October 13th, 2011

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

Posted at 1:00 AM ET

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 M&A within the industry.

Mergers and Acquisitions Opportunities

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 groupbased 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 to 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. 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-madecatastrophes. Standard scenarios have only been defined for countries within the EEA. For exposures 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. However, 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.

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