The Crucial Role of Reinsurance in Solvency II
No insurer in Europe can escape the grasp of the Solvency II project. A European Union directive, it is intended to make sure that insurance companies have sufficient capital set aside to cover all the claims they are likely to receive at a given risk level. But also outside of the European Union many countries have started or are in the process of developing comparable regulatory systems and are considering applying for Solvency II equivalence.
From laudable beginnings, which date back to the end of the last millennium, Solvency II has developed into a very complex regulatory regime based on three pillars - quantitative, qualitative and disclosure requirements.
The European Commission’s initial objective, to create a harmonized solvency system that is better matched to the true risks of an insurance company, was welcomed by the industry. However, whether the additional goal of establishing a system that is not overly prescriptive and avoids undue complexity has been reached can be reasonably doubted. Some people have even gone so far as to call the three pillar approach a three-headed monster.
But there’s no turning back. After many delays in the political process, and huge investment from the industry, Solvency II will be implemented from January 2016 onwards.
Solvency II introduces risk-based capital charges for insurance companies, but how does reinsurance affect the reinsured’s risk-based capital position under the new rules?
A simple starting point to assess the value of reinsurance for the cedent’s capital position is to look at the solvency ratio - which should always be greater than 100%.
The Solvency Capital Requirement is set to ensure that each insurer will be able to meet its obligations over the next 12 months with a probability of 99.5% (i.e., being able to survive 199 out of 200 years). A variety of risk “modules” play a role in its calculation. These include underwriting risk, counterparty default risk and market risk.
By using reinsurance, the Solvency Capital Requirement is reduced because part of the cedent’s underwriting risk is transferred to the reinsurer. In the Solvency II standard model, the underwriting risk module comprises mainly premium risk, reserve risk and catastrophe risk and reinsurance can have a risk-reducing impact on all of these elements.
Reinsurance also has a risk-reducing effect on the market risk module, as the value of available assets is reduced due to the reinsurance premium.
Nevertheless, one must remember that the reinsurance transaction also adds risk, within the counterparty default risk module. As it impacts the total effect on the capital requirement, a reinsurer’s financial strength should be a key consideration.
Looking beyond the Solvency Capital Requirement, reinsurance can also have a positive effect on a cedent’s own funds. Solvency II’s standard model establishes an economic balance sheet that determines the value of own funds by subtracting the best estimate of liabilities, plus a risk margin, from the market value of an insurer’s assets.
One of the main purposes of reinsurance is to reduce the volatility of liabilities and this in turn leads to a smaller risk margin and an increase in the cedent’s own funds as a result.
The impact of reinsurance on the cedent’s capital position also adds a dimension to common target variables of the reinsurance buying process, such as ceded premium, reinsurance cost or expected technical result.
Ultimately, the best reinsurance structure will be determined by the client’s own risk preferences. By using reinsurance structuring analysis, Gen Re can help you to identify the most appropriate risk transfer options for your portfolio.