Solvency II – Capital drivers & reinsurance solutions FIAR May 22-26, 2011 Alexandra Storr 2010 - Susanne Kaske-Taft PAM 22 March Capital drivers under Solvency II Under Solvency I a lot of fundamentals of the insurance business model have been neglected in the regulatory regime Under Solvency II the real risk landscape of an insurance company should be considered in the calculation of the solvency capital requirements Therefore the solvency capital requirements under Solvency II are influenced by a number of capital drivers compared to Solvency I Ability to increase capital Availabke capital Solvency II | Example: Capital drivers & reinsurance solutions Unexpected widening of bond spreads Embedded options & guarantees Duration mismatch (ALM) Frequency Equity & property price risk Exchange rate mismatch Insufficient diversifcation Required capital Counterpartyd efault risk Highly volatile peak risks Volatility of reserve run-off Summary Solvency II & reinsurance Examples: Insufficient diversification Transfer of peak risks Natural catastrophe risk Insurance Linked Securities Large exposure to increasing life spans Longevity swap Volatility of reserve run-off Loss Portfolio Transfer & Adverse Development Cover Internal model Examples: … value the capital benefit based on the model used Partial internal model … find the most efficient reinsurance solution … Standard Formula Identify the individual capital drivers … Reinsurance is a powerful capital management tool under Solvency II Solvency II | Example: Capital drivers & reinsurance solutions Solvency II Examples of Capital drivers and Reinsurance solutions Capital drivers Reinsurance solutions P&C Standard Formula Partial Internal Model Internal Model Insufficient diversification (Structured) Quota share High volatile peak risks (Structured) Excess of Loss Frequency (Structured) Aggregate XL Volatility of reserve run-off (Structured) Quota share / LPT & ADC / Run off Solvency II | Example: Capital drivers & reinsurance solutions Insufficient diversification and quota share Solvency II | Example: Capital drivers & reinsurance solutions 5 Capital driver under Solvency II– Insufficient diversification Insufficient diversification will lead to an increase in solvency capital requirement compared to Solvency I (Missing) diversification on the asset side will be a capital driver, too Better diversified insurers are able to deal with financial consequences of risks relatively easier and therefore more efficiently Most affected: Captives Monoliners Small local players Niche players Solvency II | Example: Capital drivers & reinsurance solutions P&C Quota Share under Solvency II Value proposition of a Quota Share under Solvency II: 300 Gross situation: 250 BSCR (99.5 % VaR): Loss 200 UW risk Market risk 2.5 mio EUR Credit risk ---------------- 150 100 12.7 mio EUR 10.2 mio EUR Reinsurance: 50 20 % Quota Share / 23 % Commission 0 Risk 1 Risk 2 Risk 3 Risk 4 … Risk n Net situation: Insurer’s share (retention) ) 80 % BSCR (99.5 % VaR) Reinsurer’s share (cession) ) 20 % • UW risk 8.2 mio EUR • Market risk 2.1 mio EUR • Credit risk 0.3 mio EUR The quota share reduces the Solvency Capital Requirement (SCR) for the insurance risk under Solvency II according to the proportion ceded to the reinsurer Solvency II | Example: Capital drivers & reinsurance solutions 10.6 mio EUR = Capital relief of the 200-year event = EUR 2.2 m Example: Highly volatile peak risk and Excess of Loss covers Solvency II | Example: Capital drivers & reinsurance solutions 8 Capital driver under Solvency II– Highly volatile peak risk Solvency II will require insurers to back their book of business with solvency capital that reflects the economic risk In contrast to Solvency I where often only the premium volume is decisive Portfolios with the same premium volume can have a totally different capital requirement If one of the portfolios (Portfolio B) contains high volatile peak risks where the resulting aggregate claims distribution is more skewed to the right than for a Portfolio A of risks with low volatility Probability Probability Claims amount Portfolio A contains only low risks Probability Claims amount Claims amount Premium volume Portfolio A VaR 99.5% Premium volume Portfolio B Portfolio B contains only high risks VaR 99.5% Probability Probability Claims amount Solvency II | Example: Capital drivers & reinsurance solutions Probability Claims amount Claims amount P&C XL per risk under Solvency II Value proposition of an Excess of Loss under Solvency II: amount of losses 300 250 For a given safety level the ratio of net premiums relative to required risk capital after reinsurance will increase considerably with a XL treaty. 200 150 100 Risk mitigation None Quota share (50 %) 50 Gross premium 0 1 2 3 4 5 6 number of losses loss burden reinsurance cover not covered An XL reinsurance treaty reduces not only the absolute variability of the reinsured’s retained losses but also their relative variability. The premium ceded to the reinsurer is in relative terms considerably smaller compared to the reduction of required capital through a nonproportional reinsurance treaty. Solvency II | Example: Capital drivers & reinsurance solutions WXL 7.000.000 7.000.000 7.000.000 R/I premium - 3.500.000 1.260.000 Net premium 7.000.000 3.500.000 5.740.000 12.300.000 6.150.000 3.500.000 57 % 57 % 164 % Capital requirement Net premium / Capital requirements Indicator: Recognition as reinsurance Capital requirements net Premium & Reserves net Capital requirements gross Premium & Reserves gross 3.500 .000 12.300 .000 5.740 .000 = 0.28 < 0.82 7.000 .000 Example: Frequency risk and Aggregate-XL Solvency II | Example: Capital drivers & reinsurance solutions 11 Capital driver under Solvency II– Exposure to frequency risk 12% 10% 8% 6% 4% Often, there is no protection against frequency risk below the deductible (missing horizontal protection) 30 28 26 24 22 20 18 16 14 12 Number of losses The aggregate claim is the result of the combination of the distribution of the claims amount (severity) and of the distribution of the claims frequency The more dangerous the claims frequency for any given severity, the more capital required to back the portfolio Solvency II | Example: Capital drivers & reinsurance solutions 8 This in turn is the result of the combination of the distribution of the claims amount (severity) and of the distribution of the claims frequency 0% 10 2% 6 Within Solvency II, the required solvency capital is determined by the distribution of the overall aggregate annual loss Portfolio B 14% A growing risk-taking ability often implies a growing deductible for the CXL programme which exposes the insurer to frequency risk below the deductible Portfolio A 4 Probability 2 Primary insurers are normally well protected against losses from a severity perspective (vertical protection) through the core Catastrophe Excess of Loss (CXL) programme 0 Portfolio B requires more capital than Portfolio A P&C Aggregate XL under Solvency II Value proposition of a Structured Stop Loss & Aggregate XL & under Solvency II: Loss ratio per year / % Term limit 400 mio EUR 200 150 100 200 mio EUR 140% 200 mio EUR 200 mio EUR Insurance risk: 150 % 160 % Level of the capital relief determined by the design of the cover and the additional structural elements Especially if the structured elements influence the risk mitigation or utilize the diversification in time or over lines of business Qualitative aspects: 0 Year 1 Year 2 Year 3 Solvency II | Example: Capital drivers & reinsurance solutions Multi-year covers are providing certainty regarding price and capacity for a specified future periods This could be used as a qualitative argument for the regulator (Pillar 2) Example: Volatility of reserve run-off and LPT & ADC Solvency II | Example: Capital drivers & reinsurance solutions 14 Capital driver under Solvency II– Volatility of reserve run-off While the final payments to a policyholder or a beneficiary will not yet be precisely known, the run-off contributes to the absolute volatility of an insurer’s result This implies that the client will need, from an economic perspective, risk capital in order to support the run-off of a portfolio of liabilities The inclusion of the volatility of reserve run-off may decrease or (more likely) increase the capital requirement 1. Timing risk Total claims amount to be paid Expected payout pattern Slow er payout pattern Faster payout pattern 0 1 2 3 4 5 6 Time 2. Reserving Risk Claims incurred (one AY) Reserved 100% estimate at end AY Paid 1 Solvency II | Example: Capital drivers & reinsurance solutions 2 3 4 5 Time Loss Portfolio Transfer (LPT) & Adverse Development Cover (ADC) under Solvency II Claims Expected claims (Claims provision on balance sheet) “Loss Portfolio Transfer” premium (Net present value of claims provision) Run-Off solution Reserve risk (a) “Adverse Development” Cover (a) Timing risk (b) “Loss Portfolio Transfer” Cover (b+c) Investment risk (c) Value proposition of a LPT/ADC under Solvency II: Insurance risk: LPT removes the timing risk ADC removes the reserving risk => both consequently remove the necessity to set aside regulatory capital Market risk: Time Remarks: Normally the capital relief from transferring the LPT part will be lower than the relief achieved by reinsuring adverse claims (ADC) So far in some European countries the LPT is not recognized as reinsurance Solvency II | Example: Capital drivers & reinsurance solutions Reduction of market risk due to the reduction of investments Legal notice ©2010 Swiss Re. 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