There’s no time to waste – reinsurers must stay ahead of their clients as the market gets to grips with handling risk under the new regime

Solvency II is revolutionising the insurance industry, just as deregulation did in the 1990s.

It comes at just the right time: consistently risk-based and economic supervisory systems at the highest level are more necessary today than ever.

Solvency II created the supporting principles for such systems long before the current economic crisis, and Europe took on a pioneering role. But as risks have a global dimension, the new type of regulation is being discussed beyond Europe’s borders. In the EU, the framework directive is in its second development phase, and it is clear from the documents from CEIOPS that an increasingly conservative-to-restrictive approach is being taken. This is unacceptable from the insurance industry’s point of view, especially on risks that have almost no point of contact with the current financial crisis.

Yet there is cause for optimism. Ultimately, it is a matter of finding a reasonable compromise in line with the accepted economic principles of the framework directive.

What is so revolutionary about Solvency II? It represents a departure from corporate management based on accounting principles towards management geared to the return on risk-based capital, taking account of all an insurance company’s risks on the assets and liabilities sides of the balance sheet.

Solvency II may act as a catalyst for eliminating traditional weaknesses in the insurance industry. It reveals inadequate matching of interest structures in life insurance; it makes it more difficult to offset lack of profitability in underwriting by pursuing risky investment strategies; it scrutinises the efficiency of risk transfers – reinsurance structures in particular. It also has the potential to take the insurance industry’s management methods to a new level of quality and sustainably change the business.

The huge changes linked to Solvency II are already a reality for many market players. Insurers big and small have long been using modern enterprise risk management methods, and these companies were rewarded in the crisis. To meet the requirements of Solvency II by the time it is launched in 2012, everyone else must start making preparations now.

There will be no winners or losers under Solvency II. The latest Quantitative Impact Study did not reveal any dependency between solvency level and line of business transacted. The assumption that big insurers are at an advantage was also disproved.

The study showed that small insurers in several European markets were especially well capitalised. Neither regional nor national factors play a big role. The variance between solvency ratios (from less than 100% to well over 300%) was great in some markets and lower in others, which means every insurer needs to develop its own strategy for Solvency II.

Only one correlation is equally significant for all EU insurers: those with high solvency ratios also exhibit a relatively high diversification effect (in per cent of basic solvency capital requirement).

Providers whose business model or market position stops them diversifying for strategic reasons can optimise their net portfolio in an attractive and efficient way by buying reinsurance. The effect of reinsurance is no different than under Solvency I: the primary insurer reduces its risk capital by transferring risk; the reinsurer, in line with its better diversification, has lower capital demands to meet. What is new is that this commercial advantage can be measured accurately and reflected favourably in the cedant’s economic balance sheet. Moreover, Solvency II no longer provides for any limitation to the recognition of reinsurance.

Under Solvency II, well-diversified reinsurers with high risk management expertise will be in greater demand as business partners for sustainable, innovative risk transformation. For reinsurers with a good rating, the competitive advantage is clear. CEIOPS ‘Consultation Paper no. 51’ spells out that reinsurers’ capital strength will be weighted more strongly under Solvency II than will diversification through placement with several reinsurers.

Details of implementing Solvency II have not all been ironed out yet, but the revolution has begun and the principles are clear. Insurers know it is time to position themselves for the start of a new era.

Munich Re has set up a solvency consulting team to support its clients, which is integrated in the risk management unit and collaborates closely with clients in developing well-informed, customised risk transfer solutions.

Reinsurers will only be able to meet their clients’ increasing expectations under Solvency II if they can offer the decisive additional step from risk transfer to risk transformation.

Margarita von Tautphoeus is head of solvency consulting at Munich Re