Approaches to Reinsurance Regulation

The reinsurance industry is a very important part of the structure of the insurance industry of any country.

It is the reinsurance industry that provides the much-required stability and backup capital that enables insurance companies to underwrite more business. Hence, the regulation of reinsurance companies and the reinsurance business is equally important when compared to the regulation of insurance companies.

Over the years, different countries have come up with different approaches toward the regulation of the reinsurance business.

Some of these approaches have worked better as compared to other approaches depending upon the underlying economy.

In this article, we will discuss the three main approaches to the regulation of reinsurance companies as well as their pros and cons.

Domicile-Oriented Regulation

A domiciled-based reinsurance regulation regime focuses excessively on reinsurance companies that are domiciled locally. This means that the first step for all insurance as well as reinsurance companies is to obtain a domestic license that validates their local credentials.

Once such a license is obtained, the regulatory authority obtains the right to create detailed rules and regulations which impact the operations of these firms. In some countries, dealing with non-domiciled counterparties may be completely disallowed. However, in most parts of the world, dealing with non-domiciled reinsurance counterparties is allowed. It is more expensive and there are more regulatory hurdles to doing so. This is done with a view to ensuring that the regulator has complete control over the operations of these reinsurance firms.

Hence, in such cases, even if foreign reinsurance companies want to participate in a local market, they generally have to create a local subsidiary and get it licensed by the regulatory authorities.

Domicile-oriented schemes are generally suitable for first-world countries which have a strong capital market. This is because if these excessive regulations are applied in small emerging markets, they would end up driving out capable international reinsurers.

The entire purpose of domicile-based reinsurance is to ensure that reinsurance premiums are retained within the nation. This allows for better reinforcement of regulatory orders passed by the relevant authorities.

Fully Liberalized Regulation

In many ways, a fully liberalized reinsurance regulation scheme can be considered the exact opposite of a domicile-oriented regulation scheme. This is because domicile-based regulations have excessive rules and regulations.

On the other hand, a fully liberalized regulation scheme has almost no regulations. In such scenarios, regulatory authorities may make no distinction between a foreign-based reinsurance company as well as a local reinsurance company. Domestic insurance companies are free to choose any reinsurance company in the entire world!

The advantage of this approach is that it is easy to implement. There is no need to design an exhaustive list of procedures governing rules for licensing and license renewals. This saves a lot of time and effort for the regulatory agencies as well as the reinsurance companies.

Another advantage of this approach is that it allows risk to be spread out amongst reinsurers from different parts of the world. This dispersion of risk is in line with the general insurance principles which state that risk must be diffused in order to make it more manageable. However, this type of regulation has a huge disadvantage.

The disadvantage is that the regulatory agencies have very little control over where the risk is actually being transferred to. Hence, there is a high chance that low-quality reinsurance companies may end up obtaining a large chunk of the market. This could pose a systemic risk to the entire market as the failure of a few reinsurance companies could erode customer confidence and even cause direct financial losses to other insurance companies.

Quality-Oriented Regulation

A third approach called quality-oriented regulation is considered to be a mid-way between the two mentioned approaches. In this approach, the regulatory bodies do supervise all the reinsurance companies which operate in the market. However, the level of supervision is different.

The domestically domiciled reinsurance companies are regulated more closely. On the other hand, foreign-based reinsurance companies are not regulated as closely. However, only top foreign-based reinsurance companies with strong financials and stellar track records may be authorized to participate in the reinsurance markets. These companies may be required to submit their audited financial statements which clearly explain their cash flow position and overall financial position.

The task of evaluating the financial position of these foreign-based reinsurance companies may be done directly by the regulatory bodies or the task may be outsourced to international rating agencies.

The advantage of the quality-oriented regulation approach is that it allows the best of both the above-mentioned approaches. On the one hand, it allows for maximum participation of different types of reinsurance companies. On the other hand, it also provides regulators with control over the operations.

For example, if a domestic insurer uses an international reinsurer, they may need to take some additional steps such as increasing their reserves or adding solvency premiums in order to offset the execution risk which may be created by transferring the reinsurance premium to a foreign country.

The quality-based approach has been considered to be optimal by both developing as well as developed countries. This is the reason that it is widely used by different countries across the world.

The bottom line is that there is more than one way in which regulators across the world deal with reinsurance companies. The specific ideology chosen depends upon the political as well as economic ideology of the country as a whole.