What You Need to Know About Solvency II and Reinsurance
The purchase of reinsurance is one of the key elements of efficient capital management within the Solvency II regime. The mountain of documents on certain Solvency II topics, however, might discourage most professionals who aren’t involved in the implementation process on a daily basis. This blog explains Solvency II and its impact on reinsurance without bogging you down.
Solvency Ratio in Solvency II
The equation is simple. We need to know the amount of Own Funds (OF) and divide it by the Solvency Capital Requirement (SCR).
Own Funds (OF) refers to surplus capital that remains when the liabilities are deducted from the total assets. For the Solvency II regime, we would be talking about the market value of assets and the market value of liabilities – the values that would hold true in a fair market transaction between two knowledgeable parties.
Solvency Capital Requirement (SCR) is the (economic) capital that should be held to ensure that the insurance company can meet its obligations to policyholders and beneficiaries with certain probability and should be set to a confidence level of 99.5% over a 12-month period. That stipulation limits the chance of financial ruin for the following year to a 1 in 200-year event. This puts the Value at Risk at a 99.5% confidence level.
The OF and SCR figures need to be calculated separately in a process defined by the European Insurance and Occupational Pensions Authority (EIOPA).
What Is the Function of the Solvency Ratio?
Each insurance company is required to maintain its Solvency Ratio at 100% over time. Should the insurance company fall below this level, it needs to inform the regulator and present a realistic recovery plan that shows how it aims to bring its Solvency Ratio to 100% over the following six months. Falling below the Minimum Capital Requirement (MCR), which represents an 85% confidence level instead of 99.5%, would accelerate the recovery plan to a maximum of 3 months. If a company fails to recover, the regulator can revoke its insurance license.
Solvency Ratio has other functions. Many insurance companies may use a certain level of solvency to demonstrate financial health to their customers, e.g. 150% could be a strategic goal.
Also, Solvency Ratio is also seen by some as a buffer against adverse developments. Maintaining a 150% solvency level might not only increase the chances of securing the ability to meet obligations but also the capacity to continue operating after an adverse event.
How Does Reinsurance Affect the Solvency Ratio?
Buying reinsurance influences the numerator (OF) and the denominator (SCR) in the equation (see Figure 1).
The reinsurance agreement can have a substantial impact on the risk margin on Economic Balance Sheet, leaving its other parts relatively unaffected. This leads to an increase of OF, resulting in a higher Solvency Ratio after reinsurance.
Risk transfer through reinsurance obviously also has an impact on the SCR. It reduces the gross SCR (before reinsurance) to a net SCR (after reinsurance), which could be a fraction of the gross SCR amount. The denominator of the Solvency Ratio equation diminishes, thereby increasing the solvency.
We will have a closer look at how reinsurance changes the Economic Balance Sheet in the next part of the blog.