The introduction of the impending Solvency II insurance and reinsurance regulatory environment is likely to be a “major development” for the insurance-linked securities (ILS) market, according to a representative of EIOPA.
Petr Jakubik, who leads the Financial Stability Team at the EU insurance and reinsurance industry watchdog, the European Insurance and Occupational Pensions Authority (EIOPA), said that the risk transfer afforded by ILS transactions could impact sponsor capital requirements under the Solvency II regime.
Speaking at an event in Zurich yesterday hosted by the University of St. Gallen, where the academics from the university launched its latest study into the ILS space, Jakubik spoke about the impact Solvency II could have on capital markets risk transfer and ILS.
As insurance-linked securities, such as catastrophe bonds, collateralized reinsurance and other securitised ILS instruments, provide a way of ceding insurance risks to the capital markets, they could help cedents or sponsors to benefit on a capital requirement basis.
As a result of ILS transactions, “capital requirements for the ceded risks can be lowered,” Jakubik explained.
“Generally, the Solvency II framework is very likely to be a major development for the ILS market,” Jakubik continued, “Solvency II will recognise securitisation and derivatives as effective risk mitigation techniques.”
That will be good news to some in the ILS space, where there has been a little uncertainty over how ILS based risk transfer will be treated. Jakubik gave some comfort that it will at least be treated on an equal basis with other forms of risk transfer and recognised as such by the Solvency II framework.
He provided a note of caution however, that ILS transactions that feature basis risk are a more difficult tool to calculate the resulting effect on capital requirements for the ceded business.
“ILS are potentially complex,” he said, referring to how they will be treated under the standard Solvency II formula. “The question is how to capture basis risk, which occurs whenever the cover is based on an index not directly related to the indemnity of the insured party in question.”
“The key issues is hence whether the ILS properly transfers the risk,” he explained.
Under the Delegated Regulation of Solvency II, the extent of any cover provided by a risk transfer transaction needs to be clearly defined and should not result in any material basis risk. Other issues such as double counting of the risk mitigation effect are also relevant to index based ILS structures and tools.
EIOPA has issued guidelines to help cedents better understand how to assess material basis risk, he said.
Jakubik hinted that Solvency II could be seen as a positive development for ILS. Under the framework regime insurers may require additional risk transfer and with ILS offering a very cost-effective and efficient option, as well as having the security of full collateralisation, the impending regime could help to stimulate further interest from sponsors in Europe.
Solvency II should support the development of ILS, be in favour of it and also support the use of securitisation as a risk transfer tool, Jakubik explained during the talk.”Solvency II will change a lot of things. Solvency II will definitely change the world,” he commented.
“Currently the view is that it should be in favour of insurance-linked securities, because Solvency II framework most likely will support the development of insurance-linked securities, because Solvency II will recognise securitisation and derivatives as effective risk mitigation,” said Jakubik.
Clear definition of the extent of the cover offer needs to be included in transactions, but as long as this is in place and basis risk minimised ILS should be an effective capital tool for insurers seeking to meet the framework requirements.