by ~ Robert A. Whitney (Email)
The following is drawn from remarks delivered to the Massachusetts Reinsurance Bar Association at its annual cocktail reception on April 24, 2012.
Good afternoon. My name is Robert Whitney, and I am the Deputy Commissioner and General Counsel of the Massachusetts Division of Insurance. I greatly appreciate the opportunity to speak with you today. Of course, anyone would find it very difficult to top the remarks given by last years speaker at this event the Commissioner of Insurance, Joseph Murphy, who spoke about the ongoing activity of the Division of Insurance so I will not even try!
Instead, Id like to spend a few minutes talking to you about a topic that has been of utmost interest to reinsurers, cedents and others in the reinsurance industry for quite some time: namely, the regulation of reinsurance.
After many years of relative quiet, unprecedented levels of exposure have rocked the insurance industry during the past decade, beginning with the September 11, 2001, terrorist attacks in New York City. The attacks were soon followed by a rash of natural and man-made disasters that seemed to build in severity from one year to the next: the devastating 2004 Atlantic windstorm season; Hurricanes Katrina, Rita and Wilma in 2005; and the greatest financial turmoil in generations during 2008-2009.
Since then, insured losses from additional natural and man-made disasters around the globe and in the U.S. including the nuclear reactor meltdown in Japan, the offshore oil spills in Australias Great Barrier Reef and in the Gulf of Mexico, as well as the unending parade of tornados, hurricanes, tropical storms, and extensive flooding throughout the U.S. and even here in New England has further challenged a now global insurance industry.
Throughout this period, insurer insolvencies have been negligible. Other than the well-reported case of AIG accepting funds from the Troubled Asset Relief Program, only two other insurers Allstate and Lincoln National ultimately received any relief funds whatsoever. On the whole, the financial condition of the industry has proved to be strong and resilient. At no point did any insurance activity result in any significant impact to the reinsurance market, let alone the larger economy.
Nevertheless, the decade has been witness to sustained calls for reform of U.S. insurance regulation. Many of the complaints have centered on the fact that the insurance sector is alone among financial services in being subject primarily to a state-based regulatory system. Under such a system, it is presumed that that efficiency, fairness, economic growth, and transparency have not been maximized as they could have been under a single, national system of regulation. Also, the complainants point to other developed countries in the world that have national insurance regulatory frameworks in place, and many such as those in the European Union have moved to a single regulatory paradigm across national boundaries.
The primary goal of reinsurance regulation is to ensure that reinsurers are able to meet their obligations for losses paid by ceding companies. Like a primary insurer, a reinsurer licensed in a state is subject to that states solvency requirements. These requirements (e.g., minimum capital levels) vary among the states. However, unlike a primary insurer, a reinsurer does not have to be licensed in each state in which it operates. An individual state is unable to directly impose its solvency standards on reinsurers in other states or countries. As such, each state is able to focus only on the regulation of those ceding insurers and reinsurers within its own jurisdiction.
In an attempt to deal with this situation, the National Association of Insurance Commissioners (NAIC) developed a model law in 1984 with minimum standards to encourage uniform reinsurance regulation within the country. The model law was amended in 1989 to increase the standards. While some states have adopted the model law, most have not followed the NAICs guidance.
History of Reinsurance Regulation
Insurance as a risk-transfer mechanism dates back thousands of years, before Edward Lloyd first opened his coffee house in the City of London. Historically, early methods of transferring or distributing risk were practiced by Chinese and Babylonian traders as long ago as the third and second millennia BCE, respectively. Chinese merchants distributed their wares across multiple ships in order to limit the loss due to any single vessel's sinking. Arab traders pooled their wares in long-distance camel caravans and shared the risk of loss from desert raiders.
In more contemporary times in the United States, Benjamin Franklin helped found the insurance industry in 1752 with the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. The current state insurance regulatory framework has its roots in the 19th century. New Hampshire was the first state to appoint an insurance commissioner, in 1851; many other states followed suit soon thereafter.
In 1869, in the case Paul v. Virginia, 75 U.S. 168, the Supreme Court held that "issuing a policy of insurance is not a transaction of commerce. As a result, the states were left with responsibility over the taxation and regulation of insurance. In the ensuing 140 years since the Paul decision, the states have continued to be primary regulator of the insurance industry in our nation.
With regard to reinsurance, the U.S. system includes both direct and indirect regulatory approaches. As noted earlier, direct regulation is imposed on any insurance company licensed in one or more U.S. states by that states department of insurance. A reinsurer licensed by a state is subject to the full spectrum of insurance regulations to which a primary insurer is subject. While state insurance laws vary, most are based in large part on model laws and regulations developed by the NAIC.
U.S. regulators uniformly recognize that, given the enormous size of the insurance marketplace, the reinsurance capacity can only be satisfied by allowing non-U.S. insurers to assume reinsurance business in the US. In fact, nearly one-half of the reinsurance premiums are reinsured outside of the US. According to the NAIC, more than 4,000 reinsurers from more than 100 countries either assumed premiums or owed recoverables to U.S. cedents last year.
The regulatory approach to reinsurance in the U.S. has traditionally been focused on the ceding companys reinsurance arrangements, with the overriding concern being the solvency of the assuming company (the reinsurer), the impact of reinsurance on the ceding companys financial position, and the ultimate impact on consumers. There is good reason for this concern.
The two largest insurance insolvencies in U.S. insurance history, those of Transit Casualty Company and Mission Insurance Company, occurred in the 1980s, partly due to uncollectible reinsurance from their reinsurers. For example, due to inadequate recordkeeping, Transits 1983 annual statement listed 460 reinsurers, but the receiver for the insurer identified business with over 1,700 reinsurers!
In addition, Missions inability to meet its obligations as a reinsurer was a contributing factor in the insolvency of Integrity Insurance Company, the third-largest U.S. insurer insolvency. The NAIC thereafter moved to strengthen solvency regulation, specifically developing an accreditation program that requires state insurance departments to meet certain prescribed standards. It also established minimum capital requirements for insurers, based on the riskiness of their business.
Reinsurance can have a substantial effect on the financial condition of an insurance company. The annual financial statement, filed in accordance with statutory accounting principles, is the primary financial tool used by state insurance regulators to evaluate the financial condition of insurers and reinsurers. However, the form of annual financial data reported by insurers has historically acted to limit the ability of state regulators to fully assess the effect of reinsurance on the financial condition of reinsurance participants.
Also, the availability of reinsurance financial data reported to regulators varies by the type of reinsurer. Reinsurers file the same financial statements with the NAIC and state regulators as do other insurers. However, primary insurers assuming reinsurance often combine primary insurance and reinsurance financial data in their annual statements. This aggregated data has typically not been detailed enough to reflect reinsurance activity and its impact on an insurers financial condition. Also, unlicensed foreign reinsurers do not file comparable financial statements with state regulators.
The NAIC has increased reinsurance reporting requirements for the annual financial statements that insurers file with state regulators. These requirements allow state regulators to better assess the impact of reinsurance on the financial condition of insurers. In particular, new reporting requirements quantify overdue reinsurance and enable regulators to better detect potential problems with uncollectible reinsurance.
Potentially uncollectible reinsurance has always been seen as a significant problem to insurance regulators and well as industry members. One challenge for regulators has been where there has been a lack of oversight over reinsurers domiciled abroad and not licensed in any U.S. jurisdiction. Since American regulators cannot directly regulate such foreign companies, the indirect mechanism by which state regulators have exerted control over the reinsurance market has been through the credit for reinsurance laws, which will be discussed in more detail in a moment.
Reinsurance Regulatory Reform
Within the last several years, there have renewed and successful efforts to once again attempt to deal with the issue of the regulation of reinsurance.
A. Nonadmitted Insurance and Reinsurance Reform Act
In 2010, Congress enacted the Non-Admitted Insurance and Reinsurance Reform Act (NRRA) as part of the Dodd-Frank financial reform legislation. See 15 U.S.C. §§ 8201 et seq. The NRRA, which became effective July 21, 2011, generally preempts the application of state credit for reinsurance laws to insurers not domiciled in the state. As such, under the NRRA, a ceding U.S. insurer need only satisfy the credit for reinsurance requirements of its own domicile state.
The NRRA is similar to previous stand-alone legislation that had been proposed in Congress in recent years. The enacted reforms do not give any authority to any federal agency to regulate reinsurance, but instead prohibit multi-state taxation and regulation of reinsurance by allowing only one state to regulate those transactions. The NRRA requires that changes be made to the prevailing state-based system governing the regulation of reinsurance. For example, under the NRRA, no state may deny financial statement credit for reinsurance, if the credit is recognized by the ceding insurer's state of domicile. The law also provides that the laws of non-domestic states, except those with respect to taxes and assessments on insurance companies, are preempted to the extent they apply to reinsurance agreements.
The NRRA further provides that for a defined category of insurers principally engaged in the business of reinsurance called Professional Reinsurers the state of domicile shall be solely responsible for regulating solvency. Finally, non-domestic states are specifically prohibited from requiring Professional Reinsurers to provide financial information other than the financial information required by their domiciliary states.
The NRRA limits its reinsurance preemption provisions to states that are accredited by the NAIC or that meet requirements that are "substantially similar" to the NAICs financial solvency requirements. Currently all states meet this threshold requirement.
B. Credit for Reinsurance Model Law and Regulation
During its fall 2011 meeting, the NAIC adopted important changes to its Credit for Reinsurance Model Law and Regulation. The centerpiece of the amendments is a process by which unauthorized reinsurers may qualify to post reduced collateral to satisfy state credit for reinsurance standards that apply to U.S. cedents. Other important aspects of the amendments included new regulatory notice requirements for ceding insurers concerning concentrations of risk and clauses required to be included in reinsurance agreements for ceding insurers to receive credit for reinsurance.
A reinsurer certified by a state will be required to post collateral in an amount that corresponds with its assigned rating in order for a U.S. ceding insurer to be allowed full credit for the reinsurance ceded. The amendments effectively replace the old credit-for-reinsurance regime, in which non-admitted off-shore reinsurers, regardless of financial strength, must secure their reinsurance commitments by posting collateral in order for the ceding company to be able to record the reinsurance as an asset or reduction of a liability.
The new Model Law also provides state insurance regulators with discretion to grant financial statement credit for all or part of such reinsurance without substantial security. An important aspect of the model law to insurers is the discretion granted to the commissioner of insurance to accept any other form of security acceptable to the commissioner. While this provision has not been adopted by all states, it does allow the states some flexibility and still protects insureds, claimants, ceding insurers, assuming reinsurers and the public generally.
These amendments to the NAIC Model Law and regulation have followed a general trend among the states and at the federal level towards modernization of reinsurance regulation. Florida, Indiana, New Jersey, California and New York already have adopted laws permitting unauthorized reinsurers to post less than 100% collateral if they qualify based on financial strength ratings and other factors.
Future Regulatory Efforts Federal and Global
As the reinsurance industry moves forward through the second decade of the 21st Century, there have been increasing calls from some parts to change the structure of the way in which reinsurance has been historically regulated or under-regulated as some would maintain.
A. Reinsurance Regulatory Modernization Act
In 2009, the NAICs Reinsurance Task Force drafted a proposed law as a framework for modernizing the domestic regulation of reinsurance in our country the and between the U.S. and other countries. The draft law is called the Reinsurance Regulatory Modernization Act. This law would establish two classes of reinsurers, so-called National Reinsurers and Port of Entry Reinsurers. States with the requisite resources and expertise would establish Home State and Port of Entry supervisors, who would regulate the non-U.S. reinsurers exclusively and who, through that port of entry state, would have the ability to write reinsurance across the entire United States.
In the draft law, the power of preemption is given to the Port of Entry Supervisor and the Home State Supervisor in terms of determining the financial solvency of the reinsurer. This decision would be binding on other state regulators.
Non-U.S. reinsurers, who have chosen not to form a U.S. domestic reinsurance company, are required for each reinsurance risk that they write on behalf of the ceding company to post 100 percent collateral for that risk. Non-U.S. reinsurers, such as Lloyds of London and others, have been very vocal in their opposition to this requirement. As a result, many non-U.S. reinsurers have chosen not to form U.S. entities, which would be subject to U.S. taxation and state insurance regulation. The draft law would act to potentially reduce the collateral requirements of non-U.S. reinsurers.
The draft law would also provide credit for reinsurance determinations made by the various states' insurance commissioners. The domestic regulator currently has the authority to deny some or all of the credit for reinsurance on the balance sheet of the ceding company, thus indirectly determining the financial viability of the reinsurer. The draft law would change this outcome, as once the port of entry state or home state regulator determined that the reinsurer was financially able to pay claims, there could not be a refusal on the part of the domestic regulator of the ceding company to deny credit for the reinsurance.
The reinsurance industry has been unable to come together in support of the draft act. Foreign carriers like Lloyds support the concept of reducing the collateral requirements of non-U.S. reinsurers; some of the ceding companies are equally opposed to the reduction of collateral for foreign insurers and have been vocal in opposing the bill on Capitol Hill. Absent broad support from the industry, it is unlikely that the draft act will be enacted into law anytime soon.
B. EU Reinsurance Regulation Proposal - Global Approach
Another proposal for regulation of reinsurance has come out of the European Union, where, several years ago, the European Parliament approved a reinsurance directive to create uniform reinsurance regulation in what were then all 25 member states. The legislation directed all E.U. countries to adopt standardized regulation for reinsurers and will permit them to operate anywhere in the E.U. while reporting only to their home country supervisor of insurance. Many reinsurers in Europe have welcomed the transition as it has helped doing business across borders, as the result of the reinsurance directive was to impose imposes the same essential minimum standards of regulation everywhere in Europe.
The role of reinsurance in providing a safety net for the insurance industry has never been more critical than it is today. The global reinsurance industry supports the primary insurance industry with only a small portion of the capital and takes on the most devastating risks without collateral or the assurance of payback.
Some reinsurers have expressed concern about a regulatory environment in the United States where different rules can be imposed by 50 state insurance departments. They note that the European Union is creating a uniform regulatory structure that will operate throughout its member states. The Reinsurance Association of America (RAA), along with some of the major reinsurance companies operating in the US, has argued that state regulation of reinsurance should be phased out, and replaced by a system where reinsurance is regulated at the federal level. The RAA and others claims that the state-based regulatory system discourages global reinsurers from participating in the U.S. market.
There is no evidence, however, that the state-based regulatory system that has worked so well for many years in the U.S. has actually dissuaded any reinsurers from participating in the U.S. market. Individual state regulators, with their focus on insurer solvency, are in a unique position to be able to closely monitor insurance and reinsurance company activities in their own jurisdictions, to ensure that both remain strong and solvent.
As I previously noted, the ability of state regulators to assess the effect of reinsurance on the financial condition of reinsurance participants has in the past been limited by the form of annual financial data reported by insurers. The NAIC, however, has increased reinsurance reporting requirements for the annual financial statement that insurers file with state regulators, and these requirements have enabled state regulators to better assess the impact of reinsurance on the financial condition of insurers, and be more vigilant in reviewing and evaluating these annual financial statements to ensure the solvency of their domestic carriers.
Only time will tell whether global reinsurance regulation efforts like those being currently undertaken in the EU will result in a more solvent, better functioning reinsurance market. If it does, we will likely see a renewed effort in the United States for reinsurance regulation on the national level. Until that time, however, individual state regulatory agencies like the Massachusetts Division of Insurance will continue their good work of keeping our insurance and reinsurance marketplace strong, safe and secure.
Robert Whitney is a member of the Massachusetts Reinsurance Bar Association, and is also the Deputy Commissioner and General Counsel of the Massachusetts Division of Insurance. The views expressed above are his own. Mr. Whitney may be reached at firstname.lastname@example.org.
2012 Robert A. Whitney. All rights reserved.
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