By James C. Massie
October 31, 2011
The United States is the world’s largest insurance market and the largest consumer of property/casualty reinsurance in the world. Florida is the peak zone for insurance and reinsurance catastrophe protection. Global reinsurance companies play a critical role in maintaining the financial health of the Florida insurance marketplace.
Reinsurance
In its simplest terms, reinsurance is insurance for insurance companies. Reinsurance is a transaction in which one insurance company (the reinsurer) indemnifies, for a premium, another insurance company (the ceding insurer) against all or part of the loss that the insurance company may sustain under its insurance policies. In other words, the insurance company transfers some of its risk to one or more reinsurance companies.
The fundamental objective of insurance – to spread the risk so that no single entity is saddled with a financial burden beyond its ability to pay – is enhanced by reinsurance, which enables risks to be spread throughout the world.
Reinsurance is a global business. In 2009, 57.8% of the reinsurance premiums on U.S. business was written directly by non-US reinsurers, and 42.2% was assumed by U. S. professional reinsurers. In 2009, reinsurance was ceded to or recoverable from over 5,300 reinsurers in over 100 jurisdictions outside the United States.
The Role of Reinsurance
Reinsurance benefits insurance companies and the public at large in three ways:
1. Reinsurance enables an insurance company to offer more coverage than it could otherwise by limiting an insurer’s loss exposure to levels commensurate with its net assets.
2. Reinsurance stabilizes an insurance company’s operating results by reducing significant fluctuations in loss experience.
3. Reinsurance enables companies to spread catastrophic losses around the world.
Encouraging the participation of reinsurers worldwide is essential to providing much needed capacity in the U.S. for both property and casualty risks. By way of example, reinsurers paid $57.9 billion, or 45% of the 2005 hurricane losses and they paid over $34 billion or 60% of the September 11 terrorist attack losses.
While reinsurance contract language can be tailored to meet the needs of the ceding insurer, in the context of catastrophe reinsurance, contract language generally defines “occurrence” much more broadly than just the specific criteria for hurricane triggers found in derivative contracts. Reinsurance treaties typically cover other events that can cause major damage such as tropical storms, tornadoes, and wildfire conflagrations. A derivative trade only pays for the specific type of risk named in the trade, and then only if the conditions of the derivative are met (typically either an industry loss or a parametric wind speed trigger).
Reinsurance is a competitive business, which has experienced relatively weak returns over the long term
• The U.S. reinsurance industry has a lower return on equity than the U.S. property and casualty insurance industry, the U.S. commercial bank industry, the U.S. diversified financial services industry, and the average of all U.S. industries (data excludes mortgage and financial guaranty in 2008 and 2009.) The U.S. reinsurance industry is also subject to more dramatic negative spikes than other financial services industries. Even when considering 2006, the U.S. reinsurance industry has experienced a cumulative net underwriting loss for over 20 years (for every dollar in reinsurance premiums, reinsurers pay out more than a dollar in losses and underwriting expenses). Investment returns for U.S. reinsurers have averaged less than 6% due in large part to conservative investments required by U.S. state law and regulations.
• In Florida, private reinsurance rates have decreased on average three out of the past four years. In 2007 reinsurance rates decreased 10% – 15%. In 2008 reinsurance rates decreased an additional 10% – 15%. In 2009 reinsurance rates increased 10% -15% primarily due to the fact that insurance demand increased at a time that reinsurance supply was constrained due to the turmoil in the capital markets. In addition, worldwide 2008 was the third worst catastrophic insured loss year in history (although Florida did not suffer any catastrophes that year) including Hurricanes Gustav and Ike. The June 1, 2010 report from the brokers indicated that Florida reinsurance renewal rates generally decreased 10% – 15% for the current hurricane season and that reinsurance capacity was near record levels.
Reinsurance Regulation
• Like insurance, reinsurance is regulated by the states. In Florida, reinsurance is regulated primarily by Section 624.610, Florida Statutes plus applicable regulations.
• Insurance regulation is focused on protecting consumers and usually involves significant oversight of rates, policy forms and market conduct of insurers. The focus of reinsurance regulation is different. Because reinsurance contracts are between two sophisticated parties – the insurer and reinsurer – reinsurance regulation focuses on the financial solvency of the reinsurer. Because the reinsurer’s solvency is regulated rather than the terms of the reinsurance contract, each ceding insurer can negotiate reinsurance that satisfies their specific business needs. Ceding insurers generally utilize reinsurance brokers in helping them negotiate reinsurance terms and price with reinsurers. Reinsurance brokers represent and have a fiduciary duty to the ceding insurers, not the reinsurers.
• The U.S. regulatory system enables ceding insurers to purchase reinsurance from both companies that are licensed in the United States and those that are not.
• There are two methods of reinsurance regulation: direct and indirect.
o Direct regulation applies to those reinsurers that opt to be licensed in at least one state in the United States. U.S. licensed reinsurers are subject to the same entity regulation as U.S. primary insurers, including:
• risk-based capital requirements
• holding company laws
• state licensing laws
• annual statement requirements
• triennial examinations
• investment laws
o Indirect regulation is utilized to regulate the reinsurance transaction. Reinsurers that do not opt to obtain a license in the United States are regulated for solvency by their home country regulator. U.S. regulation of such reinsurers is primarily through the credit for reinsurance mechanism.
• Credit for reinsurance laws allows these unlicensed companies to assume risk directly from U.S. ceding insurers without restriction so long as they provide acceptable security for insurers to receive financial statement credit for that reinsurance.
• Credit for reinsurance laws enable a U.S. ceding insurer to treat amounts due from reinsurers as assets or reductions from its liabilities if certain defined criteria are met. As a general matter, credit is allowed if the reinsurer is licensed or accredited in the same state where the ceding insurer does business or if the reinsurer is domiciled in a state that employs substantially similar credit for reinsurance laws to those imposed by the ceding insurer’s state of domicile. If the reinsurer does not meet any of these criteria, it must either establish an acceptable U.S. trust fund (like Lloyds has done) or establish appropriate security in the United States, such as a letter of credit for the ceding insurer to be able to take credit for the reinsurance.
• The Florida legislature amended its credit for reinsurance laws in January 2007 to allow credit for reinsurance that would otherwise not meet the specified requirements of its credit for reinsurance law so long as the assuming insurer holds surplus in excess of $100 million and has a secure financial strength rating from at least two nationally recognized statistical rating organizations deemed acceptable to the Insurance Commissioner. In determining whether credit should be allowed, the Commissioner shall also consider the quality of the assuming insurer’s regulatory jurisdiction.
• Reinsurers are also subject to U.S. federal and state antitrust laws. While the McCarran-Ferguson Act provides a partial exemption from federal antitrust laws for the “business of insurance”, the exemption only applies to the extent that such business is regulated by the state and does not involve a boycott, coercion or intimidation.
Insurer Options with Regard to Reinsurance
• Reinsurance is essentially a substitute for the amount of risk insurers would have retained themselves if they had not transferred that risk to the reinsurer. Thus, the cost of reinsurance is essentially a surrogate for the amount insurer “net” rates would have to increase if they retained the risk.
• In addition, the total cost of reinsurance has two components. The price/rate per unit of risk and the amount of reinsurance purchased. Even when reinsurance prices/rates are declining, as they were in 2010, if an insurer buys more reinsurance, its total reinsurance cost may increase.
• Insurers do not necessarily have to purchase reinsurance. A homeowners’ insurance company may choose from a number of options instead of purchasing reinsurance. The insurer may:
o Write less catastrophe exposed business and/or write more non-catastrophe exposed business to balance its book of business;
o Keep the risk itself;
o Raise capital by selling stock or attracting new investors;
o Obtain loans;
o Access the capital markets to purchase capital market products in lieu of traditional reinsurance. Some capital market products include catastrophe bonds, ILWs (industry loss warranty products), and sidecars.
o Pursue some other method of financing.
• The fact that an insurer elects to purchase private reinsurance – knowing in advance the price of that reinsurance – means that the insurer had the opportunity to evaluate all of its other options and made a business decision that reinsurance is its best option for its particular circumstances. Thus, it is difficult to understand why the cost and purchase of reinsurance is sometimes criticized by the regulator when all of the other options apparently are worse.
• Because reinsurance requires capital, insurers have a vested interest in only buying as much reinsurance as they need and no more. If an insurer is purchasing sufficient reinsurance to protect itself from a one in two hundred fifty year event (rather than the one in seventy year event Florida’s regulator is now apparently requiring), that insurer has made a prudent business decision that its purchase of reinsurance is necessary for its particular circumstances.
Accounting Treatment for Reinsurance
• Because risk is transferred from the insurer to the reinsurer and the reinsurer agrees to indemnify the ceding insurer for covered losses, insurers account for reinsurance as either a reduction of liabilities or as an asset in their underwriting results.
• Reinsurance accounting treatment is only appropriate if it is subject to the same standards as reinsurance: risk transfer and an indemnity based payment based on the insurance company’s actual incurred losses, with no opportunity to record a gain on the transaction.
• Many capital market products such as catastrophe bonds, ILWs and sidecars have been structured to qualify for reinsurance accounting treatment by transferring risk and basing payment (indemnification) on the insurance company’s actual losses, with no opportunity to record a gain on the transaction.
Proper Accounting Treatment is Important
• Accounting rules establish the guidelines by which insurers and other companies prepare their financial statements, which are in essence a “snap shot” of a company’s financial health.
• To properly protect consumers and evaluate the solvency of an insurer, regulators, rating agencies and others that rely upon financial statements use an agreed upon set of rules for accounting.
• Financial statements are only reliable because all appropriate parties know the applicable rules and standards for their preparation and audit. This enables all parties to use a consistent system to compare the financial strength and results of insurers. Florida should not create its own accounting rules, particularly when such rules can mask an insurer’s true financial circumstances.
Regulators are very comfortable with the regulation of credit risk for reinsurance recoverables. This is because a reinsurer must be licensed, authorized (meaning subject to US state regulation including in all the states the reinsurer is licensed), post collateral, or be approved by the regulator to post reduced collateral because they are highly rated and are financially sound.
About the Author: James C. Massie, Attorney at Law, Tallahassee, FL was admitted to the Florida Bar in 1974 and has served as General Council of The Florida Ports Conference; Florida Seaport Transportation and Economic Development Council; and Florida Ports Financing Commission. Mr. Massie also represents the Reinsurance Association of America.
