Capital motivated reinsurance under Solvency II

Capital motivated reinsurance - reinsurance where the insurer's primary buying motivation is to optimise its amount of, or return on, traditional capital - has historically been applied when an insurer is required to hold reserves and capital in excess of a true economic requirement. A reinsurer that is able to hold a level of capital closer to that economic level - for the exact same risk - can create value from this difference. A successful capital motivated reinsurance transaction shares the savings from this capital difference between the insurer and the reinsurer, making them both better off than they would have been without the transaction.

The occurence of such differences will change as we move from Solvency I to Solvency II. Under Solvency II, the solvency margin requirements should move towards a more economic level. This will eliminate some types of capital motivated reinsurance, but others will move to the forefront for the first time.

Solvency I

Solvency I, which is now almost 40 years old, defines the capital required by an insurer with a small number of factors, most of which are applied to balance-sheet numbers. With the benefit of 40 years of experience in a world that has changed tremendously during this period, there is wide agreement regarding the need to replace Solvency I with a new system. The risks borne by an insurance company simply cannot be embodied in so few factors, and balance-sheet numbers are not designed to measure risk.

Solvency II

Although Solvency II is not yet finalised in many detailed respects, it is already sufficiently clear what its goals are and that there is sufficient political will to implement it. One might liberally summarise the philosophy behind Solvency II as follows:

- Identify the risks;

- understand the risks; and

- reflect the risks in the level of capitalisation.

As a first step, Solvency II for the most part abandons Solvency I's over-simplified factors for determining underlying capital charges and, instead, uses scenarios. For example, where Solvency I might say to use "4% of reserves", Solvency II will say to use "change in net value of assets for a permanent 25% decrease in mortality" for longevity risk. This is a more complicated calculation, but it is a calculation that captures the true nature of the risks. In keeping with Solvency II's economic foundation, these scenarios attempt to replicate how a market assesses value.

Correlation adjustments

Under Solvency I, the capital requirement for any given risk can be determined in isolation of all other risks underwritten by the insurer. It is also independent of any risk-mitigating actions taken by the insurer.

Solvency II, however, recognises that Solvency I and its simple additivity do not reflect the true correlation between risks. To ensure the safety of a company up to a given level of confidence (for example, 99.5% per Solvency II), the amount of capital needed is not the sum of capital requirements to separately protect each product or line of business at that same level of confidence. Total company capitalisation at that level would imply a greater degree of safety than intended (for example, 99.9% instead of 99.5%) because the various worst cases are unlikely to all take place simultaneously. Some risks are uncorrelated (for example, mortality and asset default) while others might even be negatively correlated (for example, mortality and longevity). Solvency II therefore makes assumptions about correlations between each risk.

Correlation deciphered

Despite all the complicated formulae, there are a few simple truths that can be drawn from Solvency II's correlation matrices.

One can only determine the incremental impact of adding or removing risk from an insurer's portfolio by redoing the whole calculation for all the risks.

If one has a single dominant driver of required capital (for example, 50% of solvency requirement is from disability), one will calculate a higher incremental capital requirement for adding another unit of that risk than if the total for that risk was less dominant (for example, only 25% of solvency requirement from disability).

When adding an incremental unit of any risk, one adds less required capital when that risk has as low a correlation with the other risks as possible.

Using these principles and their respective converses, one can discover an optimal mix of risks for an insurer. This is the theoretical point at which natural hedging properties implicit in the correlation factors are fully exploited.

Capital motivated reinsurance will, therefore, become the quest for that optimal risk point under Solvency II.

Case No 1

Imagine a life insurer that has two dominant risks in its portfolio: longevity and investment risk. These greatly exceed their risk exposures to mortality and lapsation, and their Solvency II Solvency Capital Requirement calculation captures this fact via the correlation matrices. Adding incremental amounts of either of these risks, therefore, adds the maximum capital requirement for this risk (due to having one dominant driver of required capital). Conversely, removing some of either longevity or investment risk via reinsurance will result in a large reduction in required capital.

One type of capital motivated reinsurance under Solvency II will occur when this company cedes annuity business (i.e., longevity and investment risks) to a reinsurer that is not similarly heavily weighted towards those risks. The insurer will thereby reduce its capitalisation by a relatively large amount, and will therefore measure its benefit from the reinsurance against the prior cost of servicing that large amount. The reinsurer will be able to accept this business and only have to add a relatively smaller amount of capital, and will reflect the cost of this smaller amount in the price that it requires to participate in the transaction. It is the difference between these 'small' and 'large' capital amounts (the 'economic capital gap'), and the foregone cost of servicing this difference, that will lead to a capital motivated reinsurance transaction. The two parties would split these savings and each would end up with an improved return on economic capital or other relevant measure after the reinsurance.

Case No 2

Solvency II reflects diversification in many dimensions, but it doesn't recognise all commonly accepted economic effects. Geographical diversification, for example, is not fully recognised as a source of risk mitigation for life insurance. Even though Solvency II is clearly based on economic and risk principles, it does have to make certain approximations and simplifications in order to arrive at a manageable model. Those pragmatic shortcuts will, however, introduce uneconomic elements.

For example, a multinational life insurer with a high concentration of business in Europe could create and exploit an 'economic capital gap' by ceding European business to a reinsurer that is not already similarly overweight in that area. This would, however, need to be a reinsurer whose own capital requirement is determined by a requirement that does recognise the diversification benefits of spreading life risk geographically.

Similar to the logic in the first example, the insurer will achieve a greater reduction in required capital than the reinsurer's increase in required capital, and the cost of servicing this difference will be available to be shared between the insurer and reinsurer.

Reinsurer as capital management expert

If one carries though these ideas, one ultimately arrives at a situation where reinsurers become clearing houses for risks, shifting those risks between insurers and capital markets in order to find the best home for each block.

We are not that far from that situation today, and reinsurers' roles already include globally managing the economic combination of risk and capital. Now that Solvency II will make these same principles of primary importance to all EU insurers, the role of reinsurance can only expand.

Reinsurance is an important source of capital in addition to equity or debt capital, and it will continue to be so in the future, even if the circumstances under Solvency II are different.

Contact

Paul Sauve, Vice President, Business Development

RGA International Reinsurance Company Limited

German Representative Office

T. [phone]

E. [e-mail]

www.rgare.com.

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