Solvency II will benefit the reinsurance market through an increase in demand, which is already being seen in longevity risk transfer and also benefit the domiciles or markets which have sought Solvency II equivalence, particularly in commoditised reinsurance lines, according to Fitch Ratings.
Solvency II equivalence has taken a significant effort from the likes of Bermuda and Switzerland, with years of regulatory preparation and development required to ensure alignment with the EU’s SII regulatory requirements.
But that effort could pay off and interestingly may be particularly beneficial for Bermuda, given the islands focus on being a reinsurance hub with particular expertise in property and catastrophe risk underwriting and transfer.
Fitch Ratings said in a report today that Solvency II equivalence is most important to reinsurance companies targeting the more commoditised and shorter-tailed lines of business, such as property catastrophe risks, where price is more of a factor than the ability to significantly customise offerings.
So effectively, if it comes down to a choice between markets, in a softened line of business like property catastrophe risks, the fact Bermuda and Switzerland have gained equivalence with Solvency II could favour the companies operating there.
“We expect the main beneficiaries of new business to be the financially strongest reinsurers in the EU and the jurisdictions whose regulatory regime is considered fully equivalent to S2,” Fitch explained.
Additionally, Fitch said that it expects to see increasing demand for reinsurance more generally, as a result of the Solvency II regime and its more stringent capital requirements.
So far this is largely evident in one part of the market, with Solvency II having already contributed to “a marked increase in longevity reinsurance, particularly among UK life insurers with bulk annuity business,” according to Fitch.
And the reason for this comes down to capital requirements, with longevity linked assets a major weight on balance-sheets in the new Solvency II world.
Fitch goes into detail; “Longevity risk significantly increases the capital requirements for new annuity business while interest rates are very low because of the S2 risk margin. This increased capital requirement has made insurers keen to reinsure longevity risk, as the associated capital charges for counterparty risk with large, financially strong reinsurers are much lower than those for retained longevity risk.”
Aside from the increase in demand for longevity reinsurance, which seems to have been the first manifestation of a changed approach to risk transfer and reinsurance under Solvency II, there is an expectation that it will also stimulate demand for life reinsurance protection more broadly, and eventually a greater use of reinsurance in other lines where capital needs increase.
“Fitch expects that S2 will increase demand for reinsurance products as insurers can strengthen their S2 capital positions through risk transfers that reduce volatility or improve the certainty of cash flows,” the rating agency continues.
However it will take time for the regime to bed down and for the anticipated upticks in demand for reinsurance capacity flow through, but the experience in longevity markets, where ceding insurers have been keen to offload risk while reinsurers keen to take it due to diversification benefits making the assumption efficient, likely to play out in similar ways in other lines over time.
More generally, as Solvency II comes on-line while insurers and reinsurers get to grips with the regime, its capital requirements and how to manage their portfolios most efficiently, there are signs that large, rated reinsurers and Solvency II equivalent regulatory regimes could find advantage in their positions.
“Higher-rated reinsurers domiciled in countries with full equivalence for Solvency II (S2) have a competitive advantage over those with lower ratings or domiciled in non-equivalent countries,” Fitch believes.
Higher ratings mean a lower capital requirement for counterparty credit risk, under the Solvency Capital Requirement (SCR) calculation, and at the same time full equivalence means simpler reinsurance transactions, again increasing the attractiveness of dealing with rated reinsurers domiciled in those locations for European insurers.
Of course posting collateral is also a factor that can reduce counterparty capital charges, which benefits the insurance-linked securities (ILS) fund market, some sidecars and other fully collateralised reinsurance vehicles. EIOPA itself said previously that Solvency II would be a major influence on ILS market growth.
Solvency II is not anticipated to have as much of an effect on collateralised reinsurance as it is on lower-rated, non-equivalent reinsurance players, in fact in this new Solvency II landscape full collateralisation may become an increasingly attractive option for ceding companies, given it can result in a simpler solvency capital calculation.
So on that basis both the rated property catastrophe reinsurers in Solvency II equivalent domiciles, such as Bermuda and Switzerland, and the ILS fund or collateralised reinsurance market could both stand to benefit from Solvency II as European cedents look to efficient ways to source more risk capital.
Especially so since Fitch says equivalence may have “the greatest influence on more generic, short tail, commoditised reinsurance products, e.g. property, where cost and price considerations are more sensitive.”
Whether there is a difference in the level of burden and effort faced by ceding insurers over transacting with a rated entity in a Solvency II equivalent regime, versus a fully collateralised ILS fund or reinsurer (which could be domiciled anywhere) is not fully clear.
But still, the simplicity of the collateralised product and the almost zero counterparty risk, given the collateral is held independently in trust, could be a deciding factor that actually benefits ILS players more in the longer run as the market comes to terms with the implications of these new solvency requirements.
Fitch also notes that size still matters, especially where diversification can allow large reinsurers to discount certain lines, and that expertise as well remains key and these factors could outweigh Solvency II equivalence in more complex or tailored reinsurance transactions.
With capital quality a key decider, collateralised protection will seemingly always be a popular form of reinsurance. Whether Solvency II benefits the ILS market is yet to be seen, although we do understand that it has resulted in greater visibility of some longevity risk transfer opportunities already.
Of course any increase in reinsurance demand will benefit the ILS market and its investors, while the desire to transact with equivalent domiciles will benefit Bermuda and Zurich rated reinsurance players as well, perhaps helping those ILS players who are fronted out of those locations.
The equivalence issue could make it attractive for any ILS fund manager planning to set up a rated vehicle to establish it in a Solvency II equivalent regime. That could perhaps be another way that ILS funds can raise their relevance in the market, by offering collateral backed, rated reinsurance paper in an attractive regulatory environment.