic methods are not yet frequently applied by reinsurers.

The allocation of capacities based on the calculation of a risk portfolio that uses a probabilistic approach modelling different business segments diverges from the ratio approach used by the rating agencies.

The most advanced models developed and employed by the leading reinsurance groups model underwriting risks using stochastic approaches and analysing the impact of special events (for example: a crash at the stock exchanges) using scenario techniques.

In practice this has to be done at group level rather than at entity level.

To handle the complexity of the problem total risk models are designed to derive distributions of losses taking into consideration the influence of different portfolio mixes and different retrocession programs.

In due course, these approaches will become widespread. At present only the big market players are able to do these calculations.

The currently used methods for the analysis of underwriting risk are comparable. A discussion of total enterprise risk models is included in section 8.5.3.

The other important requirement is the premium rate that has to be paid by the cedant. The rates are usually derived from pricing models. These are actuarial models, based on reasonable assumptions on loss ratios which derive the premium level required. The parameters used for these analysis are either also developed from historical data of the company based on internal data basis or are drawn from external sources taking into consideration the results of the own reserve analyses.

For the pricing of facultative business the parameters may be specific to the risk exposure of the risk insured and reflect its probable maximum loss. The probability of a major loss is also taken into account.

In practice, it may happen that the underwriter gives discounts on the calculated premiums. There is a control issue on the extent to which these premiums are agreed when entering into the contract. If there are these agreements, the discount has to be taken into account for the risk calculation.

8.5.2 Organization of risk management

The requirements concerning capacity allocation and premium calculation have to be applied to the individual business units. It is essential for the company to control this process.

It is best practice to have separate organizational units which

- perform the pricing and capital allocation (capacities)

- do the underwriting

- control the observation of the requirements

If there is no separation of the different departments, this may cause additional business risk. In practice, this separation of execution and control is not always in place.

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It should also be noted that depending on the reinsurance cycle the priced rates often cannot be achieved. A good risk management should reflect this when updating the underwriting guidelines.

Another major risk management factor relates to the information gathered from the cedant. The reinsurer has to rely on the information gathered by the cedant. There are other general sources of information which can be used, but the input on how much risk has been assumed by the portfolio has to come from the cedant. Especially for non-proportional business, portfolio information about the cedants portfolio gives no complete indication of the development of the reinsurance portfolio.

History has proved that a lack of information on the reinsurer's side about the cedant, its products, its risk strategy and its economic environment can lead to disastrous losses. This risk is greatest for business written through intermediaries.

Accordingly, the underwriting guidelines have to define the degree of information to be gathered and the procedures to be taken before accepting businesses from direct insurers especially in the case of business accepted via intermediaries.

One method of ensuring compliance with underwriting guidelines is to require that two underwriters have to sign a contract. However, this is of less practical use, because it is industry practice for the written documentation of a contract to be completed a month after entering into a contract.

8.5.3 Risk management across the whole enterprise

This section describes a common approach to risk management across the whole enterprise. As most of the companies use a similar approach, the basic principles will be illustrated.

There are differences concerning the approach over one or more periods. Some models automatically allow for investment risk. The techniques for deriving results differ from company to company.

The model includes all lines of business, (possibly macroeconomic variables) and quantifies the variability of investment returns. It is based on an adjusted capital approach which allows the user to allocate the capacity of a company or group. It gives a complete overview of the risk portfolio of a reinsurance company.

Claims are segmented into basic losses, large, single and catastrophe losses. Basic losses are assumed to follow a normal distribution. Large, single and catastrophe (cumulative) claims are simulated by the estimation of the expected amounts and the frequency. The amounts mostly follow a Pareto distribution while their frequency is generally represented by a Poisson distribution.

There are alternative approaches where the probability distribution is determined by reference to special classes of frequency distributions without a division into different categories of claims. There is no information available on how these classes are designed.

The risk based capital can be derived from the probabilistic distribution of risks and allows for an assessment of capital adequacy.

In summary, the most advanced models developed and employed by the leading reinsurance groups model underwriting risks using stochastic approaches and analyse the impact of special events (for example: a stock market crash) using scenario techniques.

In practice, the modelling has to be done at group level rather than entity level.

General implications

The aim of all the models is to identify a figure that quantifies the company's overall risk and enables the company to assess the adequacy of its capital or to allocate the available capital.

The risk portfolio of a reinsurance company is a very complex dynamic system. It is composed of underlying risk-driving factors, including events that may threaten the business, as well as portfolios of insurance and financial market products or combinations of both. The risk factors are by nature outside the company's control, but can be managed by portfolio techniques. Risk factors subject to portfolio management are time dependent. For simplicity the models generally take a time horizon of between one and a few years into account. In reality the time scale goes from an hourly basis for investment portfolios up to the basis of decades for mortality rates.

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The effect of fluctuating risk factors is generally measured in terms of changes in capital and in the annual result.

The structure can be determined via identification of the various risk factors and a combination of similar products in portfolios.

The risk portfolio is structured in line with the information required by management. In particular, key factors concerning different lines of business, types of contracts or geographical segments are taken into account.

Risk factors

The first step is the identification of the risk factors. It is necessary to distinguish between economic and underwriting-specific risk factors. Economic risk factors comprise macroeconomic variables such as fluctuating interest rates, foreign exchange rates, inflation, gross domestic product growth or equity indices. Risk factors relating to underwriting are large and cumulative claims like natural perils (earthquakes, windstorms, floods) or man made threats such as fire in a large industrial plant, which can result in business interruption. Other risk factors are, for example, changes in the legal environment which can have a huge impact on liability claims (e.g. asbestosis). The possible losses caused by underwriting specific risk factors usually have a major impact on the portfolio but the probability of those events is relatively low. Due to this low frequency and high severity aspect, these events are analysed as loss scenarios when specifying underwriting risk factors.

Events with high frequency and low severity are excluded from the loss scenarios. The impact of these claims is referred to as normalised business fluctuations which is assumed to be a normal distribution. It is modelled directly at portfolio level by estimating yearly aggregate loss or result distributions.

Finally, for each segment the claims ratio is split into categories of claims, for example, basic claims, large claims, single claims and catastrophes.

Risk factors trigger claims or influence the size of claims on many different contracts and they influence the diversification of portfolios. For each possible event cumulative claims may impact on many contracts.

The modelling of risk factors concerning underwriting loss scenarios has to be based on expert knowledge and experience. Some loss scenarios can be based on events which actually occurred in the past, allowing the company to fall back on past experience like natural perils or liability threats (asbestosis). Other scenarios may not yet have been experienced but they represent situations which could occur in the future.

The identified risk factors have to be quantified. For many underwriting specific risk factors it is sufficient to specify a single distribution for frequency (per year), strength or severity. It is assumed that these events can be regarded as independent and that the underlying probability distributions do not change over time. For example, windstorms in different years can be assumed to be independent of each other and their frequency and strength are more or less constant. In the case of loss scenarios for which observations were made in the past, analyses can be made of the losses incurred in the insurance market as a whole. Physical models can also be used to assess loss scenarios associated with natural perils.

Loss scenarios are, in practice, often described by frequency and severity distributions. Severity distributions contain information about a specific portfolio or line of business so that the generic concept of a risk factor is abandoned. On the basis of common underlying risk factors there is only the possibility of an approximate calculation of dependencies between losses on different portfolios.

Examples of underwriting loss scenarios are in property business arising from natural perils such as earthquakes, floods, windstorms.

For third party liability losses there are no well established models as in the case of natural perils. Quite often in practice it is necessary to rely on foresight and intuition. Changes in people's attitudes and in legislation can have a significant impact. Examples of third party liability losses include environmental pollution, asbestosis or product liability.

Even lines of business that seem little exposed to risk, such as the motor business, require closer examination. Events such as hail may cause significant losses on a motor portfolio.

Life and health loss scenarios include infectious diseases, such as Aids. Further examples which have a more local influence include pollution or nuclear contamination, and various natural perils, such as earthquakes or storms. Also, changes in the long term trends of mortality and morbidity rates have an impact on loss scenarios. For example, the trend of changing compensation payments to long-term care claims influences significantly the development of a scenario. These potential losses are likely to have a more long-term impact and are therefore more significant for long-term business.

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In addition to the calculation described above there are also macroeconomic risk factors that have to be taken into account. There can be factors which influence the business as a whole for the company such as recession, domestic product growth or inflation.

For long term business like third party liability or life and health management of interest rate exposure of the portfolio has a strong impact on profitability. The interest-rate risk can be limited by adopting a duration matching strategy.

For life business there is in practice a widespread use of asset liability matching to reduce the long-term portfolios' sensitivity to interest rates. In contrast, property-casualty business is less exposed to interest rate fluctuations given the long-term nature of their liabilities. Here a matching strategy is generally not common.

The global nature of reinsurance business means that the market is exposed to the risk of fluctuating foreign exchange rates which have to be modelled too. By and large foreign exchange exposures can be reduced to a low level. Adequate reserves for claims payments are held in each currency.

Investment risk is another risk factor which has an impact on the capital adequacy of financial institutions in general. We refer to our analysis in section 8.7 of this study. Credit risk also has to be taken into account. This is the possibility of a counterparty not being able to meet its financial obligations. The loss potential is assessed by quantifying the underlying exposure and the default probabilities of counterparties. The whole contractual period must be considered and recoveries taken into account.

There is a trend towards increasing exposure to credit risk in view of the growing number of new financial and alternative risk transfer products that encompass explicit or implicit credit risk (see section 8.6).

Probability distribution

For the determination of a probability distribution for the yearly result the identified risk factors are combined with the exposures and normalised business fluctuations have to be quantified and added. The calculation is done either for the existing portfolio or for the portfolio the company anticipates will be written.

The portfolio associated with high frequency events usually has a small claim fluctuation. The normalized fluctuations are generally described by aggregate distribution done yearly. Usually the distributions are based on the historical frequency and severity of losses in the portfolio. The historical data used in this procedure should first be adjusted for trends in claims inflation and changes in the underlying exposure. The claims data has to be filtered for claims associated with the loss scenarios, to avoid double counting.

The identified results have to be aggregated. The probability distribution for the whole exposure has to be constructed to account for all the different risk factors on the portfolio and to show an overall result for the company.

To account for the interdependencies between different sub-portfolios, it is necessary to start with the individual risk factors and their impact on the results of each portfolio. The process is repeated for all risk factors in order to arrive at the overall result. With the inclusion of retrocession into the model, the final result is derived either from net underwriting results or from a separate analysis of the retrocession cash flows.

After the probabilistic model of the company's risk portfolio is calculated, the results can be compared with the level of risk capital. There is no standardised formula for risk based capital. The underlying methods and assumptions have to be taken into account so that the management can understand the applicability of the model to the company and its limitations. Only then will the company be in a position to judge whether the underlying assumptions correspond to their aims and if the scenarios used to model the risk portfolio are adequate.

Once a company has selected a model for calculating the risk adjusted capital and fixed a certain survival probability, it can determine the required level of risk adjusted capital. If the risk-bearing capital exceeds the required level of risk adjusted capital, there is scope for taking on additional risk by changing the risk portfolio. If the risk-bearing capital is lower than the required level of risk adjusted capital, risk can be reduced by either implementing measures on the investment side or by modifying underwriting exposure by means of reinsurance or retrocession.

The information obtained from a probabilistic description of the risk portfolio can be used for purposes other than the control of capital adequacy. For example, pricing can be combined with the model described above. The actuarial pricing of reinsurance cover is usually based on the principle of the premium being equal to the sum of the risk premiums plus a loading. This calculation includes the net present value of liabilities e.g. expected future cash flows discounted with an appropriate rate. A loading principle can serve as a benchmark for the underwriter to allow a comparison of market conditions with a targeted return. After inclusion of investment income and potential losses, the distribution gives an indication of the probability of insolvency for a given portfolio and retrocession programme.

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Limitations

The major limitations of these models result from the following factors:

- the determination of the different probability distributions is to a certain extent subject to judgement

- the distribution parameters are gathered from historical data and there is a risk that future events will not resemble the past

Because the functionality of adjustable features ( profit sharing ) cannot be modelled, the model does not fully reflect reality.

The argument against this criticism is that this represents an additional prudence factor.

In summary, it can be concluded that even such models do not represent the real world. It is often necessary to work with planned portfolios. At present there are no better approaches available at the corporate level.

8.6 Monitoring credit risk

Credit risk (excluding credit risk of investments) mainly relates to the collectability of receivables. Credit risk or counterparty risk (sometimes referred to as default risk) arises when the counterparty of a creditor fails to fulfil his contractual obligations. In general, all types of lending entails default risk.

For assumed business this mainly belongs to premium income, for ceded business to the recoverability of loss reserves. The issue of reinsurance recoverables remains a significant one for the reinsurance industry and is focused on the ultimate collectability of retroceded liabilities.

The use of retrocession creates a significant level of credit risk if amounts due under a retrocession contract are not fully collectible in case of insolvency. The monitoring of credit risk is important when placing retrocession cover.

For international businesses, even if it is not common, sometimes bonds or stocks are deposited to secure technical reserves. Therefore, not all recoverables are at material risk, as companies may have used these techniques to substantially reduce the financial risk associated with future recoveries.

However, the risk strategy of reinsurance companies depends on the market expertise of their underwriters supplemented by ratings of international rating agencies to make informed judgements about the good standing of the trading partners.

Appropriate counterparties should be selected to diversify and limit credit risk, taking into account the importance of qualitative aspects such as the skill of management, market behaviour and long-term relationships, as well as their strengths and their ability to pay.

Reinsurers should maintain an active dialogue with their partners and continually monitor their financial conditions so that the security that was originally anticipated will be realised at collection.

The use of ratings by international rating agencies should complete the analysis of reinsurance companies to evaluate security. Ratings not only take into consideration other areas of analysis, such as operating performance and business position, but also benefit from the insight and judgement of experienced analysts. A rating is an indicator of a company's ability to meet its financial obligations.

Proper credit risk analysis performed throughout the industry leads to an efficient distribution of capital funds on competitive terms. In the absence of credit risk analysis, the credit risk still exists but can only be estimated. This risk is then charged back to the company through higher reinsurance fees. Credit analysis done by competing reinsurers drives down costs by reducing the uncertainty.

Reinsurers with a high degree of directly written business tend to have enough market knowledge to evaluate the solvency of their customers, whereas reinsurers which write business through intermediates often have a more limited overview and have to rely on other sources of information. There is a high risk that the failure of an intermediary could result in bad debts.

Naturally, credit risk increases with the duration of the reinsurance contracts, such as annuity reinsurance and the run-off of losses.

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As already explained, credit risk is the risk of a counterparty not being able to meet its financial obligations. There is a trend towards increasing exposure to credit risk in view of the growing number of new financial and alternative risk transfer products that encompass explicit or implicit credit risk.

The loss potential is assessed by quantifying the underlying exposure and the default probabilities of counterparties. The whole contractual period must be considered and recoveries taken into account. The default probabilities are closely linked to retrocession-driving factors and are assessed per category of creditworthiness. A feature of credit and surety business is that periods of large losses typically persist for several years, with the result that the different underwriting years are not independent. Furthermore, it is difficult to hold well-diversified credit risk portfolios in a single economy given their strong dependence on macroeconomic variables.

8.7 Management of investment risks

Generally the management of investment risk for reinsurance companies gives rise to the same considerations as for other financial institutions and therefore, general approaches to the management of investment risk are not discussed here.

However, there are several aspects which are specific to the reinsurance industry:

■ Because of the international nature of underwriting, in practice the investment portfolio covers many currencies. These multi-currency investments bear special kinds of risks.

■ The reinsurance exposure has a potentially higher degree of volatility of the cash flows than the direct insurance. The volatility arises from the variety of different types of contracts (e.g. proportional, non proportional, facultative business) and the different types of business caused by the geographical spread of the exposure.

■ The premium calculation regularly takes into account investment income on funds supporting outstanding losses. Therefore, the reinsurance company depends on investment income (cash flow underwriting).

Sometimes there is even an investment income guaranteed to cedants.

These aspects indicate the need for sophisticated investment management. As a result of this, the market has started to develop asset liability management techniques. Our review of the industry revealed that the application of highly sophisticated multi-year simulation models is the exception rather than the norm. In practice, approaches such as duration matching are frequently used.

Almost all companies frequently apply stress tests. Generally, there are systems in place that calculate the impact of defined changes in indices or interest rates. This area is dealt with in more detail in the "Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision".

Taking only the underwriting risk into account, the investment strategy is, in general, rather conservative. Exceptions are some investments in compound instruments and derivatives. For example in Germany by the end of 1999, on average 47% of total investments of professional reinsurers were investments in affiliated undertakings, 24% in fixed income securities and loans, 18% in investment funds and only 3% in shares and other variable-yield securities.

This means that the inherent risk of reinsurance business is regarded as being high. Therefore, management strategy is generally to avoid a risky investment strategy. The management of the company becomes difficult if assets are subject to a significant risk which is independent of underwriting.

As the volatility in underwriting business is high, the modelling of an appropriate sophisticated asset-liability-management-system is quite complicated. Given the high degree of uncertainty, the confidence that can be placed in these models is limited. On the other hand, the efforts to implement such systems are significant. The reason is the complexity of the portfolio structure of a reinsurance company.

The cash outflow of a reinsurance company, even in short tail business, tends to take two or three years. This is longer than in other industries. Therefore, even for short tail business, investment returns have to be taken into account.

8.8 Management of foreign currency risks

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As reinsurance is an international business, most of the reinsurance companies are exposed to adverse currency exchange movements.

Most reinsurers write business in a large number of currencies. Therefore, the liabilities as a result of the international risk portfolio are paid in several different currencies. Although this kind of risk may have different aspects, the industry generally invests in relevant currency assets to match the equivalent currency liabilities.

Companies enter into hedging transactions to reduce risks that can adversely affect their financial position and net income, including risks associated with changes in foreign exchange rates.

A hedging instrument is defined as an asset or liability whose value moves inversely, and with a high degree of correlation, to changes in the value of the item being hedged. Various financial instruments can be used to implement hedging strategies to reduce foreign exchange risk.

The industry practice of matching liabilities with the assets in the corresponding currency cannot cover the complete risk as generally investors are not able to manage perfect hedges as the timing and severity of the liabilities are subject to estimation.

Two issues need to be addressed:

■ how can liabilities be hedged?

■ what is the amount of liabilities at the year-end and in the course of the year?

How can liabilities be hedged?

Hedging instruments are intended to reduce risks resulting from changes in foreign currency exchange rates. However, the hedging instruments themselves generate specific risks. Risks associated with hedging instruments include correlation risk, basis risk, credit risk and opportunity cost.

Correlation risk is the risk that the gain on the hedge position will not offset the loss on the hedged item to the extent anticipated because the hedge and the hedged item did not move in tandem.

Basis risk is the risk that the difference between the spot price of the hedged item and the price of the hedging instrument will increase or decrease over time. The basis is sometimes referred to as the spread. Many factors can influence the pricing of hedging instruments and the underlying items being hedged.

Credit risk is the risk that the counterparty to the transaction will not honour its commitments. The creditworthiness of the other party is particularly important when dealing in instruments not traded on a securities or commodities exchange.

A commonly used technique of hedging is to match foreign liabilities directly with investments in the same currency to eliminate the risks described above.

As long as these investments are not subject to market value risks, this form of hedging is sufficient.

Unfortunately, this method of hedging may be suboptimal in terms of investment income. Investments in bonds nominated in other currencies may earn higher interest. Shares have in the past consistently achieved higher returns than bonds.

In addition a complete management of the liabilities in the books of a reinsurance company could involve the handling of over 50 foreign currencies giving rise to substantial administration costs.

Furthermore, hedging of liabilities generated from underwriting may not fit in with the investment strategy of the company. In particular, the investment of the operational cash flow in liquid investments may be inconsistent with a company's investment priorities, for example when a company is interested in the foundation of a major subsidiary which has to be financed.

Therefore, in practice, as well as matching investments in the same currency as the liability, hedging is practised by investing in a currency basket. Other methods are investment in foreign currency options, future contracts or similar derivatives.

The use of a currency basket gives rise to the issue of the degree of correlation between the basket of a few currencies and the development of the multi-currency portfolio. Although analysis might show that this correlation has existed in the past this is not necessary true for the future.

Derivatives frequently do not match the payment pattern of the liabilities in regard to their duration. In particular either contracts with long duration are not available on the market or they are

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too expensive. Even if these derivatives are bought they do not guarantee full protection against adverse developments.

What is the amount of liabilities at year-end and in the course of the year?

With respect to this question several problems exist:

■ What is the amount of liabilities to pay per currency and do the reported loss reserves represent this amount;

■ How to deal with the time lag between the beginning of the contract and the reporting of the reserves by the ceding company.

The effective amount of liability has to take into account whether the reported reserves are adequate. The reserves in that currency should not include significant margins or deficiencies.

In practice, there are actuarial methods available which are capable of giving reasonable answers to the adequacy of loss reserves. In section 8.4 these approaches are discussed in detail.

Although in many reinsurance companies actuaries are employed to work on loss reserving, they seldom do reserve analysis based on currency segments. As long as this is not done or impossible to do due to erratic developments within a currency defined segment, approximations have to be applied which result in additional uncertainties regarding the amount of liabilities in a certain currency.

Another significant problem that may arise is the time lag between the signing of the contract and the reporting of loss reserves. In most countries loss reserves are reported just once a year. The reinsurance company has to estimate the loss reserves to overcome the information lag between the first cash flow at the beginning of the contract (e.g. premium payment) and the reserve reporting. The risk of misestimating significantly depends on the quality of the estimation system of the company and the general information available.

8.9 The role of securitisation

Securitisation is used as a basic method for transferring insurance risk to the capital markets. This allows traditional risk-bearers such as insurance companies to be replaced by the capital market or investors. The capital markets can provide more capacity for risks than the reinsurance market especially for low frequency, high severity risks. These risks can otherwise be very difficult to insure.

When traditional reinsurance capacity is insufficient or unavailable, securitisation is warranted, if the economic conditions are reasonable.

8.9.1 Recent and future evolution

In February 1994, reinsurance risks were securitised for the first time. Reinsurance markets nearly collapsed due to catastrophe losses in the previous years. Property catastrophe reinsurance was in very short supply in the wake of Hurricane Andrew and the Northridge earthquake in the early 1990s. The short supply, of course, led to inflated prices. All this led to the development of financial instruments capable of transferring insurance risk to the capital markets.

More than USD 5 billion in property catastrophe risk has been securitised worldwide to date (about USD 1 billion annually). Securitisation has become established as an important tool for placing risk for insurers. However, securitisation has somewhat slowed in recent years. A possible reason for this could be the consolidation of capital markets in general. Although investments in securitised risks bear for the investor the advantages of over-average yields and a dispersion of investment risks, securitisation products remain complex and sometimes difficult to analyse.

The future development of risk transfer through securitisations is being assessed differently within the industry. Some industry players primarily consider securitisation a form of advertising. This is certainly a positive effect that goes along with the initial offering of new and innovative products. Others believe that the volume of securitisation in the future will vary with the level of reinsurance prices and the development of capital markets. Still others contend that the role of securitisation will remain limited to catastrophe risks and not expand on traditional reinsurance as long as reinsurance rates remain stable and costs involved in securitisation remain high. The financing of new life insurance business, i.e. the financing of policy acquisition costs in life insurance through either bank loans or securitisation, is expected to gain importance.

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Undoubtedly, the relatively short experience with securitisation makes a forecast difficult. Swiss Re outlines in its study on capital market innovation16 that key issues such as standardisation, regulation, and education still have to be resolved for an active securitisation market to develop. Swiss Re estimates the volume of annual catastrophe bonds to grow up to perhaps USD 10 billion by 2010 and sees a vast market potential for capital market solutions linked to non-catastrophe risks as well, although these will remain a complement for traditional reinsurance.

8.9.2 Aspects of securitisation

Securitisation brings with it several advantages such as reduction of credit risk, diversification of funding for insurers and of investment for investors as well as a relatively high rate of return for investors, to name a few. Through securitisation, capital market participants have had the opportunity to become more familiar with the reinsurance concept.

Securitisation has the quality of an AAA reinsurer and provides management with an unprecedented level of security. Underwriting risk could be transferred completely to the markets.

The search for coverage for larger amounts of reinsurance often proved unavailing or the coverage available was too expensive, since reinsurers limit their exposure to any one risk. Hence, securitisation can eventually be less expensive, with almost unlimited capacity making it a viable alternative. Securitisation provides in addition protection against fluctuations in the price of reinsurance through a multi-year coverage at set prices.

Credit Risk

Counterparty risk plays a significant role in the selection of reinsurers. During periods of financial stress, reinsurance becomes increasingly important. Diversified reinsurance sources and business relationships with financially strong reinsurers is paramount for insurers at such times. Instruments involving the capital markets can be structured to minimise credit risk.

Insurance solutions involving the capital markets can be structured to minimise credit risk. Funds collected through the issuance of catastrophe bonds are invested in investment grade securities and held as collateral in a trust account for the benefit of investors and the reinsured. A non-US reinsurer commonly establishes a special purpose vehicle (SPV) as a trust account. This SPV then transforms the reinsurance risk into an investment security. The SPV matches every dollar in potential claims with a dollar of capital, giving this arrangement greater credit quality than conventional reinsurance.

Higher rates of returns

Catastrophe bonds tend to pay higher rates than those for corporate bond or asset-backed securities of the same credit rating. This spread or the difference between these rates typically compensates investors for model risk, when expected losses are higher then estimated, allowing for a cushion and the relative illiquidity of catastrophe bonds.

Portfolio diversification

Insurance linked securities reduce the overall statistical risk of an investment portfolio as insurance events are uncorrelated with fluctuations in the price of stocks and bonds.

8.9.3 Type of transactions

A great amount of insurance securitisation transactions have involved catastrophe bonds, although long-tail risks could also be handled through this technique.

Typically, a reinsurance contract between cedant and a SPV is entered into. The SPV in turn issues catastrophe bonds to investors. If there is no loss event, investors receive coupon payments on their investments and a return of principal. If there is a loss event, which is predefined, investors suffer a loss of interest and perhaps even principal as the funds are paid out to the cedant in fulfilment of the reinsurance contract.

There are three types of triggers for the majority of catastrophe bonds, namely indemnity, index or physical. Settlement of the first type is based on actual insurer losses. This type has no basic risk, but there is the threat of adverse selection and moral hazard. This means the insurer tries to cede

16 Swiss Re (2001) "Capital Market Innovation in the Insurance Industry" Sigma No. 3 (Zurich).

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those risks that are most problematic or after reinsurance is purchased, the insurer is less motivated to mitigate the risks.

Settlement of index based securitisation is based on industry losses and could, therefore, expose an insurer to a material amount of basic risks. Lastly, a physical index is used in settling claims of the third type of securitisation.

Although there have been a few securitisation transactions involving life insurance also, these transactions seem primarily motivated by the need for financing of new business in contrast to catastrophe bonds which primarily transfer risk.

8.9.4 Techniques of securitisation

Insurance linked securities can be structured to minimise portfolio risk. As mentioned earlier, most insurance linked securities involve catastrophe bonds (short "cat bonds"). Returns stemming from cat bonds depend on the performance of an index of industry losses reported by an independent agency, for instance Property Claims Services.

A typical transaction involves the investor, who purchases bonds from the issuer, in this case the SPV (special purpose vehicle), which in turn enters into an insurance contract with the cedant. Special purpose vehicles are usually licensed as reinsurers on an offshore location such as Bermuda or the Cayman Islands. Its sole purpose is the business related to the securitisation. Total focus on this one order of business works to minimise the risk to which the counterparties are exposed.

Proceeds provided by or invested in the bonds end in a trust account, which purpose the SPV normally serves, with restrictions as to investment and withdrawal of the funds. These investment earnings together with premiums paid by the cedant serve as coupon payments to the investor. If there has been a loss event, the amount due to the cedant as the defined coverage is paid out to the cedant at the end of the "loss development period" following the maturity date, during which the amount of losses payable is determined. If there are no loss events, the principal amount along with final coupon payments is paid out to the investors.

There are many variations to this model. For instance, often a reinsurer serves as an intermediary between the SPV and the cedant. The reinsurer can then retain some risk for himself before retroceding to the SPV. The amount retroceded could also be divided among two contracts, for example, allowing for recovery under the first based on index losses and the second based on actual losses of the cedant. Another variation would be a bond issue with a guarantee to return some percentage of principal to the investors at maturity if there is no loss. This feature is known as defeasance. If there is a loss a full return on principle can be paid out at a later date. This delayed repayment is then funded by zero coupon bonds, that are purchased at the maturity date with the guaranteed portion of the proceeds.

There is an alternative to cat bonds for transferring risk, namely through swaps. Here a series of fixed payments is exchanged for a series of floating payments whose values are determined by the occurrence of an insured event. The counterparties of a swap must be insurers in some jurisdictions. But in New York, insurance regulators ruled in 1998 that insurance linked swaps, in which payments are not based on the actual loss of the cedant, are financial contracts, and it is questionable whether such contracts can be entered into by insurers and reinsurers.

8.9.5 Techniques for the calculation of probable maximum losses (PML)

Reinsurers assess PMLs on both a contract by contract basis and across segments. Overall loss scenarios are also considered by many reinsurers and can be thought of as a whole account probable maximum loss. However, the degree to which such assessments are made is very variable.

The techniques for calculation depend on the type of reinsurance written. For facultative business, cedants should advise a PML based on an individual exposure assessment e.g. from an engineer's report. The reinsurer needs to know the basis of this PML and ensure it is a probable maximum loss rather than possible maximum loss or estimated maximum loss. The reinsurer then assesses its PML by applying the underwriting limits, sum assured, etc.

For per event insurance, the reinsurer needs to identify for each contract and each line of business the value and location of the exposures. A catastrophe model can then be used to assess the accumulated exposures and possible losses. All such assessments can be summarised in a database/spreadsheet. For pro-rata business, cedant's PMLs should be used and pro-rated.

Some reinsurers use PML factors e.g. an estimated percentage which is considered a possible loss is applied to the sum insured. All PMLs so assessed must be captured centrally. However most

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reinsurers would not be in a position to set up fully complete set of PMLs. Any individual reinsurer will be able to assess PMLs far more satisfactorily with some books of business than for others.

Overall PMLs necessitate sophisticated modelling of the underlying exposures on which PMLs have been assessed as considered above. These must include consideration of disaster scenarios.

8.10 Financial condition reporting

The nature of the business that reinsurers are exposed to is extremely diverse and is not suitable for standardisation of the approach to risk assessment and the establishing of technical provisions unless broken down to more standardised sub-segments. Even then most reinsurers will have exposure to non-standard books, and there is the issue of aggregation across different classes.

This aggregation requires assessment of the dependence structures across the different risk factors. This is a difficult process usually involving significant uncertainty and requiring judgment as well as adequate analytical abilities to exist. Any standardised approach is likely to be difficult to carry through to this part of the process. However, true risk assessment and assessment of capital adequacy cannot be completed except at this final stage.

Given this diversity good governance requires some centralised assessment of the issues within each reinsurer. This type of approach has been covered in section 8.5.3. Without such an approach a reinsurer will be more restricted in seeing how the various types of risk interact and affect the capital levels required. However some reinsures will not have the sophistication to develop these techniques in the short term and moreover there will often be issues such as lack of information from cedants which will restrict the ability to use this approach.

In these circumstances it would still be possible for a suitable expert in a central position to assess the various issues faced by the company. Given that any rule bound form of regulation of reinsurers is faced with difficulties caused by the diversity of the business, it would appear that any such rules would be enhanced by an assessment by a suitable expert backed by a financial condition report. This would cover the approach to risk assessment and technical provisions, including comments on the retrocession program, dependencies between classes, and other wider issues affecting the company. A financial condition report should also cover risk accumulations, the effect of any securitisations written or placed, and other matters relevant to the assessment of capital adequacy.

The availability of such a report would provide the regulator with the ability to understand the approach being taken and the quality of the work being undertaken. It would provide a significant amount of information that would not be available through standardised rule based regulatory approaches. Also, it would form a basis for discussions with companies.

8.11 Summary

There is a very high degree of diversity of reinsurance business. The approaches to risk assessment and establishing technical provisions are therefore very wide. Practical constraints on the degree of sophistication which can be utilised are very real and not easily overcome due to the international exposures involved.

Good practice involves a central function assessing the overall picture. A financial condition report which summarises the issues and the assessments made would be an excellent source for regulators to become aware of the controls and practices in place.

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Description of certain reinsurance

arrangements Main types of reinsurance

Facultative business and treaty business

Reinsurance can be arranged between the insurer and the reinsurer, in respect of individual risks or in respect of a group of risks. Facultative reinsurance relates to one specific risk. Treaty reinsurance relates to a group of risks.

Reinsurance

Facultative Treaty

Reinsurance contracts can be divided up into two main groups; facultative arrangements apply to one specified risk, treaty arrangements apply to a group of risks

Under facultative business the reinsurer receives an offer from the insurance company to underwrite a risk. The offer determines the nature of the risk, start and end of the insurance period, the sum insured and the premium. The reinsurance company can accept the risk offered by the ceding company in full or in part as a proportion or as a fixed sum. This type of agreement is designed to cater for the following unusual factors.

■ size (personal accident cover),

■ type or conditions (chemical plants particularly prone to explosion),

■ likelihood of occurrence (such as the insurance of a satellite).

There is also a relatively unusual type of contract known as facultative obligatory cover. Under this type of arrangement the cedant chooses which risks are to be ceded and the reinsurer is obliged to accept them. This type of contract is not very common, but is similar to treaty polices.

Under treaty reinsurance the cedant (the company taking out the reinsurance cover) agrees to cede, and the reinsurer agrees to accept all business written by the cedant which falls within the specific terms of the contract (the treaty) that they have entered into. Individual risks are not negotiated.

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Reinsurance

FacultativeTreaty

Appendix I

Quota-Share Surplus Excess of loss Stop loss

Under proportional reinsurance the reinsurer agrees to cover a proportionate share of the risks ceded. Premiums and losses will follow that of the ceding company. Loss adjustment expenses, however, are not necessarily shared on the same basis.

Non-proportional cover allows the insurer to retain risks up to a certain predetermined limit, whether on a risk by risk basis or in aggregate (risks are pooled to determine whether or not the limit has been exceeded). Non-proportional reinsurance arrangements play an important role in an insurer's risk management. Arrangements of this nature, if constructed carefully, can enhance an insurer's results.

Proportional reinsurance arrangements dilute an insurer's results by ceding an element of premiums and claims. They make both profits and losses smaller. In this way, proportional reinsurance increases an insurer's capacity to accept risks. Proportional arrangements cannot improve the loss ratio of an insurer's net account compared to that experienced on its gross account. Non-proportional reinsurance however can enhance the results of its net account compared to the results of its gross account.

Proportional treaty reinsurance

Quota-Share

The quota share contract is the simplest of all forms of treaty reinsurance. The reinsurer agrees to reinsure a fixed proportion of every risk accepted by the ceding company, and so shares proportionately in all losses. In return, the reinsurer shares the same proportion of all direct premiums (net of return premiums), less the agreed reinsurance commission. The treaty will specify the class(es) of insurance covered; the geographical limits and any other limits on restrictions (such as any specific types of risks or perils excluded from the treaty). The treaty usually provides that the ceding company will automatically cede the risk while the reinsurer will correspondingly accept the agreed share of every risk underwritten that falls within the contract.

(Source: Carter, 2000)

Surplus

Similar to "quota-share", surplus treaty is a form of proportional reinsurance by which the insurer accepts a certain share of risk, receiving an equivalent proportion of the gross premium (less reinsurance commission) and paying the same proportion of all claims.

The basic difference between the two are that under surplus treaties the reinsured only reinsures that portion of the risk that exceeds its own retention limit while under quota share arrangement, there are no retention limits. Furthermore, quota share reinsurance can be used for any class of insurance whereas surplus treaties can only operate for property and those other classes of insurance where the insurer's potential maximum liability is categorically expressed.

(Source: Carter, 2000)

Non-proportional treaty reinsurance

Excess of loss reinsurance

Under a contract of excess of loss reinsurance, the reinsurer only becomes liable once a claim exceeds the retention of the ceding company (the retention is also known as the deductible). The treaty may set an upper limit on the reinsurer's liability. These limits are often referred to as excess points. Any further element of the claim is borne by the ceding company, or may be covered by further layers of excess of loss reinsurance.

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Proportional and non-proportional business

Both, facultative and treaty contracts, may be concluded on a proportional or non-proportional basis.

Non-proportional Proportional Proportional Non-proportional

Stop Loss reinsurance

A stop loss treaty is a form of non-proportional reinsurance which limits the insurer's loss ratio, (the ratio of claims incurred to premium income). It may apply either to a particular class of business or to the insurer's total result. For example the reinsurer may be liable to pay for claims once a loss ratio of 110% of net premium income is reached, upto a maximum limit of a 150 % loss ratio. Should the loss ratio exceed 150% any further losses are borne by the insurer.

Reciprocity Business

This is the reciprocal exchange of reinsurance business. Reinsurance companies might seek an exchange of reinsurance business in return for their own cessions, particularly when their own business is profitable. Reasons for reciprocity business can be the company's desire to obtain a more diversified business, to increase their net premium income by adding to premiums retained from their direct business the premiums for reinsurance business (Source: Carter/ Lucas/ Ralph: Reinsurance, 4th Ed., 2000). Reciprocity business in these cases can be understood as traditional reinsurance business. However, reciprocity business can also be understood as ART business if the reinsurance assumes both profitable and unprofitable business from the same ceding company with profits and losses offsetting each other.

Factors determining the risk profile of reinsurance contracts

The risk that the reinsurance company is exposed to when writing a reinsurance contract depends, amongst others, upon the contractual features of the respective contract. The following provisions can increase or decrease the risk:

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Sliding-Scale Commission Rate: by using sliding-scale commission rates the reinsurance company can reward a ceding company for ceding profitable business and conversely penalise a cedant for poor experience. This gives the ceding company an incentive for underwriting (and ceding) high quality business.

Profit Commission: by paying a profit commission in addition to a flat commission the reinsurance company can reward the ceding company for a better than average experience. In the case of a poor experience the reinsurance company pays lower profit commissions partly offsetting the higher loss payments.

Loss Participation Clauses: by using loss participation clauses the assuming company can penalise the ceding company if a treaty's loss experience deteriorates. Under these provisions the reinsurer can recover expenses from the ceding company.

Profit sharing: under profit sharing agreements the insurance company returns at regular intervals a varying percentage of the amount by which net premiums exceed claims.

Overall, the risk the reinsurer is exposed to depends on the overall reinsurance program of the ceding company. For example a reinsurance company writing a quota-share contract is exposed to a higher risk if the quota-share is not accompanied by an excess-of-loss treaty (compared to a quota-share that is accompanied by an excess-of-loss).

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Appendix II

(Source: Reinsurance, January 2000)

Captives by domicile -1998

The following data gives an overview of other important captive domiciles:

Domicile

Non-US western hemisphereBermuda Cayman Islands BarbadosBritish Virgin Islands Bahamas British Columbia CuracaoSubtotal

Europe & AsiaGuernseyLuxemburgIsle of ManIrelandSingaporeSwitzerlandJerseyGibraltarSubtotal

US onshoreVermontHawaiiGeorgiaColoradoTennesseeIllinoisUS Virgin Islands Delaware New York MaineRhode IslandSubtotal

Official statistics

1497485 215 80

2316 15 2331

360 255 175 151 51 23 14 10

1039

33454 15 149 8 8 6 2 1 1

452

Total 3822

Lloyd's: summary of the regulatory approach

Anybody wishing to establish a new syndicate at Lloyd's (whether intending to underwrite insurance or those writing predominantly reinsurance) must obtain consent to do so. The consent will be for:

■ the management of a specific syndicate (with effect from a specified date);

■ for specific years of account; and

■ to write specific classes of business (Risk Categories) - this will include writing reinsurance business.

Any Lloyd's consent to form and manage a new syndicate may be subject to conditions.

Applicants must produce Realistic Disaster Scenarios. These are designed to enable syndicates, managing agents and Lloyd's Regulatory Division to see a syndicate's potential exposure to major losses. They enable the syndicate to demonstrate that risk is managed adequately. They also highlight to the syndicate

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Appendix II

where their major exposure is and allow the Regulatory Division to see whether the necessary systems and controls exist within the syndicate and there is adequate reporting at board level. Fifteen disaster scenarios have been prescribed by Lloyd's (e.g. European storm/flood with a £10 billion insured loss, loss of a major North Sea oil/gas complex to include property damage, removal of wreckage, liabilities, loss of production income and capping of well).

Lloyd's will test the assumptions in the business plan and application against realistic ultimate loss ratios by class of business. Lloyd's sets capital levels for the supporters of the syndicate on the basis of these realistic assumptions and in conjunction with a risk assessment which uses, inter alias, the Risk Based Capital ("RBC") system.

In addition, a new syndicate will attract an additional loading calculated using various factors from the business forecast and other conclusions drawn from the overall application, and interviews with key staff including the compliance officer and the proposed active underwriter. A syndicate loading will be added to the RBC figure for the first three years of account for every new syndicate. This will be recalculated each year based on updated information obtained from the agent

Monitoring

The regulatory focus at Lloyd's is risk-based, as opposed to rule-based. Best practices and benchmarks are established in conjunction with the leaders in the major lines of business, not just among Lloyd's syndicates but also among major companies.

All syndicates (insurers and reinsurers) have to publish an annual business plan. These are provided to capital providers of each syndicate, and are monitored centrally by the Regulatory Division of Lloyd's. The plans must include information on:

■ Management and management control systems

■ Description of market conditions

■ Each class of business written

■ Reinsurance arrangements

■ Potential impact on the syndicate's results of Realistic Disaster Scenarios

■ Aggregate monitoring

■ Forecast levels of business

In the past, Lloyd's required independent loss reviews of any syndicate incurring losses in any one year exceeding 100% of syndicate capacity, and the findings of the reviews were used as a basis for strengthening regulatory practices in the market.

Although such reviews are no longer automatic, the major themes which emerged -namely risk management practices, individual competence, and the LMX spiral underpin the current regulatory approach. Lloyd's monitoring efforts focus on perceived high risk areas. Investigations are targeted on business plans, realistic disaster scenarios and peer group comparisons. The aim is to highlight problems and encourage stronger risk management.

As a result of investigations into the LMX spiral, Lloyd's instituted a daily review of underwriting slips: regulatory staff check slips for inherent risk, coding, pricing and consistency with syndicate business plans. The review also considers large risks, and those written 100% by individual syndicates. The Regulatory Division has also, in the past, conducted reviews into the market-wide use of specific reinsurers, so as to identify potential problems should the reinsurer collapse.

Lloyd's also undertakes reviews of all managing agents and syndicates; these include examination of underwriting slips and outward reinsurance cover notes,

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Appendix II

examination of the practices used to establish the reinsurance to close, and those used to establish the realistic disaster scenarios. On the basis of these reviews, agents and syndicates are allocated a competency rating, which is then fed into the risk based capital system.

Capital requirements

Risk based capital is the term used to describe Lloyd's methodology for calculating members' funds at Lloyd's. There are two main elements : the Risk-Based Capital formula and where appropriate, a capital loading.

The formula looks at the historic experience of each category of business (including reinsurance) and seeks to equalise the expected loss cost to the Central Fund of each portfolio. This means that each underwriting portfolio should present the same risk in terms of Lloyd's chain of security. For existing members, the formula determines the capital required to cover both underwriting in the proposed year and the possibility that the reserves set for past years are insufficient. The formula largely assumes an average level of credit for reinsurance but the actual reinsurance spend is currently being phased in. Diversification credit is applied across years of account, for business mix and for participating across several managing agents. Where a syndicate feels its performance is better than market average it can apply to use its own data. Any resulting improvement in the syndicate's ratio will feed through into those of its members.

In addition, a capital loading may be imposed if the monitoring work performed by the Regulatory Division gives rise to concerns. All existing syndicates and agents have been given a rating from 1 (least good) to 4 (best). Those causing concern i.e. ratings 1 or 2, may be subject to a loading (currently 20% and 10% respectively).

The Risk Assessed Capital ("RAC") software uses the formula and, if applicable, any loading to calculate an RAC ratio. If the calculated ratio is below the minimum (45%) the minimum percentage will be applied to the member's capacity. This results in the Funds at Lloyd's amount to be provided by that member. If the RAC ratio is above the minimum then the RAC percentage figure is applied directly to the member's capacity to produce the FAL amount.

New syndicate ratios are produced by using the RAC model and a Lloyd's adaptation of the assessment undertaken by the FSA for new entrants to the insurance market. This involves, inter alia, reviewing syndicate business plans for the first three years of trading and calculating minimum capital requirements sufficient to cover at least that period. A similar process is carried out in year 2, but this also takes into account the actual versus planned situation for year 1. The new syndicate should submit an outline business plan for the first three years of account. Specific regulatory requirements in respect of reinsurance

Lloyd's maintains good standards with regard to the financial security of reinsurers. As a market, it is one of the world's largest reinsurers. The proportion of reinsurance ceded was 31.4% of gross premium income for the 1997 account. Inter-syndicate reinsurance has fallen steadily and was £425 million in 1999.

There are no formal guidelines for excess of loss reinsurance arrangements although the market has tended to be conservative in its use of unrated companies.

Financial strength ratings are widely used to as part of the decision to purchase reinsurance. Lloyd's Regulatory Division does, however, place limitations on quota share arrangements. To be acceptable, quota shares must not exceed 20% of syndicate capacity or 50% of premium in the particular risk category. Where the reinsurer is not a Lloyd's syndicate, it must have minimum net assets of at least £150 million, have a Standard & Poor's rating of A+ or better and/or a Best's rating of A or better, and be incorporated in one of a number of specified jurisdictions.

Lloyd's has also introduced more general requirements for managing agents in the form of the "Code for Managing Agents: Managing Underwriting Risk", issued in 1997. It sets out the agent's general responsibility in respect of risk management and provides guidance as to how this may be achieved. It includes sections on:

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Appendix II

■ Determining the underwriting and reinsurance policy of the managed syndicate

■ Accepting risks on behalf of the syndicate

■ Managing the reinsurance programme

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Appendix IV

With regard to the management of the reinsurance programme, the code suggests that, where practicable, a reinsurance security committee should be established to introduce procedures for monitoring and assessing the security of, and exposure to, reinsurers on all types of reinsurance. In particular, it should compile a list of acceptable security for all types of reinsurance and, in respect of each reinsurer, should set appropriate maximum exposures at class of business, syndicate and agency level. This will ensure that adequate information is available to assess the syndicate's protections at any point in time. Procedures should also be developed and implemented for obtaining the Board's authority for purchasing reinsurance from reinsurers not currently on the list.

The reinsurance security committee will need to ensure that all individuals with authority to purchase reinsurance are fully aware of the list of acceptable security for all types of outward reinsurance and of any maximum exposure levels. It will also need to satisfy itself that systems and procedures are in place to provide the necessary control framework and management information to enable those responsible for reinsurance security to fulfil their responsibilities.

Finally, the payment performance of reinsurers will need to be monitored, and any disputes or failures of cover should be reported to the Board.

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Detailed description of actuarial reserving methods used

Triangulation

The used triangles have the following format:

Development Year

AY 1 2 3 . . . n-2 n-1 n1 2 3 C(1,1)

C(2,1) C(3,1)

C(1,2) C(2,2) C(3,2)

C(1,3) C(2,3) C(3,3)

. . . C(1,n-2) . . . C(2,n-2) . . . C(3,n-2)

C(1,n-1) C(1,n) C(2,n-1)

n-1 n C(n-1,1) C(n,1)

C(n-1,2)

where C(i,k) is the accumulated loss (either incurred or paid) for accident year i at development year k.

Corresponding triangles can be constructed for the development of the premium or the commission and brokerage.

A wide class of methods can be specified as loss development factor methods.

In the underlying model each (conditioned) expectation of an unknown amount C(i,k+1) with k>n-i can be described as

E[C(i,k+1)| C(i,1),...,C(i,k)] = E[C(i,k+1)| C(i,k)] = f(k) • C(i,k).

Chain Ladder Method

The best known method to estimate the unknown factor f(k) is the Chain Ladder Method.

Chain Ladder estimates f*(k) are weighted averages of the historical development factors, i.e. the year-to-year factors f(i,k) = C(i,k+1)/C(i,k), k = n-i:

n-k n-k

f* (k) = X C (i, k +1)/ X C (i, k)

Applied to the diagonal elements of the triangle, a square will be obtained with the ultimate position in the last column.

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n n

i=1 i=1

Appendix IV

This is the standard version of the Chain-Ladder-Method. For a proper actuarial analysis several adjustments are required, e.g.

- a limitation of the scope of accident years- a consideration of trends within the observed development factors f(1,k),...,f(n-k,k)- a smoothing of Chain Ladder-factors f*(1),... , f*(n-1) in case of instable patterns via

several functions (e.g. Exponential, Weibull, Power, Inverse Power)- a tail factor f(tail) if the earliest reliable accident years are not settled

Adequate estimates of tail factors are either market factors or an extrapolation of the smoothing function.

Ultimate premiums and ultimate commissions also have to be estimated.

Since the estimates for the ultimate loss are heavily dependant on the diagonal value C(i,n-i+1), any outliers on the diagonal will show a remarkable effect. Some methods can be applied to adjust the diagonal. The diagonal value is split into a developing part (which the development factors are applied to) and a non-developing part, this part is added to the other part.

A favourite method to calculate this split is the Cape-Cod-Method. Using the

so called year-to-ultimate factor

u(k) = f (k) f (n-1) f(tail)

- with f(•) being estimated with Chain Ladder or a smoothing or any other method - andthe lag factor

l(k) = u(k)

the used premium • P(i) is computed (with P(i) being the ultimate premium for the accident year i).

With the average diagonal loss ratio based on the used premium

Inherent in this method is the assumption that premium rates are stable. If this is not the case, the

historical premiums need to be adjusted to take account of rate changes. Thus for proportional business information about changes in the quota of the cedant have to be available. For non-proportional business the cycle of the underlying rates needs to be considered.

Bornhuetter-Ferguson Method

Another method commonly used in the United States is the Bornhuetter-Ferguson Method.

Apart from the development factors described above this method depends on independent expectations about the accident years. An initial loss ratio LR(i) for the accident / underwriting year is required that may be the underwriters' estimation. Also market information or the average of the historical loss ratios, calculated with the Chain ladder-ultimates, may be taken into account.

With the lag-factor and the ultimate premium P(i) the ultimate loss for year i is estimated to be

C(i,n-i+\) + • LR(i) • P(i).

Additive or Loss Ratio Step-by-Step Method

mk/nb/552

CC =

C(i,n-i+1) is split into a developing part

CC • P(i)

and a non-developing part (which may be negative)

C(i,n-i+1) - CC • • P(i).

116

The Additive or Loss Ratio Step-by-Step Method is also a method sometimes used by non-life actuaries.

With P(i) being the ultimate earned premium the development of the loss ratio LR(i,k) = C(i,k )/P(i) is analysed instead of C(i,k) only.

In the underlying model each (conditioned) expectation of an unknown amount C(i,k+1) with k>n-i can be described as

E[LR(i,k+1)| LR(i, 1),... , LR(i,k)] = E[LR(i,k+1)| LR(i,k)] = d(k) + LR(i,k),

and the unknown movement of the loss ratios d(k) is estimated by

d*k=2 C (i, k+1)/ 2 P( i) - 2 C (i, k) / 2 P(i)i=1 i=1 i=1 i=1

which can be interpreted being the weighted average rate of year-to-year movements of the loss ratios.

Also this method takes trends, smoothing and a tail into consideration.

(LR(i,n-i+1) + d* (n-i+1) + . . . + d* (n-1) + d* (tail)) • P(i) will

be the expected ultimate loss within this model.

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Appendix V

Expected Loss Method or Naive Loss Ratio Method

For business without any historical development or for the current year being not fully reported the Expected Loss Method or Naive Loss Ratio Method may be the appropriate way to estimate the ultimate loss, which is calculated for the accident year i using

LR(i) • P(i).

The ultimate loss ratio LR(i) may be derived from the pricing process, underwriter's information or, in case of a given history and a current year being not fully reported, from historical loss ratios.

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Main Sources

■ Basel Committee for Banking Supervision: ISDA's response to the Basel Committee onbanking supervision's consultation on the new capital accord, May 2001.

■ Brendon Young and Simon Ashby (2001) "Insurance As A Mitigant for Operational Risk"Operational Risk Research Forum, Vers.2, (May).

■ IAIS (2000) "On Solvency, Solvency Assessments and Actuarial Issues", Issues Paper (March).

■ IAIS (1998) "Supervisory Standard on Derivatives" Supervisory Standard No. 3, (October)

■ National Association of Insurance Commissioners (2001) Securities Valuation Office Research Vol.1 , Issue 2, (February).

■ National Association of Insurance Commissioners (2000) Financial Regulation Standards and Accreditation Program,, (December).

■ Insurance Steering Committee (2001) IASC Draft Statement of Principles, (December).

■ Tillinghast, Towers-Perrin (2000) European Commission ART Market Study, (October), London.

■ Babbel, D./ Santomero, A. (1996) "Risk Management by Insurers: An Analysis of the Process" Wharton Financial Institutions Center Research Papers, No. 96-16.

■ Reinsurance Association of America (1996) Alien Reinsurance in the U.S. Market.

■ Financial Stability Forum (2000) Report of the Working Group on Offshore Centres,(April).

■ Comite Europeen des Assurances (2000) Framework for a European Regime for the Supervision of Cross-Border Reinsurance, (May).

■ Comite Europeen des Assurances (1999): "Towards a single "passport" for reinsurance in Europe" CEA Position Papers, (May).

■ IAIS (1998) "Supervisory Standard on Licensing" Supervisory Standard No. 1 , (October).

■ IAIS (2000) "Guidance Paper for Fit and Proper Principles and their Application" Guidance Paper No. 3, (October).

■ European Commission (2001) "Approaches to Reinsurance Supervision-Follow-up and Structure of Work Programme" Discussion Paper to the IC Reinsurance Subgroup, (June).

■ European Commission (2001) "Considerations concerning "licensing" system and "passport" of reinsurance supervision" Discussion Note to the Members of the IC committee on Reinsurance, (June).

■ European Commission (2001) "Solvency II: Presentation of the Proposed Work" Note to the Solvency Subcommittee of the Insurance Committee, ( March).

■ European Commission (2000) "Approaches to Reinsurance Supervision" Discussion Paper to the IC Reinsurance Subgroup.

■ European Commission (2002) "Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision" A study by KPMG (to be published April/May).

OTHER REFERENCES

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Appendix V

1. Cologne Re (1998) Risk Insights, (September), Vol.2, No.4.

2. Swiss Re (1996) Rethinking Risk Financing, (Zurich).

3. Swiss Re (2001) "Capital Market Innovation in the Insurance Industry" Sigma No.3 (Zurich).

4. Swiss Re (2000) Late claim reserves in reinsurance, (Zurich).

5. Lloyds (1998) "A Review by U.S. State Insurance Regulators" Report of the Examination Team to the Surplus Lines (E) Task Force, (September).

6. Standard & Poor's (2000) "The French reinsurance market 1999" Global Reinsurance Highlights, (September).

7. Standard & Poor's (1999) "Ten years in Reinsurance" Global Reinsurance Highlights, (December).

8. Lloyd's (2000) "Two top reinsurers team up to form web-based exchange", Lloyd's of London Press Limited, (December).

9. Stefan Forster, Dr. Alexander Konig (1999) "Capital at Risk" Fachreihe der Bayerischen Ruck, (June), Issue 25.

10. Eberhard Muller(2000) "Sinn und Unssinn von RBC-Modellen - Anmerkungen zur Nichtlinearitat von Risiken" Zeitschrift fur Versicherungswesen, Nr.21/1, November.

11. Swiss Re (1997) "New perspectives: Risk securitization and contingent capital solutions", (Zurich).

12. Standard & Poor's (2000) Standard & Poor's Response to Basel Committee Proposals, Standard & Poor's CreditWire, London, (January).

13. G. Blomberg und Dr. W. Schnabel (2000) " Nicht-proportionale Ruckversicherung in der Sachversicherung" Versicherungswirtschaft, Heft 21/2000.

14. Ernst Wehe (1994) "Ruckversicherung im Umbruch Versicherungswirtschaft, Heft 21/1994.

15. Andrea HeB (1998) "Financial Reinsurance" Hamburger Gesellschaft zur Forderung des Versicherungswesens mbH, Heft 20, (January).

16. Rolf Nebel (2001): The Case For Liberal Reinsurance Regulation, Geneva Association Etudes et Dossier No. 247.

17. Dr. Thomas Renggli (2000) "ART 2000 - Entwicklungstendenzen in der nicht-traditionellen Risikofinanzierung" Zeitschrift fur Versicherungswesen, Nr.7/1,(April).

18. Hugh Rosenbaum (1998) "A Good time to hold an insurer captive" Reinsurance,

(June), 17-19.

19. Tony Dowding (2000) "No holds barred" Reinsurance, (January), 14-15.

20. George Sandars (2000) "Growing appreciation of ART" Global Reinsurance, 64-67.

21. D. M. Jaffee and T. Russell (1997) "Catastrophe Insurance, Capital Markets, and Uninsurable Risks" The Journal of Risk and Insurance, Vol.64, No. 2, 203-230

22. Dr. Peter Liebwein (2000) " Klassische Ruckversicherung als Tailor-Made solution" Versicherungswirtschaft, Heft 17/2000.

23. Dr. M. Grandi and Dr. A. Muller (2000) "Versicherungsderivate"Versicherungswirtschaft, Heft 9/2000.

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24. Guy Carpenter (1998) "Global Reinsurance Analysis 1998" A Guy Carpenter Special Report, Guy Carpenter & Company Inc., (September).

25. Swiss Re (1998) "The global reinsurance market in the midst of consolidation" Sigman No.9/1998, (Zurich).

26. Moody's Investors Service (1999) "Assessing Credit Risks of US Property and Casualty Insurers" Moody's Rating Methodology, (March).

27. A.M. Best (2001) "Current Guide to Best's Insurer Financial Strength Ratings" A.M. Best Ratings & Analysis, July.

28. Warren Cabral (1998) "Bermuda's hidden treasure" Reinsurance, (February).

29. Janina Clark (1998) "Europe inside and out" Reinsurance, (September).

30. Marie-Louise Rossi (1998) "The world according to Europe" Reinsurance, (September).

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