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

by Artemis on April 2, 2012

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.

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david mckibbin April 2, 2012 at 5:37 pm

Absolutely right. If I could add an additional point I mention on Twitter (@creditplumber). That is the growing pricing arbitrage for corporate trade credit risk between insurance and capital markets. This is particularly important given the ongoing weakness in traditional credit intermediation methodologies. This has a impact on funding structures non-financial corporates will adopt as captive/cellular/transformer structures begin to be used for trade credit risk.
Solvency II will undoubtedly mean insurers/reinsurers will review more forensically their risk-based capital allocation methods as they search for higher quality premium income and reduced earnings volatility. Equally, Basel III and many other regulatory screws being applied to their corporate bodies means banks are racing to reduce RWA’s and de-risk balance sheets. Simultaneously, they must find effective risk transfer methodologies that offer greater value to many disenchanted corporate clients. Add to this the under-reported role of monoline trade credit insurers over the last few years who have done little to regain customer confidence in what is essentially a shallow market of diminishing returns. Therefore the opportunity to develop funding solutions for non-financial corporates (rather than ILS simply serving the financial community) is therefore significant.
We’re seeing longevity risk moving from traditional financial markets to insurance markets and vice-versa for cat risk. There is nothing stopping trade credit risk being transferred away from traditional credit intermediaries via the insurance and reinsurance carriers via the “captive” route. This provides a significant and growing opportunity for “cross-sector risk transfer” (about which the UK FSA addressed a discussion paper in May 2002 which was clearly little read) that will appeal to CFO’s looking to ease credit costs and availability whilst structuring more robust internal and external funding mechanisms.
It also offers the Financial Markets an opportunity to begin rebuilding lost customer confidence. Financial Market participants can provide products and services that address clients needs, rather than products and services they have traditionally wanted to sell to them but which ultimately let them down.

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