Introduction
A dynamic risk market demands insurance companies to constantly seek new solutions to manage their capital and risk position. This position is further challenged by volatile financial markets, low interest rates, and of course, competition. As insurers assess their risk appetite and aim to achieve an optimal balance of risk, reinsurance solutions have proved to be an effective solution. While traditional reinsurance solutions are effective tools for risk management, ‘Non-traditional Reinsurance Solutions’, are oriented towards providing specific business solutions rather than pure risk transfer. In this piece, we discuss the insurance regulatory framework around Non-traditional Reinsurance Solutions in India.
Traditional Reinsurance versus Non-traditional Reinsurance Solutions
Reinsurance is the traditional and prevalent model of risk transfer in the insurance industry. In traditional reinsurance, insurers park their risks with a reinsurer and the reinsurers pay claims under the terms of the reinsurance agreement/ treaty, in the event of a claim by the insurer. Traditional reinsurance utilises traditional forms of ‘capital’ such as shareholders money and pools risk through traditional mechanisms, for example, by holding diversified portfolios. Historically, this ‘traditional’ form of risk reinsurance had been the preferred route of insurers and reinsurers in attaining their primary purpose of ‘risk transfer’.
In Non-Traditional Reinsurance Solutions, a broad category of various types of reinsurance solutions are customized for the specific needs of a cedant. Risk pooling mechanisms and ‘capital’ sourcing is structured and customised (for example source of capital may be capital markets) and the primary purpose may not be ‘risk transfer’. Generally, the purpose of Non-traditional Reinsurance Solutions is to provide business solutions such as profit and loss arrangements, capital management etc.
‘Financial reinsurance’ is an example of Non-traditional Reinsurance Solution followed for life insurance. Financial reinsurance attempts to address some of the financial objectives of a direct insurer, such as generation of capital for writing new business, either by a cash injection from the reinsurer or by re-structuring future profits contained in a block of new business or in-force business. Certain other examples of Non-traditional Reinsurance Solutions (for life insurance) would be:
- finite reinsurance (it is a type of reinsurance contract that incorporates the time value of money, such as spreading risk over time and generally taking into account the investment income generated over a period of time),
- aggregate stop-loss (where losses over a specified amount during the contract period are covered by the reinsurer and not by the original insurer or ceding company), and
- surplus relief (the ceding commission provides surplus relief to the primary insurer by compensating for the cost of the policy acquisition).
Indian Regulatory Framework
Although the Indian insurance regulator, i.e. the Insurance Regulatory and development Authority of India (“IRDA”) has not explicitly defined Non-Traditional Reinsurance Solutions or any of the types of Non-traditional Reinsurance Solutions, IRDA’s prescription of the insurance regulatory framework does contain provisions that are relevant for the Non-traditional Reinsurance Solutions. We have discussed these below.
Alternative Risk Transfer vis-a-vis Non-traditional Reinsurance
The IRDA (Reinsurance) Regulations, 2018 (“Reinsurance Regulations”) prescribe provisions dealing with ‘alternative risk transfer’ (“ART”). The Reinsurance Regulations define ART to mean “non-traditional structured Re-insurance solutions that are tailored to specific needs and profile of an insurer or re-insurer” and has noted that ART can also be considered as ‘financial reinsurance’ in ‘life’ insurance business. The Reinsurance Regulations further prescribe that ART solutions (i.e. tailored non-traditional structured solution) require prior approval of the IRDA. We have also dealt with ‘insurance linked securities’ as ARTs in detail in our previous article here.
Thus, it is imperative to note that all Non-traditional Reinsurance Solutions require prior approval of IRDA. Such approval by IRDA is subjective on a case to case basis.
Reinsurance as a Risk Transfer:
The Insurance Act, 1938 defines ‘reinsurance’ as “the insurance of part of one insurer’s risk by another insurer who accepts the risk for a mutually acceptable premium”.
It may be noted that at a principal and policy level, the IRDA expects ‘reinsurance arrangements’ to serve as a ‘risk transfer’ mechanism. In this regard, IRDA has also prescribed that reinsurance treaties applicable for a particular financial year should meet risk transfer requirements[1]. IRDA has further prescribed that any re-insurance arrangement which does not have “pure risk transfer” such as “capital gearing treaty, alternate risk transfer solution, financial re-insurance, non-traditional structured re-insurance solution or any other term or name called”, need to be informed to the IRDA[2]. Thus, Non-traditional Reinsurance Solutions such as ARTs, capital gearing arrangements, financial reinsurance, etc., are considered by IRDA to be arrangements, which are “not pure risk transfer”.
It may be pertinent here to note that IRDA in the past has expressed concerns over reinsurance arrangements, which are not “pure risk transfer”. In this regard, IRDA via its March 28, 2020 circular (“March 2020 Circular”), which was issued to all general insurers, health insurers and specialised insurers, had prevented such insurers from entering into fresh ‘Capital Gearing’ treaties. This was in light of the IRDA’s view that Capital Gearing treaties were of the nature of financial arrangements and not primarily risk transfer mechanisms. In the IRDA’s view, insurers had adopted these arrangements in order to simply improve their solvency margin ratio.
The March 2020 Circular indicates IRDA’s view that ‘risk transfer’ is essential to directly permit reinsurance arrangements. While IRDA has not prescribed any risk transfer test or elaborated on the term ‘pure risk transfer’, the March 2020 Circular excluded arrangements entered to improve the solvency of the insurer/ reinsurer, capital gearing arrangements, and financial arrangements from ‘pure risk transfer’ arrangements.
Reinsurance Committee Reports:
Various reinsurance committees set up by IRDA and their reports on developing reinsurance laws in India have deliberated upon the Non-Traditional Reinsurance Solutions and recommended prescribing a ‘risk transfer test’. In this regard, the recommendations of the Reinsurance Expert Committee report dated November 14, 2017 (“2017 Committee Report”) were considered in the formulation of the current Reinsurance Regulations. The 2017 Committee Report elaborated in detail on Non-traditional Reinsurance Solutions, including its meaning, type, risk transfer test, permissibility of certain types of Non-traditional Reinsurance Solutions, etc. However, such detailed provisions do not reflect in the Reinsurance Regulations. Thus, the IRDA’s cautious approach towards adopting these recommendations vis-à-vis Non-traditional Reinsurance Solutions does not come as a surprise. It appears that the IRDA would rather deal with Non-traditional Reinsurance Solutions on a case to case basis than hard code its provisions in detail.
Conclusion:
The reinsurance industry is expected to provide holistic solutions to the insurance industry. Non-traditional Reinsurance Solutions which provide tailor-made solutions, may fuel this growing requirement. ‘Risk transfer’ mechanisms of Non-traditional Reinsurance Solutions may not be self-evident and in such a case, the insurer and reinsurer will have to evaluate the risk transferred under such reinsurance arrangements by analysing the risk exposures, and modelling of the resulting cash flows. As discussed above, the present regulatory framework requires Non-traditional Reinsurance Solutions, which do not qualify as ‘pure risk transfer’ or have a cash flow arrangement in the form of capital management, etc, to obtain prior approval of the IRDA.
The IRDA, through its order dated July 7, 2022, has also constituted a task force to study and make recommendations on issues faced by life insurers, non-life insurers and reinsurers, which will inter-alia look into ART, insurance-linked securities, catastrophic bonds, and financial reinsurance solutions. The report of the taskforce is not yet publicly available; however, it would be interesting to watch out for the recommendations of the task force, which is likely to impact the regulatory framework prescribed by IRDA on Non-traditional Reinsurance Solutions.
[1] IRDA’s circular dated January 31, 2020
[2] ibid
