The first stage of Solvency II is upon us and the countdown is on for cedants to get their internal models approved, writes David Banks. But what else do they have to plan for? We offer a guide through a changing reinsurance relationship

Solvency II is finally here … at least, that is, the process of gaining approval for internal models for compliance has now started.

On 1 April, the UK’s FSA began the pre-application process for internal models. Germany’s BaFin and France’s ACP have also begun to analyse the models of their largest insurance and reinsurance groups.

As the first official step in the winding road to Solvency II – the European directive on solvency requirements – these models will form the DNA on which a company’s capital requirements are based.

The relevance to cedants is that if they fail to get their internal model approved before the 2012 launch of Solvency II, they will be forced to apply the dreaded ‘standard formula’, which is expected to be relatively penal and will not necessarily take account of a company’s sophisticated risk mitigation measures.

That is not the only potential pitfall for European cedants, however. They can also expect Solvency II to affect their reinsurance relationships in several ways.

So what do European cedants need to do, now that the race to Solvency II compliance has begun?

1 Engage with your local regulator

Towers Watson senior consultant and Solvency II expert Mark Chaplin says interacting with the national insurance regulator to produce a good internal model will help an insurer reduce its solvency capital requirement.

But he warns that submitting a half-baked internal model will reflect badly in the long run. “Companies should try to enter pre-application early but should make sure they speak regularly to meet the requirements of the supervisor.”

2 Beware the standard formula

If a company fails to gain approval on its internal model, it would have to depend on a standard formula. This is a restrictive ‘one-size-fits-all’ approach that will not take account of all a company’s methods of risk mitigation.

It could be penal and force cedant insurers to transfer more of their risks to reinsurers.

But, as Aon Benfield Analytics Benelux division’s Solvency II expert, Jürgen Wielandts, points out, internal models are not for everyone.

“If their balance sheet does not pose a problem, most small and medium companies will opt for the standard formula approach and will therefore not apply for internal model approval,” he says, adding that such companies are then likely to go for internal models after a few years, driven by capital constraints, competition and market trends.

3 Scrutinise your reinsurer

Effective reinsurance will have an immediate impact on a cedant’s solvency capital requirement. All the more reason, therefore, to choose the right reinsurance partner. For instance, there are growing fears about the viability of contracts with reinsurers outside of the EU.

But, as Munich Re’s head of solvency consulting, Margarita von Tautphoeus, explains, many domiciles are establishing regulatory equivalence.

“Reinsurers from third countries that have a regulatory framework considered equivalent to Solvency II can provide reinsurance to European cedants on the same basis as reinsurers domiciled in Europe,” she says. But she adds that Ceiops (the association of European insurance supervisors) will provide further advice on the equivalence of third country regimes.

4 Watch the small print

The type of reinsurance contracts offered to cedants is expected to change as a result of Solvency II, as PricewaterhouseCoopers director David Wong explains. “This is because reinsurers will innovate and restructure their products to be more aligned with capital efficiencies to be gained under Solvency II,” he says.

Swiss Re executive board member Martin Albers said he anticipates that Solvency II could cause a possible restructuring of reinsurance programmes, but that it will follow a change in the cedants’ approach. “They will consider reinsurance from the perspective of risk and capital, instead of buying to budget,” he says.

5 Watch pricing of smaller reinsurers

Wong says cedants should look out for a “substantial change” in the relationship with smaller-sized and niche reinsurers. “Should Solvency II result in these reinsurers requiring higher capital levels that threaten their competitiveness, it is likely that cedants’ choices of reinsurers will reduce or the price of the cover they pay will go up,” he says.

In addition, cedants’ choice of small reinsurer vs large reinsurer could be heavily influenced by the capital perks of placing business with larger groups.

As Munich Re’s board of management member and chairman of the reinsurance committee, Torsten Jeworrek, says, large well-rated companies will benefit. “The high degree of solidity and broad diversification we provide will have a direct impact on clients’ balance sheets and reduce their capital requirements.”

6 Hurry up, there’s less time than you think

It is all too easy for cedants to become complacent about the two-year wait for Solvency II. In reality, companies could be costing themselves dear if they have not already started the process.

If it takes six months to prepare a draft model and another six months to gain approval, that gives insurers just a few months’ leeway before the 1 January 2012 renewals. Insurers also need a breathing space of several months to allow the model to bed in and to identify any cost efficiencies required.

Even if smaller cedants do not wish to apply for internal models, they should be aware that applying the standard formula will cost them time and money.

“Cedants will need the time and resources to prepare themselves for quarterly updates on fair-value balance sheet calculations and reporting that will be required under Solvency II,” Wielandts says. Insurers will need to start planning now so they can meet some stringent tests.

While the FSA, Bafin and ACP have started to analyse the internal models of insurance companies, other European regulators have not yet begun the pre-application process.

7 Expect the pre-application process to get slower

While regulators might have become more adept at handling internal model applications, the timetable should still be expected to be cumbersome.

Lane Clark & Peacock insurance consulting partner Charl Cronje says: “Regulators will have limited resources for assessing internal models, and those that find themselves too far back in the queue may well fail to get their models approved in time for 31 October 2012.”

8 Beware of the unprofitable lines gathering dust

The increased transparency of Solvency II means cedants will be forced to take a more detailed look at unprofitable lines or lines in run-off, with a view to divesting.

“Not only will Solvency II create greater transparency, but it is also likely to require increased capital to support specific elements of business, including liabilities in run-off,” Ruxley Ventures director Juliette Winter says.

Partner in PricewaterhouseCoopers’ discontinued insurance business team, Dan Schwarzmann, agrees. “It is clear that European insurers are carefully considering their discontinued operations, and exit mechanisms that deliver value are becoming more of a focus throughout Europe,” he says.

9 Expect upward primary pricing pressures

After the introduction of larger capital requirements under Solvency II, insurers are expected to see less bang for their capital buck, in other words a lower return on equity. As such, there will be less scope for insurers to use price to gain market share.

The CEA (the European insurance and reinsurance federation) says it expects consumers to ultimately pay for the higher capital requirements currently being proposed by Ceiops under Solvency II. “Policyholders would be hurt the most, as the prices of many life and non-life products would increase, our report shows,” CEA spokeswoman Janina Clark says.

10 Expect pressure to buy more reinsurance

The question remains: will cedants need to reinsure more of their business after Solvency II becomes live in 2012? The answer for catastrophe programmes is ‘yes’, according to Wielandts.

“Companies that use the standard formula to calculate their capital requirements will certainly increase their cat programme, most probably up to a 1/200 AEP level in order to avoid additional capital charges next to the premium and reserve risk charges,” he says.

He adds that the cost of these additional layers is likely to offset the cost of raising or allocating additional capital. “This is why we believe that reinsurance demand for peak cat risk is assumed to increase steadily towards 2012.” GR