4 October 2023

Eiopa's third-country reinsurance rules must strike a delicate balance

Achieving sound risk management while avoiding protectionism is crucial for addressing coverage gaps, argues Carlos Montalvo Rebuelta

The insurance business is both global and local in nature, and policyholders benefit from this dual characteristic. At the same time, reinsurance is by its nature global, making the most out of diversification in order to fulfil its task in terms of risk taking and mitigating. In practice, it is in everybody's interest that distribution of the different risks is spread amongst as many players as possible.

This idea applies in relation to traditional risks as well as emerging ones. Indeed, when it comes to "old risks" such as natural catastrophe, it is a fact that both frequency and intensity are increasing, raising the valid question of whether reinsurers will keep the appetite for such risks, and if insurers will be able to afford higher and higher premia in a hard market.

Carlos Montalvo RebueltaThe most recent Monte Carlo Rendez-vous showed a market, particularly for natcat risks, where capacities were there in a much broader way than at the beginning of the year, and reinsurers appetite to keep taking such risks - at the right price – increased. Yet this should not lead us to complacency, pretending that the challenge is over and that capacity tensions are something of the past. The situation in cyber risk – where reinsurers continue to put strict limits their risk-taking – act as a reminder of the consequences for society and our economy of an insufficiently deep reinsurance market.

In this context, the European Insurance and Occupational Pensions Authority (Eiopa) has launched a public consultation regarding the use of reinsurance provided by third-country reinsurers, i.e. those based outside the EEA.

It builds on the importance that reinsurance, as a risk mitigation technique, has for the business - both in terms of cessions and retrocessions. It also puts more supervisory focus on the effectiveness of risk transfer as a pre-condition to allow for recognition of reinsurance as risk-mitigant, including for solvency purposes (an area already covered by Eiopa in a 2021 Opinion, but not in this article, where we focus on traditional reinsurance).

A common goal: convergence

Interestingly enough, although reinsurance is seen as a global business, it is one where differentiated national approaches still exist, such as regarding the use of collateral. On such basis, the more the EU aligns its regulatory and supervisory practices, the higher the benefit in terms of convergence, leading to enhanced certainty.

The approach Eiopa is proposing is a "top-down" one, in the sense that it all starts with each entity's reinsurance strategy, where the contract must fit. This "fit" includes consideration of risk appetite towards the different risks embedded in the contractual relationship, some of which may be common to all reinsurance contracts and some that would emerge only when underwriting with a third country reinsurer.

Furthermore, it combines with a clear allocation of responsibilities towards senior management (and boards), so I would expect enhanced challenging from supervisors on both the insurer's reinsurance strategy as well as around the understanding thereof by board members.

It is also a risk-based approach, or at least it should be, in the sense that the same risk should entail the same capital charge and different risks should lead to equally different capital requirements.

"Features such as diversification, contingency planning in case of early termination, or status of collateral should be also properly considered by any insurer, regardless of domicile considerations"

This is important under Solvency II, in particular when considering that the approach taken regarding the treatment of reinsurance as a risk mitigation technique focuses mainly on counterparty risk, requiring third-country reinsurers possess a given credit rating (at least investment grade) that is not requested to EU ones, nor to those reinsurers of equivalent jurisdictions.

However, there is less focus on other risks such as basis risk, legal risk or even liquidity risk, and here differences may appear depending on the territories considered. This is particularly the case where insolvency laws differ, as it may make reinsurance treaties ineffective: a valid concern from supervisors, but also for insurers as this is a potential risk that will affect them differently as it would when operating with an EU reinsurer, thus one that must be addressed explicitly.

A risk-based framework should cover those other risks, beyond counterparty, that may stem from ceding (or retroceding) to a third-country reinsurer. But, this being the case, the same should also be expected from dealings with EU reinsurers, in the sense that risk management should not be driven by geography, but by underlying risks. Features such as diversification, contingency planning in case of early termination, or status of collateral should be also properly considered by any insurer, regardless of domicile considerations.

In the end, how different is the risk an EU-based insurer faces today regarding a UK domiciled reinsurer, compared to 2016? The only difference should be - at least until the UK changes its insolvency framework or waters down Solvency II - that an investment grade rating would not be requested from EU reinsurers, which makes sense having Solvency II being calibrated at 99,5% on a one-year horizon, i.e. the same confidence level as investment grade. All other risks should be assessed in all cases, as part of a sound approach by insurers to risk management.

Two valid questions

Eiopa's paper raises a number of questions, but let me pick two: one from the point of view of the supervisors, and another from industry's viewpoint.

The first one, around supervisory expectations, is clearly framed by referring to the business rationale for using third-country reinsurers: Why have you opted for a reinsurer located in a third country? The response can be very diverse: for example, it may have to do with capacity or appetite from the reinsurer, or with willingness to address concentration risk, even with price.

"Why have you opted for a reinsurer located in a third country? The response can be very diverse"

Therefore, what matters is there is indeed a rationale for the decision, which is consistent with the reinsurance strategy of the company, and that it is made on the basis of a proper assessment of the contract, the counterparty, the jurisdiction, etc, thus ensuring a proper risk transfer in line with the risk appetite of the company.

The second question, one that may be raised by insurers, relates to Solvency II equivalence: Should reinsurers in equivalent territories (Bermuda, Switzerland, Japan) be treated as EU ones?

Some insurers believe that, regardless of an equivalence declaration, supervisors have some additional concerns when it comes to reinsuring with equivalent reinsurers, as compared to EU ones. Interestingly enough, the response to this question can be a "cut and paste" from the previous one and should lead to the very foundation of Solvency II principles: "same risk, same capital charge; different risk, different charge". No further differences should take place under a risk-based framework.

Perhaps the best way to articulate the response to the aforementioned question can be traced and found in the EU-US Covered Agreement, where regarding reinsurance, and the need of collateral for third-country reinsurers, we find the following, broader, statement: "This paragraph does not prohibit a Host Party or its supervisory authorities from applying requirements as a condition to allow a Host Party Ceding Insurer to take credit for reinsurance or risk mitigation effects of reinsurance agreements concluded with a Home Party Assuming Reinsurer if the same requirements apply to reinsurance agreements between a ceding insurer and an assuming reinsurer which have their head office or are domiciled in the territory of the same supervisory authority."

Fears...and hope

This consultation comes at a time of political uncertainty, and some may well see a link between a supervisory statement that should have a technical basis, and the perception of growing nationalism.

This issue is captured in the 2023 edition of the Insurance Banana Skins report, where PwC and CSFI teamed up to survey the risks that keep insurers awake at night. Contrary to prior surveys, de-globalisation enters the list of risks for the first time. This concern can be summarised with a quote from a UK reinsurer: "geopolitics and the impact on the global economy from attempts to reduce globalisation and increased protectionism".

Not surprisingly, although de-globalisation ranks number 19 in the list of risks of the report, if we look only at reinsurers, it goes up to ninth.

"The response to the risk of lack of capacity by the sector requires considering all reinsurers, regardless of location, as part of the solution"

Let's conclude the article as it started: whilst when it comes to retail insurance there is no straight response in terms of the right balance between local and global, when it comes to reinsurance (or to specialty insurance) the answer to this dilemma is clear: more is better, and the response to the risk of lack of capacity by the sector requires considering all reinsurers, regardless of location, as part of the solution. At this year's Monte Carlo Rendez-vous, "uninsurability" of risks has been a common theme amongst reinsurers. Can we as a society afford this?

We face a time where reinsurers, in addition to increasing prices significantly to adapt to growing claims, are making conscious decisions to stop underwriting certain risks, leading to society having to absorb them. We are also in an era when, for the first time, some reinsurers are publicly calling for more involvement of their competitors in areas such as cyber in order to be able to respond to the upcoming demand. In a nutshell: challenging times, where being less global will lead to less reinsurance capacity and more concentration.

To conclude with a message of hope, there is clear understanding from all parties involved that growing protection gaps in markets where the role of reinsurers is key are amongst the highest concerns for regulators, industry and society.

Building from there, it only makes sense that the approach to third-country reinsurance is purely risk-based, and this removes any concern around discrimination, whilst reminding all actors that sound risk management always pays off.

Reinsurance, EU or not, is part of the solution, not of the problem. Knowing first hand that Eiopa approaches these issues from a technical rather than political perspective, I remain confident that the approach taken will lead to better reinsurance rather than to less capacity.

Carlos Montalvo Rebuelta is a partner and Global insurance regulatory leader at PwC, and is the former executive director of the European Insurance and Occupational Pensions Authority. Email: [email protected]