Proposal for a Directive on Reinsurance Supervision Frequently Asked Questions (see also IP/04/513)

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1 MEMO/04/90 Brussels, 21 April 2004 Proposal for a Directive on Reinsurance Supervision Frequently Asked Questions (see also IP/04/513) What are the main objectives of the proposal? The proposed Directive aims to establish a sound and prudent regime in the interest of policyholders. Strong and well-supervised reinsurers contribute to a stronger internal market and to international financial stability. The European regulatory system would be built on essential coordination of Member States' legislation and mutual recognition of the supervision in the Member State where the reinsurance undertaking is licensed. In other words, once licensed in one Member State which would require meeting certain Europe-wide criteria - a company would automatically be allowed to conduct reinsurance business all over the European Union under the freedom of establishment and the freedom to provide services. No additional supervision of, or checks on, the reinsurance undertaking should be performed by supervisors in host Member States (i.e those other than where the undertaking is licensed). This approach has proved its suitability over many years in the direct insurance field. The introduction of a harmonised system for reinsurance supervision should lead to the abolition of systems in certain Member States which require reinsurers to pledge assets to cover outstanding claims provisions. Such collateralisation systems restrict reinsurers choice of investments and can make reinsurance cover more expensive. They constitute a barrier to free trade in reinsurance. Currently only a few markets use collateralisation requirements, but this has created a lot of concern in the insurance and reinsurance industries. (In more detailed terms, such systems require technical provisions before reinsurance to be covered by officially authorised assets. The portion of gross technical provisions relating to the business ceded to a given reinsurer can be represented by a net claim on this reinsurer only up to the amount pledged as collateral security by the reinsurer off the cedant s balance sheet, or, in certain cases, covered by a security in the form of a letter of credit issued by a banking institution.)

2 What is the role of reinsurers? Reinsurance is basically insurance for insurers. Direct insurers - who issue policies for businesses and individuals - insure with reinsurers in order to be able to meet in full the risks they have taken on in issuing those policies. Reinsurance fulfils the following functions for an insurance undertaking: - Reducing insurance risks in the risk portfolio of the insurer - Permanently transferring technical risks to the reinsurer - Increasing the homogeneity of an insurance portfolio, which makes it easier for insurance companies to manage their overall risk portfolios - Reducing the volatility of the financial results of the insurance company - Avoiding the need for the insurance company to hold its own capital to cover the whole of the risks it has insured - Supplying capital for financing purposes, which is particularly important for newly created insurance companies so that they can get their activities started and expand further As an additional service, the reinsurer often supplies important knowledge to the direct insurers, particularly on risk management and product development How would the proposed Directive benefit policyholders of direct insurance companies? Policyholders will benefit indirectly through their insurance companies. Supervised reinsurance will bring more stability to direct insurance companies, which will reduce the risk that policyholders will suffer financial losses or lack of insurance cover resulting from insolvencies of direct insurance companies. Why the urgency when Solvency II is coming up? What is the current state of progress on Solvency II? Solvency II was launched with a wide-ranging study, published in 2002 (see It will update the whole system of solvency requirements for the insurance industry, including reinsurance, taking account of changes in the financial market, such as the use of derivatives, new insurance products and new risk management techniques introduced since the current insurance Directives were introduced in the 70s. But a majority of Member States and industry organisations believe that there is a need for rapid action to achieve tangible results in the short to medium-term. The current problems affecting the EU reinsurance market must therefore be addressed without waiting for Solvency II. Those problems include: - Uncertainty for direct undertakings (and their policyholders) on the quality of the supervision that their reinsurers are subject to. - Barriers to cross-border reinsurance services still exist (for example collateralisation requirements for outstanding claims against reinsurers in some Member States see above). - Administrative burdens due to different supervisory rules in Member States. In addition, the introduction of harmonised reinsurance supervision is important for the standing of EU reinsurance companies internationally and for ongoing discussions with third countries on market access. 2

3 The fast-track project for reinsurance will provide a good basis for later work. The Solvency II project could to a fairly large extent build on it, but will also have to take into account other long-term developments (such as substantial changes in insurance accounting or in solvency rules). A large part of the work under the Solvency II project will be performed by insurance supervisors in the framework of CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors). The Commission s Internal Market Directorategeneral is currently preparing requests for preparatory work from CEIOPS on a number of technical issues relating to insurance supervision. The Solvency II project is long-term, and the whole system - consisting of a framework Directive, regulations and supervisory guidance - will take several years to complete. In what way would the proposed Directive contribute to international financial stability? Harmonised reinsurance supervision bringing Member States regulation of reinsurance companies closer into line - would contribute to financial stability through more transparency in the reinsurance market and reduced regulatory arbitrage (i.e. different supervisory rules in different Member States that enable companies to move their activities into those markets with the weakest regulation). More transparent information about reinsurers would facilitate the markets assessments of their financial standing. Reinsurance supervision may also lead to earlier interventions by supervisors in problematic cases, which would have a clear beneficial effect on markets. The proposed Directive has been developed in close cooperation with the International Association of Insurance Supervisors (IAIS), of which the European Commission is an active member. Why did the original Insurance Directives not cover reinsurers? The third generation Insurance Directives principally cover life and non-life insurance activities by direct insurance undertakings. They also cover reinsurance activities by direct insurers. However, pure reinsurance companies were not covered. Harmonisation work started in the direct insurance field becasue the protection of policyholders and customers of insurance companies was paramount. Reinsurance is a business transaction between two professional, knowledgeable parties, and there is hence less need to protect a weaker party, such as consumers. However, recent developments in the reinsurance markets show that the reinsurance sector would benefit from suitable and harmonised supervision. Among other things, this would mean insurance companies could be more certain of the quality of reinsurance companies and have access to more information about them. That will make their choice of reinsurers easier and ultimately benefit policyholders. 3

4 What are the main elements of the licensing regime for reinsurance undertakings and what conditions would reinsurers have to meet before a license could be granted? The proposed Directive provides detailed rules on the conditions that should be fulfilled before a license to do reinsurance business is given. The request for licensing should be made in the country where the head office of the reinsurer is located. A license would be granted for the whole European Union and can relate to non-life reinsurance, life reinsurance or both. A reinsurance undertaking would have to take one of the acceptable legal forms included in an annex to the proposed Directive. Under the proposed Directive, the home Member State would require every reinsurance undertaking seeking a license to: - Limit its object to the business of reinsurance and related operations - Submit a scheme of operations - Possess the capital to fulfil the minimum guarantee fund requirement - Be run by persons of good repute with appropriate professional qualifications or experience Member States would not be able to impose requirements for prior approval of scales of premiums. Member States would not be able to apply economic needs tests in other words refuse a license just because they consider there are already sufficient operators in the market to fill existing demand, thus in practice discouraging competition. In certain cases, the supervisory authorities of other Member States would need to be consulted before the granting of a license. What are the proposed rules for investments by reinsurers? The proposed Directive includes a general prudent person approach for the investments of a reinsurance undertaking. The same technique was used in the Directive 2003/41/EC on Pension Funds adopted in May 2003 (see IP/03/669). Such an approach is qualitative and uses different risk management techniques to assess the overall risk of an insurance company s investments. The current system for direct insurance undertakings is different in that it uses defined quantitative maximum limits for certain types of assets such as equities - instead. The use of a prudent person approach in reinsurance reflects the special nature of reinsurance, the global focus of the business and the fact that reinsurers do not deal directly with policy holders. However if direct companies carry on reinsurance business, direct rules (i.e. quantitative rules) would apply, as direct companies have liabilities directly to policyholders and this gives rise to specific prudential concerns. How would the proposal help to improve access for European reinsurers to foreign markets? Harmonised reinsurance supervision as proposed by the draft Directive would give EU reinsurers a quality label, which would increase their already strong standing in the international reinsurance market. This is particularly important today, as reinsurance undertakings have seen pressure on their results and several of the largest companies have been downgraded by rating institutes. Insurance supervisors are increasingly requiring direct insurance undertakings to scrutinise the financial standing of their reinsurers. 4

5 In discussions with third countries on mutual recognition of reinsurance supervision, the lack of a harmonised supervision framework in the EU has often been quoted as an obstacle. This is particularly the case in ongoing discussions with the US in relation to the reinsurance collaterals requirement. The preparation of the proposed Directive has been followed very closely by insurance supervisors in other jurisdictions. Harmonised supervision of reinsurance will make it easier for supervisors in other jurisdictions to assess the quality of supervision in the EU and this may have a beneficial effect on the ongoing discussions to remove remaining obstacles to market access. 5