RS21828 -- Insurance Regulation: International Developments April 28, 2004 Summary Events and entities outside the United States are affecting or may affect the competitiveposition of U.S. insurers, intwo ways. First, supranational organizations are developing international standards for insurance accounting andfor aspects of supervision, such as reinsurancesupervision. Second, U.S. insurers are operating under a much more fragmented regulatory regime than theircompetitors in other countries, such as the U.K.,that are consolidating and modernizing their supervision. International standards and regulatory competition areimportant parameters on the U.S. industry'saccess to capital and therefore on its ability to provide innovative and traditional risk financing in the United States. This report was written under the researchsupervision of Barbara Miles, Government and Finance Division, and will be updated as events warrant. Economists generally agree that, while capital markets are not perfectly integrated internationally, they are farmore integrated than was true only 20 yearsago. (1) This integration has created pressures forenhancing transparency in the capital markets and for curtailing risks of "contagion." (2) Several supranationalorganizations are addressing these pressures, some specifically with respect to insurance. New internationalaccounting standards may import new definitionsof "insurance," and new transparency standards for reinsurers may help buyers shop for risk financing. At the sametime, many other developed countries aresynthesizing their supervision of financial services, while in the United States insurance regulation remainsfragmented. These trends will likely affect thecompetitive positions of U.S. insurers and reinsurers, though it is not clear presently what the direction and scopeof those changes might be. The International Accounting Standards Board (3) (IASB) has determined to create principles-based accounting for insurance contracts in two stages. Phase Iwas released on March 31, 2004, as International Financial Reporting Standard 4 (IFRS 4). (4) It is scheduled to become effective in the EuropeanUnion (EU)on January 1, 2005. European insurers have objected to Phase I because, among other things, it would require themto measure derivatives at fair or marketvalue and to show their annual gains and losses on them. Derivatives do not appear on European balance sheetscurrently, as they have little or no initial cost. U.S. insurers that are publicly traded already measure their derivatives at fair value. (5) U.S. insurers objected to several other aspects of IFRS 4. (6) Phase II has just begun and will likely be implemented in 2008. (7) The U.S. standard-setter -- the Financial Accounting Standards Board (FASB) -- hasagreed to work with IASB in converging international and U.S. accounting standards. (8) The National Association of Insurance Commissioners (NAIC) hasdecided to work closely with the IASB to incorporate its regulatory perspectives into development of Phase II. (9) Several issues will have significant effect onthe capital positions of U.S. insurers. One will be whether and how to measure insurance liabilities at fair value. Another will be whether and how to unbundlevarious kinds of insurance contracts. Insurers are also concerned about how the IASB will treat reserves for lossesand expected investment income andpremium on long-term contracts, among other issues. They fear that the Phase II rules will lead to greater volatilityin their public disclosures, and thus affecttheir capital positions -- and the market's perception of their capital positions -- unfairly and incorrectly, in theirview. (10) Whether those fears are justified orappropriate is unclear at this stage -- but it is clear that Phase II of the IASB's proposals will greatly affect insurers'competitive position in the financialservices sector. Rightly or wrongly, insurance has been identified as "the weakest link in the finance-industry chain." (11) Reinsurance has been identified as "occupyingaposition of systemic importance to the insurance industry ...." (12) Reinsurers lost about $40 billion on September 11, 2001, and they lost about that much as theequities bubble burst. (13) Financial supervisorsbegan to regard reinsurance -- again, rightly or wrongly -- as a systemic risk. (14) In September 2002, the Financial Stability Forum (FSF) (15) said that though the reinsurance industry had performed well, FSF members were concerned aboutthe opaqueness of the reinsurance market and of individual reinsurers' disclosures. It charged the InternationalAssociation of Insurance Supervisors (IAIS)with producing data on the market and with enhancing reinsurers' disclosures qualitatively and quantitatively. (16) The IAIS's task force -- known as Task ForceRe -- submitted its report to the FSF in March 2004. (17) It described how data on the international reinsurance market will be gathered and published, notedthat the IAIS has drafted a standard on what non-life reinsurers should disclose about their technical performance,and said that IAIS would be preparing globalreinsurance market reports. (18) Data on U.S.reinsurers will be compiled by the NAIC and will likely be available to the Treasury, the Federal Reserve Board,and the SEC. (19) The FSF, in receiving the report,urged that "more work be done in this complex area." (20) In October 2003, the IAIS adopted a new standard on supervising reinsurers. (21) The standard addresses reinsurers' risk management, relations with its cedinginsurers, investments and liquidity, economic capital requirements, and corporate governance. It also imposes onthe home supervisor of an internationallyactive reinsurer the obligation to share information about that reinsurer with other ("host") supervisors. It expresslycontemplates "a global supervisoryframework" based on "a system of accreditation of home supervisors"and this standard. (22) Though IAIS has begun a survey of its members' supervision ofreinsurers, it has not fixed a timetable for creating a global regulatory regime for reinsurers. (23) Some developed nations have unified their own supervisory regimes for financial services. Comprehensiveregulatory reform of financial services began inAustralia in 1996. Since then the U.K., Germany, and Japan have also unified their national supervisory regimesfor all financial services sectors. Each countryhas taken a slightly different approach. Australia formed one agency to craft and administer consistent andcomparable disclosure requirements for a broadrange of products, including deposit accounts, securities, insurance products, and pensions. It formed anotheragency to perform prudential supervision forbank and non-bank financial intermediaries. Germany unified financial supervision of banks, securities, andinsurance into one regulatory agency to achieveconsistent supervision of different sectors and of cross-sectoral issues. Japan's new Financial Services Agency,which reports directly to the Prime Minister'soffice, supervises banks, private insurers, securities, and securities markets. (24) Perhaps of greatest interest -- because it is most accessible -- is the U.K.'s undertaking to unify its supervision of financial services. The unification processbegan in 1997, and the new Financial Services Authority (FSA) acquired its full powers in 2001. It now regulatesbanking, insurance, pensions, and securities,though the process of integrating those functions continues. (25) The FSA's enabling legislation gave it four objectives -- maintaining market confidence,promoting public awareness, protecting consumers, and reducing financial crime. In pursuing those objectives, theFSA is directed to: Use its resources in the most efficient and effective manner; Recognize that a firm's senior management bears ultimate responsibility for its risk management andinternalcontrols; Make sure that burdens imposed on firms and markets are in proportion to the expected benefits forconsumers and theindustry; Facilitate innovation in the financial services markets; Acknowledge the "international character of financial services and markets and the desirability ofmaintaining the competitive position ofthe United Kingdom;" (26) Minimize regulation's adverse effects on competition; and Promote competition among regulated entities. (27) According to the FSA, the "insurance sector is a key part of the UK financial services industry. It is important, both from an economic and social perspective,that the UK has an insurance market that operates effectively [and] remains competitive in European and worldmarkets...." (28) According to the FSA, itscreation "as a single regulator highlighted differences between the regulation of insurance and other sectors inrespect of similar types of risks." (29) Accordingly,it has undertaken a major overhaul of insurance regulation to strengthen it and "to establish a common, risk-basedapproach to regulation across all financialsectors." (30) In revising its insurance regulation, the FSA has cooperated closely with and contributed to both the formulation of EU directives on insurance and reinsuranceas well as IAIS standards. The EU's Financial Services Action Plan (FSAP), due to be completed next year, containsdirectives that will directly affect therelative competitive positions of U.S. and U.K. insurers including Lloyds. (31) In addition, the European Commission (EC) has proposed a directive onreinsurance that would allow a reinsurer domiciled and licensed in an EU country, under the new standards, to dobusiness throughout the EU without furtherregulation or collateral. The directive is intended to, among other things, improve access to foreign markets --particularly the United States. (32) Unified supervision of financial services may not be successful. Certainly neither Australia's nor the U.K.'s financial supervisory authority has been free fromfailures. The efforts are noteworthy, however, for two reasons. One is that their changes may, like the proposedEU directive on reinsurance, directly affect thecompetitive positions of U.S. insurers and reinsurers.