Insurance Update. FSA proposals for implementing the Reinsurance Directive. Contents. FSA proposals for implementing the Reinsurance Directive

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1 Insurance Update. FSA proposals for implementing the Reinsurance Directive The Financial Services Authority has published its proposals for implementing the Reinsurance Directive. The aims of the directive include bringing the prudential regulation of pure reinsurers in Europe into line with the standards applying to direct insurers, and giving them more credibility in the world market. In the longer term, the regimes for direct insurers and pure reinsurers will be merged when the Solvency II project is implemented in about The FSA s proposals are mostly expected to come into force at the end of 2006, almost a year before the directive is due for implementation across Europe. Special purpose vehicles To achieve the best regulatory and tax advantages insurance securitisations often require special purpose vehicles (ISPVs) to take on some of the risks involved in the transaction by way of reinsurance. Typically these are currently set up in places such as Bermuda which are lightly regulated and taxed. The Directive recognises that member states of the EEA need to be able to compete on more even terms. The directive allows member states to authorise ISPVs on a less onerous basis than applies to mainstream insurance or reinsurance companies. In particular the solvency requirement for ISPVs will merely require that their liabilities be covered by their assets. The process of getting them authorised will be cheaper and quicker and their reporting requirements will be less extensive than those for insurers and reinsurers. A waiver, however, under section 148 of the Financial Services and Markets Act 2000 (FSMA), will be necessary to enable credit to be taken by an insurer or reinsurer for amounts recoverable or outstanding from an ISPV. These waivers will be subject to a rigorous vetting process, by reference, for example, to the «risk transfer principle» which is described below and the impact of the ISPV transaction on the ceding firm s individual capital assessment. HM Revenue and Customs has also made proposals on the taxation of ISPVs. Contents FSA proposals for implementing the Reinsurance Directive AXA: 4.1 billion share capital increase 3 Court of Appeal applies a stricter line to conditions precedent 4 Where insurers cover risks beyond their contractual liabilities Merger of APRA and Assubel into the combined Mensura group July

2 Capital adequacy for reinsurers The capital adequacy regime imposed by the FSA on UK reinsurers is already broadly based on the same principles which apply to direct insurers, so only minor changes are necessary to implement the directive. The FSA proposes that the non-life solvency margin should be applied to long-term life protection reinsurance. This will cover both pure reinsurers and insurers writing direct as well as reinsurance business. Hard asset exposure rules for pure reinsurers will be replaced by soft «prudent person» principles. In the longer term these principles may perhaps be extended to mixed insurers and direct insurers. A further Solvency II consultation paper on requirements for assets covering technical provisions is due in October The risk transfer principle The FSA has made a number of attempts since 2002 to find a formula for ensuring that transactions such as securitisations, contingent loans and financial reinsurance only count for capital adequacy purposes to the extent that there is a real transfer of risk. This issue first came to the fore for the FSA when the chief actuary of the Equitable concealed the existence of side letters impairing the risk transfer under an 800 million reassurance arrangement and had a prohibition order made against him. It is now proposed to include a set of principles in the FSA s rulebook (see rule EG of the draft Insurance Prudential Sourcebook - INSPRU) by which the firm or the FSA will determine (on a waiver application or otherwise) whether and to what extent credit may be taken for the transaction. Consideration is also being given to the possible extension of this principle more widely to all reinsurance transactions. The consultation paper seeks views on this. The regulatory treatment of reinsurance is also due to be covered by a Solvency II consultation paper and this too may have some influence. Restriction of business to reinsurance Since the first generation of EU directives applying to direct insurers, such insurers have been required not to carry on any commercial business other than insurance and activities directly arising from that business. This rule was originally contained in section 16 of the Insurance Companies Act 1982 and is now moving to INSPRU R. Determining what is covered by this restriction has never been easy, and work carried out by the FSA in its early years on draft guidance never bore fruit. The equivalent prohibition for pure reinsurers in the Reinsurance Directive is in slightly different terms. It is followed closely in the draft rules proposed with the consultation paper (INSPRU AR). It allows pure reinsurers to carry out reinsurance and related operations such as provision of statistical or actuarial advice, risk analysis or research for their clients as well as related financial sector activities. On a literal interpretation of the rule and accompanying guidance only pure reinsurers can carry out related July

3 operations, but in the longer term the position of mixed insurers and «pure direct insurers» may also need to be considered in the context of Solvency II. Reinsurance groups The FSA s rules, in line with the Insurance Groups Directive, currently only require a report on group capital adequacy from insurers who write direct business. If a report is required it must, however, also cover members of the group who are pure reinsurers (wherever in the world they may be based) and/or Lloyd s corporate members. It will become a regulatory requirement for these mainstream insurance groups to report positive group capital adequacy from the end of The FSA calls this the «hardening» of the group test. Following the Reinsurance Directive the requirement to report on group capital adequacy will be extended from the end of 2006 to «pure reinsurance groups», i.e. groups in which there is no UK direct insurer. It will not, however, extend to groups where the only UK member is at Lloyd s. The group capital adequacy test for pure reinsurance groups will be «hardened» from the end of 2007, a year later than for mainstream groups. The reinsurance passport The FSA s proposals do not cover the reinsurance passport. The directive will allow a reinsurer authorised in, for instance, Belgium, to carry on business from an establishment in the UK without a further UK authorisation. Implementing this aspect of the directive will require amendments to FSMA and will be the subject of a separate consultation by HM Treasury. The Treasury proposals will also cover amendments to the transfers of business regime in Part VII of FSMA. It remains to be seen whether the reinsurance passport will create opportunities for regulatory arbitrage arising from differences of approach in implementation of the directive or whether (as with direct insurance) it will be undermined by restrictions applied in the host state. AXA: 4.1 billion share capital increase AXA, the insurance group, increased its capital by 4.1 billion euros in June Linklaters advised it on the transaction. The purpose of the capital increase was to allow AXA to part finance the acquisition from Credit Suisse of 100 % of the shares of the Swiss insurance company Winterthur (consideration: CHF 12.3 billion ( 7.9 billion)). The share capital increase included a public offer in France and an institutional offer around the globe. The underwriting agreement constituted a "garantie de bonne fin" within the meaning of Article L of the French Commercial Code. This form of unconditional underwriting commitment, rare in France, allows the issuer to record its capital increase in its accounts as of the date of the underwriting Insurance Update. 3

4 agreement. It is not then necessary to wait for the delivery of the new shares against payment. Other elements of the financing were a three tranche issue of undated deeply subordinated debt for 1bn and 0.85bn and committed bridging financing of 5bn. The subordinated notes were the first Moody s Basket D on issue for a French issuer, a higher rating than is generally possible in France for such debt. Axa was also the first French issuer to have introduced an alternative coupon settlement mechanism relating to its share capital in the terms of its notes. This allows the issuer to settle deferred interest among other things by the issue and sale of its ordinary shares. Court of Appeal applies a stricter line to conditions precedent A recent case concerned a business interruption policy. The policy contained a provision requiring the insured to provide relevant information and documents to the insurer. Compliance with this provision was a condition precedent to the liability of the insurer. The provision had no time limitation. The judge at first instance, Judge Havery, sitting in the Official Referee s Court, held that compliance had to be within a reasonable time and that in determining what was reasonable any prejudice suffered by the insurer (or the lack of it) was to be taken into account. The judge considered that the insurer had not suffered significant prejudice as a result of the delays in providing information. He therefore held that the insured had complied within a reasonable time. The Court of Appeal disagreed and allowed the insurer s appeal. It considered that prejudice to the insurer (or the lack of it) was not necessarily relevant to the interpretation of claims co-operation clauses. On the facts the insured was in breach of the clause and its claim accordingly failed. The outcome might, of course, have been different if the condition precedent had been contained in, for instance, a household insurance policy and if, therefore, the Unfair Terms in Consumer Contracts Regulation 1999 or the FSA s Insurance Conduct of Business Rules had applied or the Financial Ombudsman Service had had jurisdiction. Where insurers cover risks beyond their contractual liabilities A recent decision in the criminal courts illustrates an important aspect of the operation of both the UK retail and wholesale markets. Insurers are sometimes criticised for not dealing expeditiously with claims that are clearly covered on the policy. At the other end of the scale they sometimes indicate that they regard other risks as covered when there appears to be no foundation for that view in the policy or the marketing materials. This can, of July

5 course, create problems when there is a change of management at the insurer. It is also an issue to bear in mind when advising on coverage issues and when seeking to comply with the FSA s expectations on contract certainty standards. In the criminal case referred to above a motorist was convicted of driving without insurance when plying for hire. His policy did not legally cover this even though the insurer accepted that it was on risk. The Court considered that the insurer s attitude to the cover did not amount to a defence to the charge. Merger of APRA and Assubel into the combined Mensura group The Belgian insurance groups, APRA and Assubel, merged in May Both groups were active in the business of labour insurance and safety at work. The new group was renamed Mensura. It is now the second largest labour insurance company in Belgium with a 15% market share and a combined net asset value of EUR104,420,345. Linklaters acted for APRA in the transaction. The two parent companies were mutuals ( gemeenschappelijke verzekeringskassen ). So the statutory merger procedure in the Belgian Companies Code was not used. Instead, the old merger technique of a transfer of all assets and liabilities followed by a liquidation of the transferor was applied. Insurance team Name Telephone Duncan Barber duncan.barber@linklaters.com Victoria Sander victoria.sander@linklaters.com Anna Tipping anna.tipping@linklaters.com Madhu Jain madhu.jain@linklaters.com Darragh Byrne darragh.byrne@linklaters.com Jonathan Goodliffe jonathan.goodliffe@linklaters.com Insurance Update. 5

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