Regulators Continue Effort to Revise Reinsurance Collateral Requirements

08 June 2007 Publication

FOCUS on the Insurance Industry

State insurance regulators at the National Association of Insurance Commissioners (NAIC) continue to work out the details of a substantial overhaul of the collateral requirements applicable to reinsurers. In 2006, state insurance regulators at the NAIC took measures to advance a rating-based proposal that would ease collateral requirements for certain non-U.S. reinsurers. The basic idea behind the proposal is to develop a regulatory system that distinguishes financially strong reinsurers from weak reinsurers and imposes collateral requirements accordingly. While efforts are underway to develop a more detailed framework for the rating-based proposal, members within the insurance industry remain divided on how or whether the current collateral requirements should be revised.

Current Collateral Requirements
Current reinsurer collateral requirements are imposed under state credit-for-reinsurance regulations. Generally speaking, these regulations require U.S. insurers to obtain acceptable forms of collateral from non-licensed or non-accredited reinsurers in order to take financial statement credit for reinsurance ceded to these reinsurers. In these situations, credit for reinsurance is permitted only in an amount equal to collateral posted by the reinsurer. Conversely, ceding companies that cede risks to reinsurers that are licensed or accredited in the ceding company’s state of domicile are permitted to take full financial statement credit without obtaining any collateral from the reinsurer. In other words, existing regulations focus exclusively on a reinsurer’s licensing or accreditation status with no consideration given to the reinsurer’s financial strength or stability. Most companies that post collateral are non-U.S. companies.

Proposal to Revise Collateral Requirements
The proposed collateral requirements seek to tie a reinsurer’s collateral obligations to its financial strength. According to the proposal, the intent is to develop enhanced regulatory requirements that provide reasonable and prudent controls over the reinsurance credit risk exposure of U.S. ceding insurers. These new requirements would apply to all reinsurers, regardless of their licensing or accreditation status or geographic location.

The proposal calls for the creation of an organization within the NAIC referred to as the Reinsurance Evaluation Office (REO). The REO would examine and rate the financial strength of all reinsurers transacting business in the United States. Based on this evaluation, each reinsurer would receive a rating placing it into one of six categories. A reinsurer’s collateral obligation would correspond to its rating. A reinsurer receiving an REO-1 rating would not be required to post any collateral, whereas a reinsurer receiving an REO-6 rating would be required to secure its reinsurance obligations at 100 percent or higher. These ratings would be affirmed or modified through periodic reviews by the REO.

Under the proposal, reinsurers seeking a rating from the REO would go through a detailed application process. The REO would review these applications and assign an appropriate rating to each reinsurer based on various credit criteria. These criteria would include (i) the financial strength ratings issued to the reinsurer by nationally recognized statistical rating organizations such as A.M. Best, Standard & Poors, Moody’s, and Fitch Ratings, (ii) the strength of financial solvency regulation in the reinsurer’s home jurisdiction, (iii) the length of time a reinsurer has been in business, and (iv) the reinsurer’s reputation for prompt payment of valid claims.

Regulators sitting on the Reinsurance Task Force heavily debated the current proposal at the Winter 2006 NAIC meeting, where it ultimately passed by a 15-5 vote. A sub-group was formed this spring for the purpose of drafting a preliminary operational framework for the REO. If the collateral proposal ultimately is adopted, it will require a major rewrite of the existing credit-for-reinsurance regulations.

Mixed Reactions to Collateral Proposal
The latest collateral proposal has received mixed reactions within the insurance industry. Proponents of the proposed collateral requirements have argued that the new rules would eliminate unnecessary costs and disincentives for non-domestic reinsurers to write U.S. business by eliminating collateral requirements where they are not reasonably required. They also claim that the new rules are necessary to ensure that U.S. credit-for-reinsurance requirements are consistent with developments in international reinsurance standards. Not surprisingly, most non-U.S. reinsurers favor the proposed ratings approach, which they view as leveling the playing field with their U.S. competitors.

Many insurers and reinsurers based in the United States, on the other hand, remain opposed to the proposed rules. Some claim the collateral proposal would undermine the financial security of U.S. ceding companies and diminish the incentive of non-U.S. reinsurers to become licensed in the United States. Others assert that the new collateral requirements would put U.S. reinsurers at a disadvantage because they would be required to comply with the collateral obligations at the same time they are subject to U.S. licensing requirements. Opponents favor maintaining the current collateral requirements or exploring different alternatives.

This article is a part of the FOCUS on the Insurance Industry Summer 2007 Newsletter.