March 17th, 2011

Succeeding Under Solvency II: Pillar One, Capital Requirements; Part III - Conclusion

Posted at 1:00 AM ET

Challenges and Opportunities

It is clear that Solvency II presents a host of challenges to (re)insurers. With a disciplined and thoughtful approach, many companies will see opportunities to lessen the impact - or even to improve their competitive stance in the industry. Below we explore in detail some of the key considerations, challenges and opportunities associated with Solvency II.

Reducing Risk - and Required Capital Levels

While QIS 5 demonstrated that Solvency II generally will require higher capital levels across the board, there are steps that non-life insurers can take to mitigate their potentially higher capital requirements. Foremost among these is a reduction of their risk levels, which can be achieved in a number of ways:

Reinsurance Solutions: Companies may utilize reinsurance solutions by adjusting their levels of nonproportional and proportional reinsurance to reduce tail risks. The reinsurance program can be structured to specifically target areas that contribute most to higher capital requirements, while maximizing the acquired capital to cost ratio.

Some estimates suggest the response to Solvency II could increase demand for reinsurance in Europe by 10 percent to 20 percent (1) .  It is expected that the bulk of this demand would come from smaller non-life primary insurers with limited geographical or business line diversification and inadequate resources to implement more sophisticated internal models. Better capitalized, or “Solvency II ready,” primary non-life insurers are also likely to review their existing reinsurance arrangements, given the potential for greater volatility in their balance sheets.

Other Risk Mitigation Techniques: The reduction in risk achieved with the use of insurance linked securities (ILS) can be recognized in Solvency II calculations, subject to regulatory approval. Options such as surplus relief or tailored nonproportional protection against extreme losses may also be considered.

Diversification: Another risk-related capital management strategy is the maximization of the diversification benefit of different business lines. This can be achieved in a number of different ways, including mergers and acquisitions (M&A). Companies may also seek to enter new business lines through organic means or by forming new distribution partnerships. This action is advisable only where there is a strategic rationale and where the insurer has expertise or experience in the line of business it is entering - for example, a scenario where a personal lines motor insurer enters personal lines home insurance. The action would not be advisable to undertake for the sake of maximizing the diversification benefit alone.

Market Risk: Market risk can be reduced through deployment of hedging strategies on the equity portfolio, or through reduction of the equity allocation in favor of corporate bonds.

Change in Focus for Companies and Boards

The Solvency II regime is increasingly being perceived as more than a “check the box” regulatory exercise that determines capital requirements. It requires the European insurance industry to critically analyze its risks, and in the process, assess the true costs attached to them.

Luke Savage, finance director and head of risk management at Lloyd’s of London, commented on the dozens of people and hundreds of millions of pounds that Lloyd’s is committing to Solvency II, saying, “If you’re putting that kind of investment into it, you’ve got to get some value out of it - it can’t just be a regulatory exercise or we’ve all missed the point.”  (2)

The Solvency II regime goes further than just capital requirements; it demands and rewards good data management, good enterprise risk management and good culture, which ultimately will please investors. In theory, this means the industry will be far more aware of its risks at all levels, better able to manage its risks and consequently better placed to optimize returns on capital.

In fact, Solvency II is likely to precipitate a fundamental shift in focus for insurance entities away from pure underwriting results onto capital and risk management. It likely will change the responsibilities for corporate boards - which will expressly bear responsibility for compliance with the various Solvency II regulations.

The PwC Solvency II survey indicated that more than 80 percent of respondents see Solvency II as an opportunity to improve risk management and 65 percent believe that it will facilitate more effective use of capital. Additional survey results showed that 25 percent of respondents saw Solvency II as a mechanism for gaining competitive advantage.

Drawbacks to the Standard Formula

As discussed earlier, (re)insurers are faced with the important decision of whether to develop their own internal model or use the standard formula supplied by regulators.

Generally, the standard formula represents a “generic” (re)insurer. It is designed to encompass a wide “one size fits all” range of all possible risk profiles in its parameters. This lack of specificity to the profile of a specific company increases the likelihood that inappropriate - or at least suboptimal - results will emerge for many insurers that use it.

The use of internal models, however, should encourage insurers to better identify and manage their risks. Larger insurers using internal models are expected to benefit largely from this. However, the benefit will be somewhat mitigated because the standard formula will have to be run parallel to an internal model for at least two years, causing a potential strain on resources.

Larger insurers prefer to avoid using the standard formula for various reasons. One concern is with its risk-factor approach to calculating capital requirements, which does not properly differentiate the risks in a portfolio. Diversification between lines of business and geographic regions is also not adequately recognized.

The standard formula also is perceived to take the insurance underwriting cycle into account inappropriately. Premium volume is used as a simplified measure of exposure in its calculations. If the market hardens and premium rates are increased, the standard formula treats this as increased exposure and hence increases the level of capital required to support this business. This approach does not reflect the risk characteristics and true exposures undertaken by the insurer.

One of the most widely criticized aspects of the standard formula calculation is the use of the market loss-market share approach, where an insurer calculates its loss size depending on its level of participation in a particular market. This approach is only adequate for larger companies with risk profiles that are similar to the market as a whole. This approach may heavily distort results for smaller players who have a significantly different distribution of risks within the market.

Finally, there are various restrictions under the standard formula limiting the effect of reinsurance. For example, under proportional reinsurance, the standard formula does not allow the cedent to benefit from a cover which contains certain features such as event limits, loss corridors or loss ratio caps, to name a few. For nonproportional insurance, only certain types of excess of loss contracts can be taken into account - and they must satisfy various standard formula criteria.

Diversification Versus Divestiture

Solvency II’s impact on capital is expected to be significant for most insurance entities - but potentially insurmountable for others. Small and mid-size firms - particularly monoline writers - will be the most vulnerable. Depending on their ability to raise capital, they may have limited options on how to meet the heightened capital requirements.

One obvious solution to meeting additional capital requirements is to increase reliance on reinsurance. Alternatively, firms may also be able to impact their capital charges by either increasing writings on a more diversified portfolio or simply divesting their participation in some lines of business where capital charges exacerbate potential returns.

Diversification is expected to become a major component of capital requirements, potentially reducing the capital charges by 25 percent to 35 percent. Since the standard formula does not provide the flexibility to reflect the true value of diversification, maximizing this effect will typically require the use of an internal model.

The impact of diversification varies significantly between different types of companies. Composite insurers are expected to benefit the most, owing to the low correlation between their mixed life and non-life risks. Reinsurers benefit because of their typically wide range of reinsured risks and geographical diversification. Reinsurers that write both life and non-life lines should receive an even more pronounced benefit.

The lack of geographic diversification of some mutuals is an important issue that dominated the discussion of treatment of mutuals under the Solvency II regime. One possible solution may be to allow mutuals to regroup across country borders in order to receive the benefit of geographical diversification.

Finally, the advantages of diversification are likely to generate incentives for mergers and acquisitions within the industry.

Mergers and Acquisitions Opportunities

Mergers and acquisitions (M&A) activity among insurers is expected to increase under Solvency II. Some insurers may divest assets due to difficulties in raising the extra capital required under Solvency II. Others may merge in order to change their operating models to facilitate Solvency II compliance. The calculations of capital requirements under Solvency II will be conducted pursuant to a group-based approach, which could spur M&A activity as insurers seek to create groups with optimal (from a capital requirement perspective) risk profiles.

Another factor affecting M&A among (re)insurers is the need to acquire the significant resources required for establishing and maintaining internal risk-assessment models. More detailed data analyses on new or more sophisticated IT systems may be required to run the capital requirement calculation and designated scenarios - and buying this capability through an acquisition may be more expedient than building it in-house.

Impact on Asset Prices

Under Solvency II, each insurer will have to consider the trade-off between the expected return on its investment portfolio versus the cost of capital required to cover the investment risk. If the cost of capital exceeds the expected return, the insurer will probably try to reduce the level of investment risk by reallocating into lower-charge investments.

A sudden reallocation by all insurers to a class of investments such as fixed income securities would inevitably cause its prices to increase sharply. This is likely to be particularly acute in the market segments with relatively low liquidity. A rise of fixed-income prices would imply a decline in corresponding yields, which, all else being equal, would imply a lower cost of capital. Taking into account the increased focus on asset-liability matching under Solvency II and the fact that the duration of the insurance portfolios of life insurance companies is quite long, the impact would be most pronounced in longer-dated securities.

Availability of Insurance Products

Under Solvency II, certain lines of business may become unprofitable for insurers to underwrite due of their higher capital requirements. Consequently, insurers may stop or reduce sales of these products. Any resulting “uninsurable” economic activities could, however, be mitigated by raising rates on the associated products, modifying the nature of some products or constructing “risk sharing” solutions among insurers such as swaps.

Reinsurance Solutions That Work … and Others That Don’t

Tailor-made reinsurance solutions may be sought by market participants to ensure effective risk management and reduction in required capital levels. Insurers with different needs and strategies will look at different routes depending on the types of portfolios they have. These include the following:

Proportional treaties could be employed to reduce concentration and thereby increase diversification of the portfolio, which would free up capacity to write other lines of business.

Nonproportional covers could be used to reduce volatility of claims experienced along with the associated capital charges.

Aggregate excess of loss covers could be used to limit frequency of claims.

Industry loss warranties (ILS) or insurance linked securities (ILS) could be used as supplemental and perhaps more cost efficient sources of protection against major catastrophe risks. A proper quantification of the basis risk found in these types of cover could provide additional capital relief. Collateral available in these transactions reduces the counterparty risk.

Structured covers could free up regulatory capital for holding against loss reserves. These include loss portfolio transfers, adverse development covers, and run-off protection.

Additional forms of alternative risk transfer mechanisms will also emerge as Solvency II unfolds. The impact of these may need to be tested and approved, and the level of risk reduction they offer will be subject to regulatory approval.

Reinsurance Under the Standard Formula Approach - Premium and Reserve Risk

The calculation of the standard formula is driven by premium and reserve volumes that are incorporated through risk factors. In general, the use of proportional reinsurance in a standard formula scenario is a good method for reduction of capital requirements through the lowered exposure to a particular line of business.

However, the benefits of proportional reinsurance cannot be accurately reflected in the standard formula when various contractual features - such as sliding-scale commissions, loss ratio corridors, aggregate limits or caps - are present in the contract. There is also no allowance for the level of ceding commission payable, which impacts the real benefit of the cover.

In the standard formula, the effect of nonproportional reinsurance could be factored in through adjustments of the premium risk standard deviation. However, the adjustments are limited to the number of possible reinsurance alternatives that could be used to reduce the level of capital required. Significant restrictions under excess of loss reinsurance also apply:

  • It must be on a per risk basis.
  • It must allow for reinstatements.
  • It must cover all insurance claims under the particular segment considered.
  • It must meet all other requirements for risk mitigation set out in QIS 5.
  • It must not contain special features such as annual aggregate deductibles or special triggers.

Other types of nonproportional reinsurance - such as aggregate excess of loss or stop loss - are simply not considered under the standard formula.

Reinsurance Under the Standard Formula Approach - Catastrophe Risk

The calculation of catastrophe risk uses standard scenarios for natural catastrophe risk and specific scenarios for man-made catastrophes. Standard scenarios have only been defined for countries within the European Economic Area (EEA). For exposure written outside the EEA, companies are supposed to use a very simplistic factor-based approach, which is likely to result in disproportionately high capital requirements.

Using the standard scenarios, companies can take their individual reinsurance programs into account. Nonproportional reinsurance such as excess of loss catastrophe protection translates to adequate capital relief within these scenarios, but technical limitations exist in accurately reflecting specific contracts such as multi-peril or aggregate protections. Furthermore, applying individualized reinsurance to non-individualized market-wide standard scenarios could result in capital requirements not reflecting the true risk profile of the company.

How Guy Carpenter Can Help

Directly or indirectly, Solvency II will effect changes to the insurance industry on a global scale. For much of the industry, it presents an inflection point. Unprepared, many companies will struggle and may even fail, but companies that have made adequate preparations can not only survive, they can actually become more successful under the new regulatory regime.

Guy Carpenter is the industry’s leading authority on Solvency II and stands ready to assist our clients in preparing for the new regime. Each company’s situation is different, so we offer a number of tailor-made solutions - each designed to be achievable and deliver real value.

Our solutions are based around targeted validation of critical components and assumptions in our clients’ capital models using our broad industry experience, technical expertise, proprietary software and intellectual capital. We provide clients with the crucial “second pair of eyes” and sensitivity testing that is stipulated by the Solvency II regulatory requirements.

Our offerings to clients preparing for Solvency II include, but are not limited to, the following:

Capital Model Implementation (Partial or Full) - MetaRisk®

MetaRisk is Guy Carpenter’s proprietary stochastic reinsurance and capital modeling platform. It is a uniquely powerful and transparent modeling platform that enables us to flexibly and transparently model clients’ entire portfolios at superior speed. MetaRisk’s capabilities span across all risk modules of the Solvency II Solvency Capital Requirement (SCR). The platform can serve as a full or partial internal model for Solvency II.

MetaRisk provides a highly realistic way of modeling reserve risk, in which its modeling reflects clients’ own reserving practices. This is particularly useful for Solvency II purposes, given the new regulations’ acute focus on loss reserves.

By building a parallel version of a client’s underwriting risk model (gross losses, ceded premium and ceded losses) in MetaRisk, we can undertake comprehensive validation and sensitivity testing as required under Solvency II. MetaRisk employs sophisticated algorithms that most closely replicate the treatment of secondary uncertainty by RMS so that MetaRisk’s estimation of extreme losses (e.g., 1-in-200 year events) is nearly exactly the same as that produced by the actual vendor model.

MetaRisk’s simulation speed allows clients to compare any desired metric for multiple alternative selections for loss frequency and severity. This allows them to sensitivity-test their original assumptions around loss ratio, premium growth, underwriting cycle and future inflation.

MetaRisk is able to simulate clients’ underwriting risk (losses and reinsurance) with a sufficient number of simulations within a relatively short timeframe. This allows an assessment of the impact of potential simulation error within their main capital model on key extreme scenarios, such as the 1-in-200 underwriting result.

Alternative Catastrophe Modeling

Guy Carpenter’s Model Development Team, established in 2004, has developed a number of industry-leading proprietary catastrophe models for peril-regions for which there are either currently no models provided by the established model vendors (RMS, AIR, EQECAT), or where we believe our model provides significant technical advances over the existing models.

Actuarial Expertise

GC Analytics’  expertise and industry leading modeling proprietary software means we can help clients with:

  • Parameterization of their portfolios
  • Supplementation of their information with industry data; and
  • Technical expertise.

GC Analytics teams can propose a number of tailor-made solutions to assist clients with their implementation of Solvency II. These solutions have been kept targeted and specific, as opposed to our offering them as a “general Solvency II advisory” service. This ensures that the solutions are achievable and deliver real value.

Experience and Exposure-Based Parameterization of Risk Losses:   Guy Carpenter can use MetaRisk® Fit, our advanced proprietary curve-fitting software, to fit clients’ historical loss histories to up to 33 different distributions, in order to serve as a second opinion to their own fittings. Furthermore, all the MetaRisk® Fit data includes calculation of the parameter uncertainty associated with fitting to limited sample sizes, providing an element of sensitivity testing.

A Range of Customized Advisory Services

Guy Carpenter offers deep advisory expertise in areas that many clients will find useful in their Solvency II preparations, including reserve risk modeling, enterprise risk management and reinsurance counterparty risk exposure.

Notes:

[1] Solvency 2: Quantitative & Strategic Impact - The Tide is Going Out, Oliver Wyman/Morgan Stanley, September 2010.

[2] Lloyd’s Blazes the Solvency II Trail, InsuranceERM.com, July 7, 2010.

 

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