Solvency II calculations, capital relief and insurance-linked securities

Solvency II is one of the hottest topics in the reinsurance and risk transfer markets at the moment. The impending changes to the regulatory environment could lead to increasingly strenuous capital requirements for re/insurers and a change in the way companies look at risk transfer.

Reinsurance intermediary Guy Carpenter has published the first part of a report looking at Solvency II. The report titled Succeeding under Solvency II – Pillar One: Capital Requirements gives an excellent overview of the issues facing the industry, what the impacts to re/insurers may be and some of the ways the changing capital requirements can be mitigated through strategies to reduce risk levels associated with Solvency II.

The report highlights the estimates made in a Morgan Stanley and Oliver Wyman study on Solvency II which suggests that demand for reinsurance in Europe could increase by between 10% to 20% from certain sectors of the industry. The new capital requirements could affect smaller re/insurers particularly hard as they seek to reduce their risk levels by restructuring reinsurance programs.

Of particular interest to us and our readers are Guy Carpenters comments regarding insurance-linked securities and the part they play in a post-Solvency II world risk management program. The report states “The reduction in risk achieved with the use of insurance linked securities (ILS) can be recognized in Solvency II calculations, subject to regulatory approval. Options such as surplus relief or tailored nonproportional protection against extreme losses may also be considered.” So ILS could prove an attractive option in some cases. The report also states “Industry loss warranties (ILS) or insurance linked securities (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.”

Discussion in the market has always suggested that Solvency II could lead to increased use of reinsurance and a desire for more innovative risk transfer solutions. The increased need for companies to prove their capital adequacy is certain to have re/insurers discussing the best way to transfer risks off their balance sheets. Capital market counterparties and catastrophe bonds are sure to come up as potential sources of alternative capacity in a post-Solvency II world.