Reinsurance: challenges and the regulator's response
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Speech by Sarah Wilson, Director and Insurance Sector Leader, FSA
Reinsurance Practice & the Law event hosted by Barlow Lyde & Gilbert LLP
18 June 2007
Good morning and thank you for the opportunity to speak at your conference here today.
As the introductory comments to your programme say, the reinsurance industry faces considerable challenges and opportunities ahead – from climate change to capital management, from increasing litigation to risk management. With this in mind, I would like to focus my remarks today on our regulatory priorities in the face of such challenges – and, in particular, our desire to promote an environment in which reinsurers are motivated continuously to improve their risk management; and in which London is seen – for the right reasons – as a regulatory platform of choice.
But before launching into this agenda, it is worth reminding ourselves again of the importance of the reinsurance industry; and of how the market has evolved over the last two turbulent years.
The reinsurance market plays, of course, a critical role in the global economy and in global welfare, enabling risk to be transferred from primary insurers who do not wish to retain all the risks that consumers, companies and governments have first passed to them. Latest figures show that the global flow of gross written premium amounts to some $140bn per year, of which approximately one-third is likely to have been transferred to reinsurers. Global reinsurance capital has grown to $157bn in 2005, in turn providing insurers and their customers with cover of a multiple of this amount.
Meanwhile, the London Market (including Lloyd's and companies operating in London) continues to be a well respected place for its ability to price, accept, and manage reinsurance risk.
Looking back, the last two years have demonstrated much of the inherent unpredictability of the reinsurance market. To go from 2005, with record losses not only sustained, but also paid for in many cases with no significant balance sheet impact, to 2006, where extremely hard rates in catastrophe classes have coincided with a very benign loss experience, is clearly remarkable. This more than anything demonstrates that performance is attributable to factors both inside and outside firms’ control, and also the inherent levels of business risk in reinsurance. As a regulator, we are keen to see this properly controlled.
Whilst Katrina and its aftermath has driven changes in traditional market participants, it has also had the effect of making the market, notably for catastrophe risks, significantly more attractive to the capital markets. This is understandable - investors see insurance risk as a new means of diversifying portfolios as they believe it to be largely uncorrelated with the other risks they run, and the rates of return potentially available during the hard part of the cycle are very attractive. For the traditional insurer on the other hand, capital market devices – be they cat bonds, side cars or something else - offer new routes to risk transfer that might otherwise be unavailable at an economic price. Properly managed, such transfers increase capacity and/or reduce prices in the insurance market – to the ultimate benefit of the consumers that we are here to protect. As ever the key for us is ‘proper management’ and I will come back to that later in my remarks.
Of course, some commentators have asked whether the capital markets have the long-term appetite necessary to write insurance business from one year to the next, given the opportunity for potentially greater returns at certain times in another market entirely. The debate about ‘stickability’ of capital is an interesting one, as some might argue that the presence of so-called ‘hot money’ in the market might make capital flows more flexible and responsive, which in turn might have the effect of reducing some of the more extreme effects of the cycle. It is possibly too early to comment on this effect, not least because the amounts involved at present remain small (at less than three percent of reinsurance capital stock) – although significantly larger than in the past.
Let me turn then to the challenges that lie ahead. In the latest edition of our Financial Risk Outlook, published four months ago, we noted the growing risk that the operating environment for firms (and consumers) could become more demanding over the following eighteen months, with increasing geopolitical risks in the light of a continuing risk of conflict in the Middle East and northeast Asia and protectionist pressures mounting in G7 economies. In such stressed situations, the sorts of correlations that the market is used to seeing and modelling can break down. We also noted the continuing threat of terrorist attack; we looked at the potential implications for firms and markets of human flu pandemic; and we considered the risks and challenges for the financial sector created by climate change. It is evident to us that senior management in the insurance market have much to contemplate, analyse and (where possible) plan for.
This is the context for the first of the regulatory priorities that I mentioned in my opening comments - our desire to promote an environment in which reinsurers are motivated continuously to improve their risk management.
Our starting point is in fact risk measurement. As you will know, while there are some insurers and reinsurers that are and were further advanced than others, we responded to inadequacies in many firms’ risk measurement by developing a capital framework whereby firms are required to measure their own risks in order to calculate for themselves the capital required to ensure a 99.5% probability of survival over one year. We refer to this as the Individual Capital Adequacy Standard, or ICAS. And our own review of the firm's analysis, combined with our supervisory view of the firm derived from the ARROW risk assessment, leads us to give Individual Capital Guidance (or ICG) - specifying the level and quality of capital we think it is appropriate for a firm to hold. In around 25% of cases (across life and general), the Guidance we have given has been equal to the capital figure specified by the firm – and we expect this proportion to grow as understanding of risk grows. Of course, many firms choose to hold more than this regulatory minimum, but it nevertheless sets a baseline. In the light of our own robustly challenging approach, we are confident that the UK insurance sector is more stable and consumers using UK insurers (and ultimately reinsurers) are better protected than would otherwise be the case.
One particular aspect of this improvement is, we hope, in catastrophe modelling. No-one in the market could fail to be struck, in the weeks following Hurricane Katrina, by the extent to which the models on which the market routinely relied failed adequately to capture the full extent of either the exposure being run or the damage that could be caused. Whilst the tragic events in New Orleans were clearly unprecedented, we were as surprised as many others by the extent to which catastrophe models failed to take into account extreme events, as well as features such as demand surge. This underlines the importance of firms considering how they might manage such catastrophic events even when they may not be able to model the set of circumstances which led to them unfolding. During some follow-up work we did during 2006, we were struck by the contrasting approaches taken by firms to their use of models, and by the correlation between these approaches and the firms’ relative fortunes after the event. Since then, firms have described to us the changes they have made, as well as the changes made by the modelling companies to their products, and we have been encouraged by what we have heard.
Another recent milestone on the road to accurate risk measurement has been the introduction of contract certainty in the UK – the market has eliminated "deal now, detail later", where insurers and reinsurers were going about their business without really knowing what their exposures amounted to. Of course, I have no doubt that the lawyers in the audience will still find plenty of business in arguing over the words on the page – but at least those words now exist, and the insurance industry has stopped paying fees for you to speculate over what they would have written had they got round to it at the time!
But effective risk measurement is but a staging post on the journey to robust risk management, and it is that which is our real goal. We took the opportunity to take stock in 2006 when we conducted some thematic work in insurers' risk management practices, which revealed that significant and encouraging progress had been made since our previous review in 2003. These improvements seemed to have stemmed not only from the introduction of the new ICAS regime, but also firms' greater appreciation of the commercial benefits of good risk management practices. As a result we saw a move away from risk management seen as a set of self-contained activities, carried out solely with the regulator in mind. For example, we were pleased to see examples where risk management information – including output from risk-based capital models – were actively being used to support strategic decision making.
However, despite these welcome developments we concluded that a number of more difficult challenges remain. In our view, many firms in the insurance market still need to assess the effectiveness of their oversight of risk management, both at Board and committee level, and to ensure that senior management have the knowledge and skills to sustain sufficient understanding of risk management processes. In a similar vein, we found some risk functions were merely acting as aggregators of risk at local and group level. Moving them towards a more strategic role in challenging and validating the risk information they receive would add greater support to senior management decision making.
Firms’ management of the underwriting cycle seems to us often to be an object lesson in their approach to risk management. In our view a well-managed insurer or reinsurer will set a risk appetite and manage itself such that it writes business which – at all points in the cycle – conforms to that risk appetite. Such an approach is entirely consistent with the continued existence of the cycle – indeed we understand the economic factors which drive it, and also understand that there may be strategic reasons why firms – consistent with their risk appetite - may wish to write business which is loss-making in the short term. But it requires a disciplined and well managed environment to achieve such an outcome – one where senior management pay attention to underwriters' incentives and put in place appropriate controls around both pricing models, and terms and conditions. Unsurprisingly, most people talk a good game in this area, and some are happy to point the finger elsewhere. And yet, in certain classes of business, notably professional indemnity and aviation, we have recently seen the market driven down towards levels that most informed commentators believe to be unsustainable. We are not convinced that that this is entirely caused by unscrupulous brokers taking advantage of naïve capacity, and believe that underwriters need to continue to act responsibly in order for the worst excesses of the past not to be repeated. Indeed, the recent thematic work I mentioned just a few moments ago concluded that most firms have documented their risk appetite, but there remains a substantial gap between defining and applying that risk appetite in practice. We shall continue to challenge firms in this area, and to look for evidence of the application in practice of the discipline that firms are keen to espouse.
Beyond the day to day work of supervising firms introducing new and better controls and models, our attention on risk measurement and management is now firmly focused internationally. In Europe, we are heavily involved in the most important capital reforms in over twenty years, namely Solvency 2. As you would expect, our approach to Solvency 2 has been informed by the same principles that have underpinned our domestic ICAS reforms – a focus on risk management, through improved risk measurement. The final framework will of course be the outcome of negotiation and will be subject to the attendant debate and uncertainty, but as negotiations continue, we are very keen to continue to bring all available evidence to bear on the debate – to maximize the chances of a genuinely risk sensitive and robust outcome. Meanwhile, we are also very pleased that the International Association of Insurance Supervisors (IAIS) is now working extensively on solvency, in particular it is currently in the process of developing guidance to its members on risk based capital requirements, risk management, valuation techniques, and internal models. We are pleased that this work is directionally consistent with our own ICAS framework, and we look forward to agreement on international standards in the near future.
Within the IAIS, and as part of a continuing EU dialogue with the US, we are also discussing reinsurance supervision and issues of mutual recognition. We continue to place emphasis on the role of senior management in firms – be they insurers or reinsurers - to identify and mitigate risks, and to exercise appropriate levels of control over their businesses. This is something we actively monitor with firms, and something which is at the heart of our regulatory approach. In this context, and in view of the great strides in the regulation of reinsurers that have been made by a number of European countries, including the UK, coupled with the impending implementation of the Reinsurance Directive across Europe, we are struggling to understand the US approach to collateralisation of exposures to non-registered, mainly "alien" reinsurers. In our view, the maintenance of collateral creates unnecessary costs for the insurance sector and ultimately the consumer and it distorts the efficient allocation of capital and competition. There are strong arguments for allowing the market to decide when additional security is needed. Surely such discrimination decreases reinsurance capacity in the US and increases premiums, with costs ultimately borne by American consumers.
Now let me turn to my second challenge - that of maintaining London's position as a leading (re)insurance market. You will no doubt be aware that whilst we do not have a statutory objective in this regard, one of the Principles of Good Regulation demands that we have take account of the UK's competitive position as a financial centre whenever we make regulatory decisions.
There are, of course, many influences on management's decision on where to locate their business: the fiscal environment, access to specialist human capital, process efficiency to name just three. I also recognise that regulation features in this debate, albeit in its broadest sense, that is, encompassing all types of regulation, not just those mandated by the FSA. Whilst we are told that tax is the single most important determinant to the decision to locate outside the UK, we have to appreciate the benefits of writing a diversified book of business by establishing operations outside the UK. This does not necessarily mean that the UK loses out – London is the only place in which all of the twenty largest reinsurers have a presence, so we must be getting something right.
We are confident that our move to a more principles-based approach, which is already well in train, and the risk-based capital approach I discussed earlier should tip the balance towards us in any insurers decision to locate.
However, this doesn't mean we are complacent. We are not willing to compromise our high regulatory standards – standards that promote market confidence and ultimately protect consumers. Nevertheless, we have tried to smooth out some of the practical aspects of our regulatory regime that may have discouraged firms which write business responsibly from locating here.
Firstly, negative perceptions still persist as to the speed with which new companies can set up in the UK, especially when new capital becomes quickly available because of changing market conditions. It is probably fair to say that authorisation periods of a year or more were not untypical prior to the FSA's creation in 2001, but we have greatly improved our processes to make them more responsive to the needs of the market, whilst continuing to safeguard high regulatory standards on which reputations are maintained. We expect insurance company applications to be considered within sixteen weeks and significantly less where they relate to a group already known to us. You will be pleased to hear that it is our aim to reduce these timescales further, if we possibly can; in fact, our experience tells us that a twelve week turnaround time is more typical in the case of wholesale general insurers. Furthermore, in times of market stress we have committed publicly to deal with applications within four weeks where the applicant is known to us already. Of course, all of these timescales are subject to us receiving complete and robust information on which to base our decision.
Secondly, as well as speeding up the authorisation process, we also wanted to foster the development of new methods of risk transfer. So we exercised our option when implementing the Reinsurance Directive to allow credit for reinsurance transactions with insurance special purpose vehicles, or ISPVs. In order not to restrict the market, and to ensure that risks were properly considered, we have done so on a case-by-case basis. Whilst potentially very attractive arrangements commercially, they do have a number of features – some general, some specific – that need to be understood fully, and the attendant risks properly mitigated. As you will well know, the alternative products don't work in exactly the same way as traditional reinsurance, and in some instances may afford less protection to the purchaser, for example in the case of forced commutation clauses. When discussing with firms how they are going to structure these transactions, we will expect them to have considered issues such as basis risk, and the extent to which they will remain exposed in a variety of different circumstances. We also expect them to show that the transaction is in keeping with our risk transfer principles, and that they have modelled, through ICAS, the effects on their regulatory capital.
Finally, we continue to work closely with the government - through the Chancellor's High-Level Group - in its objective to develop proposals to maintain and enhance the City of London's competitiveness. We look forward to discussing these proposals with our external stakeholders once they are published later this year.
In conclusion, may I leave you with two thoughts. First, faced with a challenging external environment, it is essential that senior management in the reinsurance industry continue thoughtfully and rigorously to enhance risk management in their businesses. Second, it is our aim to provide a regulatory environment in the UK which, amongst other things, fosters such work by senior management. We urge firms to keep us informed of market developments. We are keen to maintain a dialogue on the implications for our regulatory regime.