By Michael R. Nelson and Michael J. Kurtis
(Mike Nelson is Chairman of Nelson Levine de Luca & Hamilton. Based in the firm’s New York office, he represents clients in matters related to insurance, class actions, corporate business practices, antitrust, coverage, compliance, and extracontractual litigation. Mike Kurtis is a partner in the firm’s Pennsylvania office, and focuses his practice on property and casualty insurance, with an emphasis on general liability, construction defects, toxic exposure/mass-tort environmental contamination, and catastrophe claims.)
The Federal Insurance Office (FIO) was slated to submit a report to Congress on “the breadth and scope of the global reinsurance market and the critical role it plays in supporting the U.S. insurance industry” on Sept. 30, 2012.1 Like the January 2012 deadline for the FIO’s report on how to “modernize and improve the system of insurance regulation in the United States,” the deadline for the reinsurance report passed without the report or any comment or explanation from the FIO.
The reinsurance report, which is mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), has drawn much attention from both the U.S. and non-U.S. reinsurance markets as well as interest groups advocating on behalf of those markets. The directive for the report in Dodd-Frank is broad, granting the FIO significant latitude to shape the report and, consequently, the debates that will be precipitated by the report’s release. In light of its potential significance, U.S. insurers and reinsurers need to understand what the report could cover and how FIO’s analysis may impact the insurance and reinsurance industry.
On June 27, 2012, the FIO published a notice and request for comment in the Federal Register for interested parties to “submit views” for the Global Reinsurance Report. The notice specifically requested comments on: 1) the purpose of reinsurance; 2) the breadth and scope of the global reinsurance market; 3) the role the global reinsurance market plays in supporting insurance in the U.S.; 4) the effect of domestic and international regulation on reinsurance in the U.S.; 5) the role, function, and influence of government reinsurance programs; 6) the coordination of reinsurance supervision nationally and internationally; and 7) “any other topics relevant to the global reinsurance market report.”
The topics for comment identified by the FIO provide an overview of the issues that the reinsurance report can be expected to cover and the issues that, in the view of the FIO and its Director, Michael McRaith, are central to the report’s focus. Prior to the comment period’s closing date of Aug. 27, 2012, several reinsurers, insurers, and trade organizations provided perspectives as requested by the FIO. Others, including environmental groups, legal organizations and individuals representing the views of various sectors of the U.S. and global markets, also submitted comments.
Perhaps even more than the long anticipated Report on the Modernization of the U.S. Insurance Market, the reinsurance report is expected to lay the groundwork for the FIO’s approach to interacting with regulators and supervisors on a global scale.
THE PURPOSE OF REINSURANCE & IMPORTANCE TO THE U.S.
Evaluating the importance of the global reinsurance market to the U.S. insurance industry first requires an understanding of the purpose of reinsurance, what comprises the global reinsurance market, where it is, the amount of reinsurance capacity it provides, and U.S. premium ceded to it.
It is generally acknowledged that reinsurance serves four primary functions: (1) providing a mechanism for the transfer of significant risk such as catastrophe exposures; (2) limiting liability on specific risks; (3) stabilizing loss experience as to certain lines or books of business; and (4) increasing insurers’ capacity to take on new risk.2 Notably, nearly half of all reinsured risk is ceded by U.S. insurers. In terms of reliance upon the global reinsurance market, in 2011, 60 percent of U.S. reinsurance premium was ceded to non-US reinsurers.3 As of the first quarter of 2012, there are over 200 reinsurers worldwide with approximately $470 billion of available capital. Despite this figure, a majority of global insured risk is ceded to just five reinsurers. The reinsurance market is global and increasingly exists outside of the U.S. The 10 largest reinsures are domiciled in Germany, Switzerland, Bermuda, the U.S., France and the U.K.
Complex and varied state regulation as well as U.S. corporate taxes have arguably made the U.S. unattractive to reinsurers, who instead have opted to form in Bermuda and other jurisdictions. Several non-U.S. jurisdictions provide regulatory and monetary advantages to reinsurers such as Bermuda, which does not tax profits, dividend income, or capital gains, and permits contingent commissions, allowing reinsurers to pay brokers based on the volume of business brought to them. Notably, since the early 1990s no new (i.e., unaffiliated) reinsurers were formed within the U.S., while during the same time period, there was an explosion of reinsurer formation and growth in Bermuda.
Non-U.S. reinsurers play a particularly important role in ensuring the stability of the insurance sector in the face of natural catastrophes. Director McRaith noted earlier this year that 60 percent of the losses related to the events of September 11th and 61 percent of the losses related to the 2005 hurricanes Katrina, Rita, and Wilma were ultimately absorbed by the reinsurance industry. An “extreme stress test” discussed in the International Association of Insurance Supervisors’ (IAIS) July 2012 report on Reinsurance and Financial Stability concluded that large, global reinsurance groups are able to absorb even severe catastrophic losses and financial market stress. In fact, many of the largest global reinsurers held more capital at the end of 2011 than in the beginning of that year, despite a succession of major natural catastrophes in the Western Hemisphere and Asia-Pacific region.
Director McRaith has also noted that “with rare exception, property reinsurers manage risk through geographic diversification, thereby spreading risk around the world and reducing the likelihood of multiple concurrent large-scale losses.”4 Such comments evidence recognition by the FIO that the global reinsurance market has grown in importance to the U.S., particularly in the property context.
THE ROLE OF DOMESTIC & INTERNATIONAL REGULATION/COORDINATION OF SUPERVISION
In the U.S., reinsurance, like most insurance, is regulated at the state level. Reinsurance contracts are not subject to rate and form regulation like policies of direct insurance. Insurers are free to negotiate terms and agreements they deem appropriate for the particular business being reinsured. Regulators review reinsurers’ solvency, considering such factors as minimum capital, surplus, and risk-based capital, and determine whether to grant balance sheet credit to insurance companies purchasing reinsurance.
The Nonadmitted Reinsurance Reform Act (NRRA), included in Dodd-Frank, imposed new rules relating to the recognition of credit for reinsurance and regulation of reinsurers. Under the NRRA, a reinsurance company's domiciliary regulator is the sole regulator of the company's financial solvency. In addition, only the cedant's domiciliary regulator may impose requirements for the terms and enforcement of reinsurance contracts or regulate credit for reinsurance allowed to the cedent.
State collateral requirements have been criticized as prejudicial to non-U.S. insurers and a restraint on trade. Collateral requirements stem from concerns over the ability of state insurance regulators to determine whether non-U.S. reinsurers will be able to pay claims and whether judgments against non-U.S. reinsurers can be enforced – a position that has little historical support.5 In addition, the historical incidences of an insurer becoming insolvent as a result of the financial failure or defalcation of a reinsurer are limited. Over the past 40 years, only 3.7% of non-life insurer insolvencies and 2% of life insurer insolvencies resulted from reinsurance failures. In fact, reinsurance is often the single largest asset of insurers in receivership or liquidation.6
The Role of the Federal Insurance Office
The FIO is not a regulator and lacks regulatory authority, but it is vested with significant influence over U.S. policy positions and actions regarding international insurance matters. McRaith has described the FIO as “a single, unified federal voice in the development of international insurance supervisory standards.” Dodd-Frank provides that the FIO should “coordinate Federal aspects of international insurance matters.” In connection with that role, the FIO is tasked with assisting the Treasury Secretary in negotiating “covered agreements.”
Arguably the FIO’s most significant power is the ability to preempt state laws that are inconsistent with “covered agreements,” although it applies only where the preempted law provides less favorable treatment to foreign insurers than U.S. companies and is inconsistent with a "covered agreement." To exercise the preemption authority, the FIO must follow a time consuming and complex process. As of yet, the FIO has not begun to process of seeking to preempt any state laws. There has been significant industry discussion that the FIO should consider using its preemption power as a means to create uniform collateral requirements in the states.
The extent of the FIO’s preemptive power – and how that power may be asserted – remains untested as the U.S. Department of the Treasury has yet to enter into a “covered agreement” as defined in Dodd-Frank, but it has been specifically noted that such covered agreements may pertain to reinsurance collateral requirements.
NAIC Reinsurance Initiatives
U.S. trade negotiators and state insurance regulators have been under pressure from the international insurance industry to reduce or eliminate these collateral requirements. In 2011, the National Association of Insurance Commissioners (NAIC) amended its Credit for Reinsurance Model Law & Regulation (Model Law) to include a process by which non-U.S. reinsurers may qualify for reduced collateral requirements based on several factors, such as the reinsurer’s financial rating and the quality of insurance regulation of the reinsurer’s state of domicile. Some states have already enacted legislation resembling the revised model law, including Florida, New Jersey, New York, Indiana, and Pennsylvania, while a number of states are considering whether to follow suit.
There has been some criticism that the Model Law does not eliminate the collateral requirements altogether. Also, the fact that adoption of changes to the model laws is voluntary is perceived as likely to undermine uniform implementation of the changes in collateral requirements among the States. If every state does not implement the Model Law, there will likely be deliberation on how to appropriately tap into the power granted to the FIO, Department of Treasury and the Office of the U.S. Trade Representative (USTR) to establish desirable international agreements on collateral requirements and using the FIOs preemption power to implement uniform collateral requirements.
The NAIC is also working to incorporate the latest changes to the Model Law & Regulations into accreditation standards, which would create a strong incentive for every State to adopt the law.7 Still, even if the Model Law is uniformly adopted collateral requirements are likely to remain an area of international dispute. Many non-U.S. reinsurers claim than any reinsurance collateral requirements place them at a competitive disadvantage. The FIO will have to address the collateral issue in the reinsurance report. How this issue is addressed will be of particular interest to parties on all sides.
The massive overhaul of the regulatory scheme applicable to EU member states focuses on group management and solvency, and the treatment of reinsurance for financial reporting purposes. Under Solvency II, if a third-country’s regime is “equivalent” to Solvency II, reinsurance contracts with its reinsurers must be treated the same as contracts with EU reinsurers, and equal credit must be given for equivalent third-country reinsurance.
The European Insurance and Occupational Pensions Authority (EIOPA) have recommended that the regulatory systems in Bermuda, Japan and Switzerland be deemed equivalent. Although the U.S. regime has not been slated for an assessment as to equivalence, EIOPA, the FIO and the NAIC have engaged in an EU-U.S. Dialogue Project, to identify commonalities and differences between the regulatory and supervisory regimes of each.8 A debate persists within the U.S. over the extent to which equivalence is necessary, or even desirable, but the ongoing dialogue will no doubt guide the FIO’s discussion of regulatory and supervisory issues in the report.
The International Association of Insurance Supervisors (IAIS) was created to “promote effective and globally consistent supervision of the insurance industry.” FIO became a full member of the IAIS on October 1, 2011, and Director McRaith was appointed to the Executive Committee on February 24, 2012. The IAIS is developing a Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame), the purpose of which is to create systems for interaction and information sharing among regulators for group-wide supervision of internationally active insurers. Some U.S. state regulators have expressed concern that the FIO’s views regarding prudential supervision may be diametrically opposed to the state regulators’ views.
Protectionism in Foreign Markets
Director McRaith has previously expressed concern over trade barriers that inhibit the ability of U.S. reinsurers to do business in other countries. Such barriers include the imposition of local capital requirements, collateral requirements and seasoning requirements, as well as requirements that international reinsurers form local companies and hire local staff. The Federal Advisory Committee on Insurance (FACI) has been tasked with providing information about such restrictions and how they affect U.S. insurers and reinsurers operating abroad
GOVERNMENT RUN REINSURANCE PROGRAMS
The comments on government reinsurance programs received by the FIO showed a strong sentiment for ensuring the strength private insurance and reinsurance markets, while supporting the need for federal and state programs that provide reinsurance in areas where the private reinsurance market does not.
For instance, the Terrorism Risk Insurance Act (TRIA), enacted in the wake of the September 11th attacks, requires commercial property and casualty insurers to provide terrorism coverage and provided a federal backstop in the case of an act of terrorism. Similarly, the Price-Anderson Nuclear Industries Indemnity Act created a program to cover some losses in excess of private insurance for claims resulting from of a nuclear accident. At the state level, Florida’s Hurricane Catastrophe Fund, which followed the devastation of Hurricane Andrew in 1993, provides reinsurance to private insurers for residential catastrophic hurricane losses.
More recently, legislation has been proposed to provide federal support for state natural catastrophe insurance programs. The Homeowners Defense Act (H.R. 2555), introduced in 2010, would have provided reinsurance to eligible state catastrophe insurance programs, guaranteed the catastrophe debt obligations issued by such programs, and created a non-profit corporation to promote states’ use of catastrophe bonds and reinsurance to manage risk.
Concerns have been raised over federal or state reinsurance funds crowding out the development of private reinsurance, as well as the long term solvency of such programs. For example, Florida’s Hurricane Catastrophe Fund has been unable to fund its full losses since 2007, and in 2012 it declared a $1.75 billion bonding shortfall in claims paying capacity. Indeed, how the FIO will address government programs and their effects on the reinsurance market in the U.S. will be followed closely by those who benefit from such programs and by segments of the industry that perceive government programs as an unhealthy consolidation of risk within the U.S.
Interested parties on all sides can expect the reinsurance report to fuel the ongoing debates regarding reinsurance regulation and the role of the FIO. The report will likely lay out the relevant facts regarding the global reinsurance industry and explain the various competing interests at issue. The report may also include policy suggestions regarding the steps Congress should take, or not, with regard to those interests and viewpoints. It remains to be seen, however, how Congress will use the information provided in the report and the impact the report will have on the insurance and reinsurance industry.
1 Originating in the Federal Insurance Office Act and codified at 31 U.S.C. 313(o)(1).
2 Reinsurance Association of America, Comments Regarding How to Modernize Insurance Regulation in the United States, December 16, 2011.
3 Remarks by Michael McRaith, Director, Federal Insurance Office, Property/Casualty Insurance Joint Industry Forum, New York, NY, January 10, 2012
4 Testimony delivered before the House Financial Services Subcommittee on Insurance, Housing and Community Opportunity, on "U.S. Insurance Sector: International Competitiveness and Jobs," May 17, 2012, http://www.treasury.gov/press-center/press-releases/Pages/tg1585.aspx.
5 See NAIC, U.S. Reinsurance Collateral White Paper, March 2006, at 31-34.
6 Best's Insolvency Study: Property/Casualty U.S. Insurers 1969-2002, May 2004.