ICP 13 Reinsurance and Other Forms of Risk Transfer

The supervisor requires the insurer to manage effectively its use of reinsurance and other forms of risk transfer. The supervisor takes into account the nature of reinsurance business when supervising reinsurers based in its jurisdiction.

13.1
The supervisor requires ceding insurers to have a reinsurance programme that is appropriate to their business and part of their overall risk and capital management strategies.


13.2

The supervisor requires ceding insurers to establish effective internal controls over the implementation of their reinsurance programme.


13.3

The supervisor requires ceding insurers to demonstrate the economic impact of the risk transfer originating from their reinsurance contracts.


13.4
When supervising ceding insurers purchasing reinsurance across borders, the supervisor takes into account the supervision performed in the jurisdiction of the reinsurer.


13.4.1    
The cross-border nature of reinsurance transactions, together with the relative sophistication of the market participants involved in reinsurance, are key elements that the supervisor should consider when supervising ceding insurers.

13.4.2    

Taking into account the supervision performed in the jurisdiction of the reinsurer may help the supervisor to assess the overall risk profile of the ceding insurer. This can be done, for example, by reviewing the supervisory framework and practices in the jurisdiction of the reinsurer, or by engaging in supervisor-to-supervisor dialogue.


Supervisory recognition


13.4.3    
The supervisor can benefit from relying on supervision performed in the jurisdiction of the reinsurer. Benefits may include, for example, strengthened supervision as well as a more efficient use of resources by the supervisor of the ceding insurer.

13.4.4    
Where supervisors choose to recognise aspects of the work of other supervisory authorities, they should consider putting a formal supervisory recognition arrangement in place (see ICP 3 Information Sharing and Confidentiality Requirements).

13.4.5    
Supervisory recognition can be conducted through unilateral, bilateral and multilateral approaches to recognition. All three approaches recognise the extent of equivalence, compatibility or, at least, acceptability of a counterparty’s supervisory system. Bilateral and multilateral approaches typically incorporate a mutuality component to the recognition element, indicating that this is reciprocal.

13.5
The supervisor requires the ceding insurer to consider the impact of its reinsurance programme in its liquidity management.


13.5.1    
Given the nature and direction of cash flows within a ceding insurer, liquidity risk historically has not been considered to be a major issue in the insurance sector. However, there can be liquidity issues within an individual ceding insurer which could arise specifically from the ceding insurer’s reinsurance programme.

13.5.2    

Reinsurance contracts do not remove the ceding insurer’s underlying legal liability to its policyholders. The ceding insurer remains liable to fund all valid claims under contracts of insurance it has written, regardless of whether they are reinsured or not. For this reason, a large claim or series of claims could give rise to cash flow difficulties if there are delays in collecting from reinsurers or in the ceding insurer providing proof of loss to reinsurers.

13.5.3    

The supervisor should require ceding insurers to take appropriate measures to manage their liquidity risk, including funding requirements in adverse circumstances. As with all risks, the insurer should develop its own response to the level of risk it faces and the supervisor should assess these responses. There are a number of ways in which liquidity risk may be mitigated. For example, some insurers choose to arrange a line of credit from a bank in order to deal with short-term liquidity issues.

13.5.4    
Ceding insurers may make arrangements with their reinsurers in order to mitigate their liquidity risk. These arrangements, if used, may include clauses that trigger accelerated payment of amounts due from reinsurers in the event of a large claim and/or the use of collateral or deposit accounts, giving ceding insurers access to funds as needed. Use of such arrangements is a commercial matter between the ceding insurer and reinsurer.

13.5.5    

External triggers can give rise to liquidity issues, especially where reinsurers have retroceded significant amounts of business. If a reinsurance contract contains a downgrade clause that gives the ceding insurer the right to alter the contract provisions, or obliges the reinsurer to post collateral with a ceding insurer to cover some or all of its obligations to that ceding insurer, such action may cause liquidity issues among reinsurers and may be pro-cyclical. Therefore, the supervisor should be aware of the potential consequences of such triggers for the overall efficiency and stability of the market.

13.6

In jurisdictions that permit risk transfer to the capital markets, the supervisor understands and assesses the structure and operation of such risk transfer arrangements, and addresses any issues that may arise.

13.6.1    

A wide range of techniques has been developed to allow the transfer of insurance risk to the capital markets, resulting in a diversity and complexity of risk transfer arrangements.

13.6.2    

In general, arrangements used to enable risk transfer to the capital markets operate like mainstream reinsurance. For example, risk is transferred via a reinsurance contract with similar terms and conditions to any other reinsurance contract. Further, the risk assuming entity is a reinsurer subjected to licensing conditions like any other reinsurer. The defining feature of these risk transfer arrangements is the direct funding of the reinsurance risk exposure with funds raised, often exclusively, in the capital markets.

13.6.3    
Insurance risk transfer to the capital markets can occur by making use of a wide variety of arrangements. Arrangements in the non-life sector are often broadly classified into four groups: 1) catastrophe bonds (cat bonds); 2) collateralised reinsurance; 3) industry loss warranties (ILWs); and 4) sidecars. These four groups, which are not mutually exclusive, focus on different elements of the risk transfer arrangements:
  • cat bonds take the name from the financial instrument (ie a debt security) issued to fund an insurance exposure, usually a catastrophe;
  • collateralised reinsurance is generally used to highlight a credit risk mitigation feature of certain insurance transactions (ie the collateralisation of the insurance exposure);
  • ILWs refer to a range of financial instruments used by counterparties, who may or may not be insurers, to buy or sell protection related to insurance risks; and
  • sidecars refer to a legal entity created ‘on the side’ of an insurer that is used to transfer insurance risk, usually to the capital markets.
To illustrate that these are not mutually exclusive, there could be a sidecar that underwrites insurance risk via an ILW and funds the exposure through an issuance of cat bonds, the proceeds of which are used to collateralise the reinsurance risk assumed.

13.6.4    

In the life sector, some arrangements are similar to the non-life sector (for example, mortality bonds, which operate like cat bonds). Other life insurance arrangements have specific features that are not used in non-life insurance, such as the funding of certain portions of the ceding insurer’s reserves.

13.6.5    
Despite the many similarities with mainstream insurance, transactions transferring insurance risk to the capital markets have special features that the supervisor should bear in mind in order to assess the appropriateness and effectiveness of their use by ceding insurers and reinsurers.


Initial assessment


13.6.6    

Insurance risk transfer to the capital markets usually entails the creation of a dedicated entity or a legally ring-fenced arrangement, specifically constituted to carry out the transfer of risk. These are referred to by a variety of names, such as special purpose vehicles, special purpose reinsurance vehicles, or special purpose insurers; for the purpose of the ICPs, they are collectively referred to as special purpose entities (SPEs).

13.6.7    

The main purpose of an SPE is to assume insurance risk, funding the exposure by raising funds in the capital markets, and to be dismantled once its purpose has been fulfilled. Importantly, as SPEs conduct insurance business, the supervisor should consider licensing them as insurers (see ICP 4 Licensing). Licensing of SPEs should be appropriately tailored to take into consideration the unique characteristics of SPEs. In this respect, close collaboration among those supervising ceding insurers and those supervising SPEs before authorisation of the SPE and on an ongoing basis can be particularly helpful.

13.6.8    
Key elements of any SPE structure include:
  • the insurance risk that it assumes is “fully funded” (ie, that the exposure taken by the SPE is funded across a range of foreseeable scenarios from the time the SPE goes on risk to the time it comes off risk);
  • the claims of any investors in the SPE are subordinate to those of the ceding insurer; and
  • the investors in the SPE have no recourse to the ceding insurer in the event of an economic loss.

13.6.9    
In order to be able to understand and assess whether an SPE structure meets the criteria above, the supervisor should take the following into account:
  • ownership structure of the SPE;
  • suitability of the Board and Senior Management of the SPE;
  • the SPE's management of credit, market, underwriting and operational risks;
  • investment and liquidity strategy of the SPE;
  • ranking and priority of payments;
  • extent to which the cash flows in the SPE structure have been stress tested;
  • arrangements for holding the SPE’s assets (eg trust accounts) and the legal ownership of the assets;
  • extent to which the SPE’s assets are diversified; and
  • use of derivatives, especially for purposes other than risk reduction and efficient portfolio management.

13.6.10    
Understanding the role of all the parties to the SPE arrangement is critical to understanding the underlying risks, particularly as these may be fundamentally different from those involved in a traditional reinsurance transaction. The supervisor should understand and assess, among other things, the:
  • extent to which key parties have been fully disclosed (eg sponsor, (re)insured, investors, advisors, counterparties) and are known to the supervisor;
  • extent to which potential conflicts of interest between all parties to the SPE have been adequately disclosed and addressed (such as situations where sponsors also take a managing role);
  • credit risk associated with key service providers, including financial guarantors used to protect the position of investors;
  • degree of basis risk that is assumed by the ceding insurer and to what extent this could have immediate ramifications for the ceding insurer’s financial position in case of a loss;
  • details of the SPE’s management arrangements and key personnel;
  • third party assessments of the SPE structure (eg by credit rating agencies);
  • expertise of the legal advisors involved;
  • robustness of any financial or actuarial projections, if applicable (eg if triggers are indemnity based); and
  • disclosure of outsourcing agreements.

13.6.11    
As many SPEs are designed to operate with a minimum of day-to-day management, the supervisor should understand and assess the extent to which the systems of risk management and internal controls are adequate and proportionate to the nature of the underlying risks and to the complexity and expected lifespan of the SPE structure.

13.6.12    
The systems of risk management and internal controls of the SPE should ensure that, at least:
  • investment restrictions are not breached;
  • interest payments, dividends, expenses and taxes are properly accounted for;
  • movements above established thresholds in assets and collateral accounts are reported;
  • assets are legally existent and technically identifiable; and
  • liabilities can be determined on a timely and accurate basis and obligations satisfied in accordance with the underlying contracts.

13.6.13    
The supervisor should understand and assess:
  • the systems of risk management and internal controls of the SPE, particularly the extent to which these are sufficient to ensure effective operation in compliance with the SPE’s legal and supervisory obligations; and
  • operational risks within the SPE structure and any mitigation arrangements.


Basis risk


13.6.14    

The supervisor should understand and assess the extent to which SPE arrangements give rise to basis risk. This arises where the trigger for indemnity under the SPE arrangement is different from the basis on which underlying protected liabilities can arise.

13.6.15    
Where SPEs contain indemnity triggers (ie, recovery from the SPE is based on the actual loss experience of the ceding insurer) basis risk is unlikely to be an issue. However, many SPEs contain non-indemnity triggers, such as parametric triggers (driven by objectively measurable events) or modelled triggers (driven by the outcome of modelled, industry-wide losses). In such cases, there may be events where the ceding insurer will remain exposed to its underlying policyholders without having recourse to the SPE.

13.6.16    
Basis risk should be considered with reference either to the amount of credit given by the supervisor of the ceding insurer for the SPE arrangement or in the capital requirement of the ceding insurer, where such mechanisms are used.

13.6.17    
Additionally, in some jurisdictions the accounting and regulatory treatment of insurance risk transfer that uses non-indemnity triggers may be different from the accounting treatment of indemnity-based insurance. The supervisor should understand these accounting differences and the impact these may have on the financial statements of the ceding insurer and the reinsurer.


Ongoing Supervision


13.6.18    
The supervisor should understand the various issues that emerge in the ongoing supervision of SPEs and their use. Consideration should be given to the following areas:
  • measures to be taken by the supervisor if any of the licensing or authorisation conditions are breached;
  • level of capital and ability of the SPE to continue to respond adequately should covered events occur;
  • level of reporting required by the supervisor in order to understand and assess whether the SPE is complying with its obligations;
  • the SPE’s response in the event of fluctuations in the values of invested assets (eg match/mismatch between collateral account and exposure, flow of premiums, fees, commissions);
  • arrangements put in place in the SPE to ensure that the “fully funded” condition is maintained in the case that the insurance risks assumed are rolled over from one risk period to another; and
  • where the SPE undertakes multiple transactions, arrangements put in place in the SPE to ensure that the funds corresponding to each transaction


Unwinding of SPE arrangements


13.6.19    
The unwinding of SPEs is often influenced by the dynamics of insurance losses. The supervisor should understand and gain comfort with the provisions in place to require orderly unwinding of SPEs. In particular, the supervisor should understand the process related to the generation, mitigation and management of any residual risk emerging from the unwinding of the SPE.

13.6.20    
In addition, the supervisor should understand the process and stages that the SPE goes through when it comes to a natural end and its obligations have been fulfilled and the SPE is liquidated. There is a distinction between unwinding in the event of a loss and unwinding a transaction reaching legal maturity (without a loss having occurred). While the latter case is usually simple and straightforward, unwinding in a full or partial loss situation deserves close attention. Consideration should be given to the following areas:
issues relating to share buy-back and conditions to its materialisation;
  • issues relating to disposal of the investment portfolio;
  • “dismantling” of the SPE and residual risks;
  • where the SPE undertakes multiple transactions, issues relating to the segregation and legal insulation of assets per transaction; and
  • supervisory issues relating to risks which revert to the ceding insurer on termination of the arrangement.


Considerations for supervisors of insurers ceding risks to SPEs


13.6.21    
Although in many jurisdictions insurance risk transfer to the capital markets is not permitted, the supervisor should consider that some of the insurers in its jurisdiction may be transferring insurance risk to SPEs located in another jurisdiction that permits insurance risk transfer to the capital markets. In this case, the supervisor of the ceding insurer should consider, among other things:
  • whether the risk transfer taking place involves an SPE that is licensed in the jurisdiction where the insurance risk is assumed;
  • the supervisory regime to which the SPE is subject in its jurisdiction; and
  • the extent to which the ceding insurer has adequately provided for the identification, assessment and management of the risks associated with transferring insurance risk to an SPE (eg credit risk, basis risk).