Solvency II is likely to lead to extra business for reinsurers. However, every expert has their own view on the effect of the new regime. Will it mean a greater demand for capital or expertise, or both?

A glance at large reinsurers’ strategies indicates that the industry is bullish about new business arising from the introduction of the European Commission’s Solvency II capital regime in January 2013.

In a recent interview with Global Reinsurance, Munich Re’s head of reinsurance Torsten Jeworrek said he expected Solvency II to prompt insurers to buy more reinsurance, particularly from higher-rated companies.

The prospect of new business is also one of the reasons for a recent flurry of entrants into the Swiss market.The argument goes something like this: the expectation is that insurance companies will have to hold more capital against business they write under Solvency II. This leaves them with a choice of writing less business, merging with other firms to obtain a diversification credit, or boosting capital levels. As an easily obtainable, efficient and familiar source of capital, reinsurance could top many insurers’ lists.

The good news

Some think that reinsurers may be right to expect more business. “Reinsurance is an efficient form of risk mitigation,” Fitch Ratings managing director (insurance) Chris Waterman says. “It is possible under Solvency II that demand could increase because it is simpler than raising capital, going through complex M&A transactions or even de-risking your balance sheet.”

Martin Davies, responsible for capital-related reinsurance transactions within the brokerage division of consulting firm Towers Watson, agrees: “I think there are a lot of cases where reinsurance will be bought to demonstrate to regulators that the business is being run to certain tolerances,” he says.

Quota-share reinsurance in particular could increase in popularity given its ability to transfer risks completely to a reinsurer.

“We have already seen a pick-up in buying of that type of reinsurance over the last couple of years,” says Davies, adding that the main driver for this activity so far has been the financial crisis and resulting pressure on insurers from rating agencies and regulators to ensure they have strong balance sheets.

“It will probably be given additional impetus under the Solvency II regime which does give credit for that sort of purchase of reinsurance,” says Davies.

“From the point of view of the insurance company, they can cede all of the risk but retain often a good ceding commission for producing the business, so effectively they have got risk-free income, which is very positive from a solvency perspective.”

Short-term fixes

But perhaps reinsurers should not start celebrating a sure-fire increase in business just yet. Some observers say that while Solvency II will affect insurers’ reinsurance buying practices, this will not necessarily translate into more work.

“There is a big hope that Solvency II will boost reinsurance demand, but we don’t think it will,” PricewaterhouseCoopers partner Achim Bauer says.

Bauer argues that Solvency II will affect the quality, rather than the quantity, of reinsurance bought. “We will see insurance structures migrating more to the sophisticated, structured end, which is more excess of loss, whole account solutions. These are intrinsically lower volume but higher margin,” he says.

“The business will be of better quality in terms of profitability, but it will definitely be lower volume.”

Equally, while the directive may result in some firms needing increased reinsurance, the greater clarity it will bring to capital structures and the effects of different reinsurance could highlight to others that they need less.

“Companies might drop reinsurance purchases if they see it is not necessarily needed for the regulatory purpose,” says Davies at Towers Watson.

Others argue that, an initial increase in demand for quota-share reinsurance may die down as Solvency II beds in. Under the directive, insurers can either use the directive’s standard model for determining capital adequacy, or their own internal model, subject to the model’s approval by regulators. As it is not company-specific, the standard model is expected to impose more stringent capital requirements than an internal model would.

While many insurers with internal models, typically larger firms, are seeking approval for them to be used, not all will be approved on time, and these companies may seek to temporarily fund the additional capital requirement of the standard model with proportional reinsurance or quota shares.

“Given the poor level of preparation of many small to medium-sized insurers at this stage, they will be looking for quick fixes in the run-up to Solvency II, of which proportional reinsurance is one,” Standard & Poor’s managing director of insurance ratings Rob Jones says.

“Further down the path, when they become more bedded into the process, there may be a reversion to other forms of reinsurance and other forms of risk mitigation. As more insurers seek and receive internal model approval, then the non-proportional forms of reinsurance become more capital efficient.”

He adds: “I think the short-term benefits of Solvency II to reinsurers’ business volumes are fairly clear but the longer term ones less so.”

The increased demand for quota-share reinsurance in the early stages is by no means a foregone conclusion, and can depend on market conditions in both the reinsurance and capital markets. The attractiveness of the product to buyers depends greatly on whether it is more cost-effective than other options.

“The usefulness of a quota share depends on spreads for surplus debentures,” Hannover Re board member Jürgen Gräber says. “If they are wide, the quota shares will fly, but if they are narrow they won’t because insurers would rather go to banks and secure financing another way.”

Quota shares’ attractiveness to the seller can also vary according to market conditions. “In a hard market reinsurers would probably rather write non-proportional business because it would carry larger margins,” Gräber says.

Greater clarity

One expected consequence of Solvency II is a flight to quality. Cedants will be given greater credit for placing business with higher-rated reinsurers, which in theory should mean they will get more business. However, reinsurance buyers also get greater credit for diversifying their panel of reinsurers, which could counteract this benefit. “If you were a very well-rated reinsurer and used to getting 100% of somebody’s reinsurance, [the diversification credit] might actually work against you, simply because of the concentration risk,” Davies says.

While there are a lot of variables that could challenge reinsurers’ assumptions about winning more business from Solvency II, many are insistent that the introduction of the new capital regime will be a net positive for the reinsurance industry. Any shift to more structured types of reinsurance under the new regime need not be at the expense of more traditional coverage purchases.

Gräber argues that traditional and structured products are typically bought by different parts of a primary company. “We would talk to the chief financial officer and chief risk officer at primary level, not necessarily the reinsurance manager [for structured reinsurance],” he says.

The greater clarity Solvency II provides on the effects of reinsurance could lead to more informed discussions between cedants and reinsurers about capital and risk transfer. “There will be more transparency about the capital companies’ need and their benefit from buying reinsurance,” Gräber says. “Exceedance probability curves will be calculated based on a particular reinsurance structure, so customers can tell immediately how much capital relief they would get under Solvency II with a particular type of reinsurance.”

The introduction of Solvency II could also remove a longstanding frustration of highly rated reinsurers: that buyers are unwilling to pay them higher premiums than lower-rated firms to compensate them for the greater security and the expense of maintaining it. Solvency II would make this cost more explicit.

“Under Solvency II we would calculate our reinsurance pricing for expected losses and brokerage, and add on cost of capital and administration,” Gräber says. “This would be very transparent and could enhance cedants’ willingness to pay us our cost of capital.”

Need for expertise

The true effects of Solvency II are still unclear. The industry will be engaged in the fifth quantitative impact study, known as QIS5, until next month. This will inform the calibrations of the models that will determine insurers’ and reinsurers’ capital requirements.

The industry and the Committee of European Insurance and Occupational Pensions Supervisors (Ceiops), the entity charged with ensuring consistent insurance regulation across EU member states, are pulling in different directions, with insurers wanting less stringent requirements and Ceiops aiming for tougher ones.

While the uncertainty makes it difficult to determine whether there will be an additional demand for reinsurers’ money, it may spur a need for their expertise. Reinsurers’ experience in capital management could be valuable to insurers trying to make sense of the new regime.

“For property/casualty business, some insurers will use the expertise of reinsurers in respect of risk management and in restructuring their reinsurance programmes due to potential new capital requirements,” says a Swiss Re spokesman.

Gräber adds: “There have been years where reinsurers’ advisory capacities were not in demand. Now, with Solvency II on the horizon, customers are willing to listen to us again.” GR