Solvency II capital adequacy rules to increase transfer of risk to the capital markets

We’ve written a number of times about the impending Solvency II rules and what impact they could have on the insurance-linked security and catastrophe bond market. The general consensus is that the increased need for re/insurers to prove their capital adequacy will lead to a greater focus on risk transfer. This article from eFinancialNews.com (a Dow Jones franchise) discusses this topic with Niklaus Hilti, head of ILS at Credit Suisse, and he echoes the sentiment that Solvency II could boost risk transfer to the capital markets.

The article discusses the approaching Solvency II rules, which are currently slated for introduction in January 2014. The rules are designed to address insolvency of European re/insurers and what levels of capital they must maintain to remain solvent and operational. Of course much of this will come down to their risk transfer and retention strategies and this is where the capital markets have a role to play and where ILS, ILW and cat bonds could play a role.

Insurers will be able to prove stronger capital adequacy by offloading their risk to third-parties and freeing up capital and there could be an increased focus on reinsurance as a result of this. The risk transfer chain and the limited capital within the re/insurance markets will likely dictate that the capital markets will have to increase their participation in insurance and risk transfer as a result.

Hilti says in the article that due to the focus on capital adequacy, insurers will likely transfer more risk to the capital markets to reduce the cost of compliance with Solvency II. The rules will force insurers to supply more equity to underpin insurance risk and this will lead to some seeking more risk transfer with the capital markets one of the most likely sources.

This could get interesting as the market for insurance risk could become more liquid as a result, with insurers transferring risk to free up capital to then underwrite risk which pays them more attractive premiums. As you can imagine this will result in a cycle whereby risks are transferred around the market and to capital markets investors. If this does lead to greater liquidity in the risk transfer markets there will need to be greater liquidity in the secondary markets for cat bonds and other risk transfer instruments as well so that investors are more readily able to move in and out of their positions. It will be interesting to see how the adoption of the Solvency II rules impact the way risk is transferred and moves between parties, the European insurance market is sufficiently large that it will influence risk transfer markets worldwide.