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The Actuary The magazine of the Institute & Faculty of Actuaries

Reinsurance Directive

The high-quota share treaties put in place by many primary insurers for their new business demonstrates that reinsurance is an integral part of the life and health protection environment. Reinsurance has long been used as a means of reducing the volatility of claims experience. Traditionally this was achieved by medium or high surplus treaties, but over the past two decades there has been a shift from surplus to high-quota share reinsurance.
As a result, reinsurance is now very much part of the protection value chain and is used by insurers to help them to operate in what is an extremely competitive market. This competitiveness, especially in the intermediary market, is demonstrated by the small difference in monthly premiums between the cheapest providers.

Differences in regulation
The financial benefits obtained by insurers through the use of reinsurance are, to some extent, derived from the relative differences in regulation between insurers and reinsurers. In the UK, the Financial Services Authority (FSA) regulates both insurers and reinsurers, although some of their specific rules have historically differed between these two types of organisation.
The main differences arise in the treatment of solvency capital, where reinsurers have been subject to less onerous capital requirements. This reflects, among other reasons, the increased diversification benefits that reinsurers generally exhibit across clients, lines of business, and, for the global players, by geography. In addition, many reinsurers retrocede incoming risks, either through traditional reinsurance to offshore entities that can offer lower reserving and/or capital requirements, or increasingly by passing the risks associated with extreme losses to the capital markets. The regulatory treatment arising from these differences has helped reinsurance to be offered in an economically viable way for both parties.
Regulation of the insurance industry in the EU is evolving speedily towards a risk-based environment. Solvency II, expected to apply to all insurers, will move regulation down this path, but with a target date of 2010 implementation is some way off.
As an interim measure, the Reinsurance Directive aims to introduce a minimum level of harmonised prudential supervision for reinsurers across the EU, where no such common framework currently exists. The Reinsurance Directive is being implemented by the FSA in December 2006 to enable firms to benefit from the changes as soon as possible.
At the time of writing, as detailed in consultation paper CP06/16, the FSA also proposes to include more realistic reporting for insurers. Specifically, insurers will be able to make prudent allowances for lapses and, with some restrictions, be permitted to treat protection policies as assets. The short timeframe for implementation may present a number of practical challenges, ranging from the changes to models and the testing of those changes, along with a degree of uncertainty around tax issues. Furthermore, it remains unclear whether Solvency II will result in an increase in requirements.
These changes relating to allowances for lapses and the treatment of policies as assets will enable insurers to benefit from lower reserving requirements. These benefits are currently provided via reinsurance and consequently the net effect of these changes, if sought in the absence of reinsurance, may not be as large as initially anticipated by some commentators. Further, the definition of “prudent” lapses is causing some debate within the industry due partly to its subjectivity. Life offices will need to strike the right balance between offering competitive rates, being comfortable with their risk appetite and ensuring sound corporate governance.

High-value benefits
At first sight, the FSA’s measures may appear to provide insurers with less need to reinsure, and instead encourage them to retain a greater level of risk. In reality, however, the benefits that reinsurance provide for insurers will continue to be of high value. These include risk transfer, capital management benefits and access to expertise.

Risk transfer
By transferring risks to reinsurers, ceding companies benefit from greater stability of insurance profits. Reinsurance also increases insurers’ capacity, through writing large and unusual risks and by supporting new business production. Risk transfer also enables insurers to ‘lock in’ assumptions, such as mortality improvements, through guaranteed terms, and provides protection against shock scenarios including pandemic risks. Reinsurers also assume the pricing risks (modelling, volatility, trend, and parameter risks) associated with new business. In combination, these factors provide insurers with a guarantee around their revenue streams through reinsurance.

Capital management
Pillar One solvency capital differentials between insurers and reinsurers under the Reinsurance Directive are expected to become larger, providing a further incentive to reinsure. This benefit may be limited because of minimum capital levels dictated by internal economic requirements and those expected by rating agencies. However, this opportunity for lower capital will be greater for reinsurers who can demonstrate a highly diversified portfolio, and ultimately benefit their clients. Reinsurers could potentially receive lower capital requirements under the ICA/ICG realistic reporting regime because of the increased diversification aspects that reinsurers can exhibit that can then be accessed by insurers through reinsurance. These capital benefits are especially relevant given the competitiveness of the primary market for protection products, particularly for mortality business.

Access to expertise
A core component of a reinsurer’s offering is access to expertise. An example is underwriting and claims management. Reinsurers have invested heavily in these critical areas of risk management, and insurers rely heavily on the underwriting manuals produced by reinsurers. A further area is actuarial pricing. Reinsurers have large volumes of data across the market and can provide insights into experience studies and trend analyses to assist in managing risk. Finally, reinsurers can offer strong support with product development, strategic advice and market analysis.

In combination, these benefits provide a compelling argument that reinsurance should remain an integral part of insurers’ new business strategy. Risk transfer and capital benefits provide guaranteed benefits and certainty, and allow insurers to operate in a competitive market. It will be interesting to observe how the insurance and reinsurance markets react to these changes over the coming months.