Using Reinsurance to Optimise the Solvency Position in an Insurance Company Philippe Maeder, Head of Pricing Life & Health for Latin America
Table of Contents / Agenda Solvency Framework Impact of Reinsurance Reinsurance Forms Concluding Remarks 2
Solvency Framework Solvency II Capital requirements Risks involved 3
Solvency II Solvency II is an economic risk-based solvency framework based on three pillars: the first one is quantitative and covers the economic valuation of assets and liabilities, the available capital and the solvency capital requirement (SCR); the second pillar is qualitative and sets out procedural and organizational requirements for governance in risk management and internal control functions (audit), based on the firm s self assessment in the format of an Own Risk and Solvency Assessment (ORSA); the third pillar focuses around market disclosure, on the supervisory as well as on the public side. Reinsurance is one of the available instruments an insurance company has to mitigate the risks, respectively to improve its solvency ratio. Therefore reinsurance solutions aim essentially at improving the first pillar of Solvency II. 4
Solvency Capital Requirement Assets and Liabilities are estimated at market value (usually different from reported balance sheet figures). Liabilities include technical provisions at best estimate value (including a risk margin in certain cases). Free Capital SCR AC Available Capital (AC) is the difference between assets and liabilities. The Solvency Capital Requirement is calculated to cover a 1 in 200 years events that could happen within the next 12 months. Liabilities The solvency ratio is equal to AC / SCR. The free capital is also called solvency margin. 5
Which Risks are Intervening in the SRC Calculation? Market risk: interest rates, variable annuities, stock market, property; currency exchange rates, concentration. Underwriting risk: biometric risks: mortality, longevity, disability, morbidity, catastrophes, epidemics; behavioural risks: unemployment, lapses, man-made disasters. Liquidity risks: also influenced by some catastrophic or lapse scenarios. Credit risks reinsurers; derivatives and hedge providers. Operational risks legislative changes, technology. 6
Impact of Reinsurance Solutions Catastrophes Other areas 7
Where Can Reinsurance Bring Specific Solutions? Market risks: they can barely be better diversified with a reinsurer than a direct insurer; some covers reducing exposure to variable annuities or GMXX-type guarantees. Underwriting risks: biometric risks: mortality: pandemic risk stop-loss, facultative sessions (top risks); morbidity: medical expenses excess-of-loss, stop-loss (epidemics); longevity: excess-of-time, longevity swaps; disability: run-off of DI annuities in course of payment; behavioural risks: high lapse scenarios; catastrophes (natural and man-made). 8
Floods 9
Number of events General Public Release Source: Swiss Re Economic Research & Consulting and Cat Perils. 10
Fire 11
Number of victims General Public Release Note: Scale is logarithmic: number of victims increases tenfold per band. Source: Swiss Re Economic Research & Consulting and Cat Perils. 12
Earthquake 13
2014 in Summary 189 natural catastrophes, a record high and a confirmation of an upwards trend. Total economic losses globally from natural catastrophes and man-made disasters were around USD 110 billion in 2014. Global insured losses were about USD 35 billion, below the USD 64 billion average of the last 10 years. Weather events in the US, Japan and Europe caused most of the insured losses in 2014. At least 12 700 people died in natural catastrophe and man-made disaster events last year. Reference: Sigma 2/2015 published by Swiss Re Economic Research and Consulting group. 14
Other Areas where Reinsurance has an Impact Liquidity: A reinsurer can increase liquidity in paying a commission for the anticipated Present Value of Future Profits of closed portfolio that it reinsures in quota share. Risk accumulations: Reinsurance solutions can be found to mitigate risk accumulations on certain buildings / areas with highly correlated risks. Credit or default risk: The solvency of the reinsurer represents an additional threat to the insurance company if it relies on long term reinsurance solutions. Operational risk: adequate agreements must be taken so that the reinsurance on a given portfolio could continue in case of take-over or merge of the reinsurer with another company and / or strategic changes. 15
Reinsurance Covers Quota-share Efficiency of various covers Limitations 16
Impact of a Quota Share Reinsurance Treaty Why should a proportional reduction of premiums and claims affect the solvency in a significant way? not all lines of business have the same degree of risk; decreasing the weight of some of them generates a better balance of risks and diversification; the impact on the asset side can be a reduction as the volume of assets should be reduced proportionally to liabilities; depending on the reinsurer s solvency, there is a more or less significant additional credit risk that should be considered; available capital should remain practically the same, hence the ratio AC/SRC should improve generally. Why should the reinsurer have any advantage taking up this cover? reinsurers have in general a better diversified portfolio geographically and regarding the risk structure; hence their cost of capital can be smaller if they have a similar risk appetite. 17
Solvency capital (MXN bn) General Public Release Which risks require most capital? Example: average Mexican insurer, applying EU SII capital requirements: 30 25 20 15 10 5 0 18
Solvency Capital (MXN bn) General Public Release Which risks require most capital? Example: capital after reinsurance (quota share 50% with profit comm.): 30 25 20 15 10 5 0 19
Reinsurance Covers and their Relative Efficiency Can non-proportional reinsurance treaties be efficient to reduce capital? at first, it will depend which model the insurance company applies: standard or internal? Then if it is a standard approach, it will depend how much this standard model is giving credit for non-proportional reinsurance; within an internal model, catastrophe treaties are efficient to mitigate extreme scenarios; pandemics risks would be mitigated by a stop-loss cover with a trigger (retention) that are out of reach of standard mortality fluctuations. Stop-loss is the optimal solution to reduce the variance of an insurance portfolio; but it is then also the worst format of reinsurance for the counter-party, requiring a lot of capital for a small premium income. Hence it is not likely to be offered. Credit risk: the reinsurer can be hit on several treaties in case of a catastrophic event; the likelihood that the reinsurer cannot pay the promised (high) capacity should be well evaluated. 20
What Reinsurance Can and Cannot Reserving in case reserving for a product appears to be insufficient, a traditional reinsurance won t bring an immediate solution; but some structured solutions may help in solving this matter progressively. example: longevity risk: longevity swap, or cession of portfolio with later recapture at given conditions. Model errors a reserve deficiency is in itself a model error but reinsurance cannot correct a badly conceived internal model Securitisation Reinsurers can help with the structuring of securitisation of risks 21
Concluding Remarks Alternative ways Other Latin American countries Conclusion 22
Alternative Ways of Reducing Capital Redefine the investment strategy: A bad asset / liability matching will lead to increased capital needs. Swapping long term liabilities against shorter term ones is not easy, it is better to act on the asset side. Diversification of risks: Insurance companies are quick to learn which products require a lot of capital support and can redefine their product range to adjust production according to this criterion. Reinsurance can help on the existing portfolio. Securitisation: It consists of passing certain risks to the market in form of catastrophe bonds, or longevity bonds, etc. A large volume is necessary for the feasibility. 23
Capital Requirements in Other Latin American Countries Countries with Solvency 2 approach: Brazil: introducing SCR gradually: now the U/W risk capital is computed with similar aggregation formula as in Mexico. Market risk capital coming next. Chile: model approved recently, gradual introduction in the coming 5 years. Countries with factor-based capital models and enhancements: Colombia, Peru, Costa-Rica; models gradually enhanced to come closer to international best practice. Countries lagging behind: Argentina, Venezuela and other Latin American countries: factor-based capital models, but no firm plans to make rapid steps forward. 24
Conclusion Reinsurance is not a magic solution to turn an insurance company near bankrupt into a strongly capitalised business entity. Each company is different, the optimal use of reinsurance will result from a detailed analysis, together or with the help of a reinsurer or consultant. The introduction of a solvency II capital framework in Mexico puts the country in the leading group of countries of Latin America in this respect. In this economic framework, the impact and use of reinsurance is also modified: from an instrument serving the purpose of limiting the only underwriting risk, reinsurance needs to be considered now as a tool to achieve a better solvency through a variety of tailor-made solutions. The floor is yours for questions and discussion! 25
References What do you know about Solvency II?, Swiss Re, February 2013 http://media.swissre.com/documents/solvency_ii_en.pdf Insurance Solvency Regulation in Latin America: Modernizing at Varying Speeds, Swiss Re, January 2015 (also available in Spanish) http://media.swissre.com/documents/insurance_solvency_regulation_in_latin_america.pdf Balance de las Negociaciones de la CUSF, presentation AMIS, Mayo 2015 Natural Catastrophes and Reinsurance, Swiss Re, 2003 http://media.swissre.com/documents/nat_cat_reins_en.pdf Natural Catastrophes and Man-made Disasters in 2014, Swiss Re, Sigma #5/2015 http://media.swissre.com/documents/sigma2_2015_en_final.pdf 26
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