Protectionism causes concentration peril

Reinsurers face three main challenges, in the view of Hannah Grant, head of reinsurance at Insurance Europe. These are significant regulatory changes, increases in extreme weather and growing market access problems.

She said that while the first two of these, including the regulatory changes arising from Solvency II and the work of the International Association of Insurance Supervisors (IAIS), are well recognised within the industry, the third issue is less well understood.

“There has been a disappointing trend in recent years of reinsurers facing increased restrictions on cross-border business, particularly in Latin America, and also in some Asia Pacific countries,” Grant said.

This is usually driven by a desire to protect and develop local insurance markets. Some local regulators, she said, believe that by restricting or putting up the cost for foreign reinsurers to access their markets, they will be able to drive business towards local reinsurers.

“Other countries are demanding that foreign reinsurers make investments in local government and corporate bonds as a prerequisite of operating within their jurisdiction,” she noted.

“We believe that these kinds of protectionist measures are short-sighted, not least because they can lead to a concentration of risk within one country, which could—in the event of a major loss—put the local reinsurance market, and potentially the country’s wider national economy, in dire straits,” Grant said.

“Reinsurers are a huge stabilising force on a global level, diversifying risk while helping to facilitate global trade. As they have continuously performed this vital role in such a quiet manner, even during the recent financial crisis, they generally do not receive the credit they deserve.

“No-one notices when something is working brilliantly, only when something goes wrong. The role that reinsurers play in providing stability to the global economy should, therefore, be recognised far more than it is now.”

Going back to the wider regulatory pressures reinsurers are facing, she acknowledged that insurers and reinsurers face unprecedented regulatory changes and pressures at a local, a regional and a global level.

In Europe, although a few countries have already moved towards risk-based systems of supervision, Solvency II represents a fundamental redesign and harmonisation of the prudential supervisory processes and requirements. It is now in its final stages of development and the focus has shifted to implementation.

“Despite significant frustration that a range of important design and calibration flaws have not been fixed, the industry strongly supports a risk-based approach to regulation and reinsurers are among the most advanced in their preparations for the changes,” Grant said.

But she acknowledged that a great deal of work still remains, and reaching the deadline for implementation by January 1, 2016 will be challenging for companies, legislators and supervisors.

“Of particular interest to many reinsurers are internal models, both in ensuring the requirements for approval and ongoing use of internal models remain workable, as well as actually getting their models approved for use. It will be important to monitor how Solvency II works in practice and ensure that the Commission and EIOPA take action where unintended consequences are identified,” she said.

Regulatory reform

Europe is not alone in undergoing such fundamental regulatory changes, she stressed. Several regions around the world are also in the process of reforming their domestic regulation.

For example, the IAIS is working to develop a Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame). This aims to help national insurance supervisors cooperate and coordinate more efficiently and effectively.

“Such an outcome would be welcome to globally active reinsurers and insurers,” Grant said. “This project, however, also includes the development of the Insurance Capital Standard (ICS) and it is at this stage less clear exactly what this standard will be, the extent to which it will be suitable for reinsurers and how it will interact with local solvency requirements.”

This is just one of many potential regulatory changes. They do, however, often create challenges because policymakers do not always appreciate the potential for unintended consequences.

“A key consequence of regulation that is not fully appreciated is unnecessary cost, which has two components. The first component is the cost of compliance for insurers, legislators and supervisors every time regulators make a change in the rules. Well-designed regulation will avoid unnecessary costs,” she said.

“Then there are potential costs arising if solvency capital requirements are set unnecessarily high. If capital is set too high, then insurers will have to increase the price for the customer to cover the cost of the capital.

“If the providers of capital cannot earn a good enough return for the risks they would take by investing the capital, insurance companies will stop offering the product or change the design of the product so the customer has to take on more of the risk instead.

“Either way, unnecessarily high capital will tend to lead to people having less protection, which can also be bad for the economy and growth. Customers and policymakers should be as concerned about overestimating capital requirements as underestimating them.”

Grant continued: “There is also a general concern that policymakers—while having policyholders’ best interests at heart—don’t currently understand the nuances of the insurance industry to a high enough degree when designing and assessing new regulation.”