September 13th, 2011

Solvency II: Changing the Game

Posted at 1:00 AM ET

lightfoot_david_gcciDavid Lightfoot, Head of GC Analytics - International
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Market consensus holds that Solvency II will ultimately benefit reinsurers, as primary insurers faced with higher risk-adjusted capital requirements will turn to the reinsurance market as a relatively inexpensive source of additional capital and risk transfer. This assumption, however, conceals numerous challenges - and several opportunities - that Solvency II presents.

The Solvency II regime has several key benefits and drawbacks for reinsurance cedents.

Benefits

Greater Transparency and Convergence in Reporting Among Solvency II and Equivalent Regimes

In assessing the financial security of reinsurance counterparties, cedents often struggle to reconcile disparate accounting treatments across various domiciles. Disclosure requirements under Solvency II and market-consistent accounting standards will bring a high degree of harmonization in Europe and equivalent jurisdictions, greatly facilitating the analysis of reinsurer financial strength.

Improved Reinsurance Security, Overall

As the periphery of the market is gradually brought into the center by uniform capital, governance and disclosure requirements, some reinsurers will see capital requirements increase enough to encourage a level of controlled consolidation and capital re-allocation. This ultimately will contribute positively to the overall health of the reinsurance market.

A Stronger and Deeper Insurance-Linked Securities (ILS) Market

As an often more flexible and longer-term source of capital than traditional reinsurance, the ILS market may absorb some of the net benefit that larger traditional reinsurers expect to realize through Solvency II. This will work to the benefit of cedents as the capital markets compete more directly with traditional reinsurance with the aim of containing costs.

Drawbacks and Risks

Capital Requirements and Compliance Costs Are Discriminately Higher for Smaller Reinsurers, May Force Some Consolidation

Large, diversified and highly rated reinsurance groups with approved internal capital models will likely have materially lower capital requirements under Solvency II than they already maintain for their ratings. For these reinsurers, rating agencies will remain the final arbiters of capital requirements, while Solvency II will add administrative and regulatory cost and perversely could encourage a lower standard of solvency.

All reinsurers with material books of non-proportional business and/or material catastrophe exposure outside Europe are effectively forced to apply for internal model approval due to the seemingly high capital charge for these businesses contained in the standard formula. This increases the compliance costs for those companies that do not already use internal models.

Conversely, many smaller or unrated reinsurers assessed under the standard model will see capital requirements increase. We may see certain niche reinsurers withdraw from the market or combine with larger companies as a result.

More Intense, Volatile Underwriting Cycles

The widespread use of the Solvency II standard model and internal capital models in conjunction with market-consistent accounting of assets and liabilities could contribute to shorter, more volatile underwriting cycles. It also could drive more volatile earnings and balance sheets. Reinsurers, guided by economic capital models based on value-at-risk (VaR), may more actively shed assets and repurchase shares in soft markets, then seek to replace capital in hard markets.

It is clear that Solvency II will profoundly impact the reinsurance market - not only within Europe, but globally. Advances in disclosure and overall market strength will come with real costs to both the industry at large and individual companies. It is imperative that all companies affected by these sweeping changes prepare now to navigate this changing and increasingly volatile reinsurance market.

Click here to download the entire Guy Carpenter report Succeeding Under Solvency II: Guy Carpenter’s Guide to the New Industry Landscape »

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Statements concerning tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice, which we are not authorized to provide. All such matters should be reviewed with your own qualified advisors in these areas.

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