Solvency II will benefit reinsurers who are flexible and willing to take a broad view of their responsibilities towards customers, according to Andrzej Czernuszewicz of EMB.
It is a subject that many people in our industry would rather forget, but Solvency II will define the shape of insurance, the way buyers view reinsurance and the service they demand from their capital providers. The effects of the reform are being felt well beyond Europe; many other countries have moved towards risk-based regulation or are planning to do so. Even where that is not the case, insurers, reinsurers and many of their ultimate customers are now so international in their operations that it would be almost impossible to isolate these changes to one continent.
What does this matter to Bermudan reinsurers? Firstly, you may well have branches or underwriting offices in Europe. They will have to follow the new rules, especially when it comes to underwriting and reserving. Since your company would almost certainly prefer to have uniform underwriting principles and a group-wide approach to risk management and business optimisation, anything that affects the European operations will affect the group as a whole.
More importantly, however, Solvency II affects your European customers; it will influence the service they require, and the advice they receive from their consultants and brokers. Because of the vast range of companies in Europe and their differing sizes and levels of technical expertise, Solvency II will affect different insurers in very different ways; the reinsurers who read these differences and respond appropriately will provide a better service and gain competitive advantage.
Most Bermudan reinsurers will be familiar with the principles behind Solvency II (see box one). Enterprise Risk Management, and especially the practice of financial modelling, are already well established on the island. It is difficult to see how anyone in high-risk, volatile reinsurance markets could compete for long in the modern era without employing these techniques.
In fact, one of our central messages about Solvency II is that it represents best practice, not just a regulatory hurdle. You may argue about the detail, but the more sophisticated (re)insurance practitioners already accept the commercial benefits of good risk management. The reform is in effect forcing, or at least encouraging, European insurers to become smarter and better at what they do. In that sense it is helping them to be more competitive, especially in relation to their American cousins.
The big problem for the Europeans is that many of them are finding the new way of thinking quite difficult. The global companies have, by and large, a sophisticated understanding of Solvency II; with a few exceptions the medium-sized players do not, especially in the emerging markets of east and central Europe.
At a recent seminar for a national insurance association, one delegate remarked: “There are companies who are still struggling with the Solvency I regime. They simply do not have the capacity to conform with Solvency II”.
For the purposes of this article, let’s divide European reinsurance buyers into two categories: those who understand how Solvency II affects their firms and who have the in-house expertise to respond positively; and those who are out of their depth.
Of course, this is an oversimplification. Even the most knowledgeable of reinsurance buyers is still learning about Solvency II, whilst there are very few even in small companies who are completely ignorant of its workings. Nonetheless, reinsurance underwriters are either familiar with the two stereotypes or soon will be. Understanding the extent to which each customer falls into these different camps will help you to understand their specific needs.
THE SMART REINSURANCE BUYER
Reinsurance managers who know how to apply the principles of risk management successfully will have well-focused, coherent buying strategies. Their financial models (see box two) have already identified the most capital-efficient approach on a detailed class-by-class and layer-by-layer basis. This is not to say that they have worked everything out; they will still appreciate guidance.
In order to genuinely add value you will have to understand their risk management strategies and any new models and analyses driving their demands. Be flexible and prepared for changed priorities; a typical customer may require less cover in some areas and more in others. You will probably have to accept that your product has become more commoditised in their eyes and less relationship-driven. You may well find that they negotiate from a position of strength, because they know exactly what cover they need and how much it is worth to them.
THE LEARNER
Many reinsurance buyers, by contrast, will still be struggling with Solvency II implementation long after it comes into force in 2010. By no means will such people come exclusively from the ranks of the small companies; many insurers with strong market positions in their own countries are unlikely to meet the requirements in time.
It remains to be seen how Solvency II will affect the reinsurance buying patterns of such companies, but there are likely to be a range of different outcomes. Some will doubtless carry on as before and hope for the best. Others may compensate for the uncertainty by buying more reinsurance than before. Others will seek guidance, and some will cease to exist as independent entities.
For smaller insurers, financial models need not be out of reach. The costs involved should be put into perspective. In our experience, companies’ attempts to cut corners using spreadsheet models and ad-hoc processes often turn out to be false economy. On the other hand, the investment in specialist software and a good model is quickly repaid, and the time savings and added business benefits in the long term provide a lasting payoff. The cost of modelling is rarely significant compared to the cost of misplaced reinsurance.
CHANGING CUSTOMER DEMANDS In short, Solvency II is going to change reinsurance-buying patterns in ways that vary widely from company to company. Underwriters who read the changes and thought processes of individual customers sympathetically and flexibly will derive considerable competitive advantage. Whatever their chosen strategy, it is important that they view their customers through the prism of Solvency II.
What is Solvency II? Solvency II assumes that insurers and reinsurers should understand the risks inherent in their businesses and allocate enough capital to cover those risks. This represents a radical change in the way that the industry is regulated.
Solvency II has three ‘pillars’. These cover 1) capital requirements based on principles rather than a set rules. It contains the Minimum Capital Requirement (MCR) and the Solvency Capital Requirement (SCR). The MCR reflects an absolute minimum level of required capital below which supervisory action will automatically be triggered. The SCR represents additional capital to firms to absorb significant unforeseen losses.
2) the supervisory activities of regulators with the aim of identifying firms with a higher risk profile, which may be required to hold capital at a higher level. and 3) disclosure of additional information to show that the analysis is dependable.
The regulator will want to be satisfied about the quality of data and estimation procedures, the systems in place to manage risk and action plans in the event of certain risks materialising. An understanding of how different risks inter-relate may also be necessary. It assumes that (re)insurers understand not just Insurance risk, but Operational Risk, Group Risk, Market Risk, Credit Risk and Liquidity Risk. Each of these can then be further divided into sub-categories.
For all but the smaller insurers, internal models will lie at the heart of Solvency II when it comes to determining capital. These are financial models, normally created with the assistance of specialist software, that allow the user to simulate any number of possible scenarios and measure how they would affect the business. The more credible and more detailed the data and the more appropriate the models and assumptions, the more confidence there can be in the outcomes.
The good news is that these models have a wide range of other commercial benefits including: reinsurance purchase; underwriting and investment strategy; capital allocation; mergers and acquisitions; relations with ratings agencies.
Solvency II – lessons for reinsurance buyers
A key part of Solvency II is to quantify, normally through the use of financial models, all the risks inherent in the business. Any reinsurance option can then be tested with regard to its impact on overall company performance and capital. This will measure the outcomes of any number of different reinsurance strategies, taking into account the security ratings and probability of default of potential reinsurers.
They could be quite simple such as just assuming an increase in excess points. Alternatively, the analysis might turn into a wholesale review of reinsurance strategy. Armed with this information, they may be in a stronger position to take a view on the prices and terms of the contracts they are buying.
This graph shows an example of how the smart reinsurance buyer, armed with an internal model and optimisation software, can purchase their cover in order to make optimal use of their capital.
Tied up in this exercise is a calculation of the technical price of the reinsurance contract, which the smart buyer is certain to use in assessing the potential value for money of reinsurance they are offered.
This graph shows a scatterplot of the overall gross losses versus the modelled recoveries. It can be seen that in some scenarios the reinsurance is entirely exhausted and a large net loss would be made.
Within the financial model simulated gross losses are fed individually through the modelled reinsurance and the recoveries are calculated, and any unique contract features can be allowed for. Explicit reinsurer defaults can be modelled, based on say, credit ratings, and taken into account when calculating the solvency margin in each simulation.
This article appeared in Bermuda Reinsurance Magazine in November 2006
