October 12th, 2011

Impact of Solvency II on Primary Insurance Companies: Challenges and Opportunities, Part I

Posted at 1:00 AM ET

It is clear that Solvency II presents a host of challenges to (re)insurers. 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 per unit of risk 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 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. “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) he stated.

The Solvency II regime goes further than just capital requirements - it demands and rewards good enterprise risk management (ERM), 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 to 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.

Standard Formula Versus Internal Model

To comply with Solvency II, companies may calculate SCR using the standard formula that is provided within the requirements themselves, or they may demonstrate to the regulators that their internally developed, bespoke models meet the regime’s requirements. This internal model versus standard formula distinction is a major consideration for all companies preparing for Solvency II. The option that is chosen will likely be dependent on the benefit of having a more accurate representation of SCR versus the cost of compliance and increased transparency with the regulators. We expect many companies, especially the midsize and smaller companies, to adopt a partial internal model to optimize the benefits of a more accurate SCR but minimize the cost of compliance. We also expect large global (re)insurers to opt for an internal model approach.

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 from potential catastrophes 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 that contains certain features such as event limits, loss corridors or loss ratio caps, to name a few. The benefits for nonproportional insurance are not fully realized in the standard formula. They often have a higher level of risk transfer per unit of ceded premium than a proportional contract, yet they are treated essentially the same in the standard formula.

Notes:

1 Oliver Wyman/Morgan Stanley, Solvency 2: Quantitative & Strategic Impact - The Tide is Going Out, September 2010.
2 InsuranceERM.com, Lloyd’s Blazes the Solvency II Trail, July 7, 2010.

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