Swiss Re Insurance-Linked Fund Management

Original Risk: A Society for Change Agents

Solvency II reinsurance regulatory arbitrage. Good for ILS?


According to Fitch Ratings there may be a reinsurance regulatory arbitrage available that could benefit U.S. reinsurers, as cedants in Europe look to offload more of their risks, due to higher capital requirements under Solvency II, while reinsurers outside of the S2 framework could have an advantage.

Fitch’s report specifically discusses the fact that life reinsurance firms in the U.S., or other areas outside of Solvency II, may benefit from a wave of European re/insurers looking to reinsure risks such as longevity which attract high capital charges under S2.

Capital charges for counterparty credit risk are lower, compared with the charge for holding exposures like longevity risk on the books, making reinsurance transactions more appealing. And U.S. reinsurers stand to benefit as they aren’t affected by Solvency II capital charges and while U.S. capital requirements are deemed to be equivalent to S2, they are typically lower, Fitch explains.

As a result, a regulatory arbitrage could present itself to EU insurers or reinsurers looking to cede risks that attract high capital charges.

Fitch explains; “An EU company ceding certain risks to a (re)insurer outside the S2 framework could gain a relative advantage over an EU company that retains the risk. This could take place in the form of block acquisitions via reinsurance transactions or traditional reinsurance.”

Or fully collateralised coverage ceded to the insurance-linked securities (ILS) market, we would venture.

This situation could present an opportunity for ILS fund managers to present themselves as a low capital charge alternative, given the fully collateralised nature of the product represents zero counterparty credit risk.

The Solvency II regulatory arbitrage could also help to stimulate additional demand for reinsurance capacity, which again would naturally present a growing opportunity to ILS players.

Reinsuring with external parties can reduce capital requirements at the group level, where as an intragroup reinsurance agreement which are commonly used by large cedants attract capital charges at the entity level. That could make externally reinsuring, over internally, a more attractive prospect for ceding companies in the Solvency II area, thus stimulating more reinsurance demand.

Any regulatory change that stimulates increased demand for reinsurance capital will naturally have a beneficial effect for the insurance-linked securities (ILS) market as it increases its participation within major reinsurance programs.

The fact that additional demand may come from large European ceding companies, with whom many ILS managers are already key partners, and that the demand may be focused on looking for solutions offshore (outside the Solvency II region) could also benefit ILS players based outside the EU.

Full collateralisation of reinsurance is also unlikely to attract the same capital charges, given the collateral is held in trust in full and ready to be released for paying claims. That means the counterparty credit risk is minimal to zero, given the ownership of the trust and when it can be accessed to pay for claims is legally documented.

Of course the main benefit of Solvency II for ILS managers will simply be increased demand for quality reinsurance capital. Whether the outside the S2 zone arbitrage could play in their favour is less certain, given the capital charge associated with collateralised capacity will be low anyway.

But it is another factor that could stimulate more risk transfer, which for this market as it looks to deepen its partnerships with large ceding companies, can only be positive.

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