RGA’s core messages in capital motivated reinsurance (CMR) discussions have not changed for decades:
- Reinsurance is a real source of capital in addition to equity and subordinated debt.
- Reinsurance is a valuable tool for optimising an insurer’s financial position.
- CMR deserves a place in every life insurer’s capital management tool kit.
This all applies regardless of the size of the insurer or whether there is an immediate need for capital.
When RGA published its first Solvency II CMR report 10 years ago the industry believed that Solvency II was just around the corner. The reality, however, was that we had to wait another nine years – until 2016 – for the launch of Europe’s new capital and regulatory regime for insurance and reinsurance companies. This latest RGA report can now go into greater depth, drawing on RGA’s experiences concluding CMR transactions under Solvency II.
RGA expects the next wave of new CMR transactions to occur once companies fully implement and integrate the machinery of Solvency II. By that time companies will also be more accustomed to the dynamics of the new regime. One of the key factors that will contribute to the emergence of that wave of transactions is how effectively we, together, discuss the issues that are relevant to CMR under Solvency II (and not just in Europe). In discussing and explaining CMR under Solvency II so far, we’ve found ourselves needing to adopt a new vocabulary, or mindset, to convey the necessary ideas.
The core of this document, therefore, presents brief commentaries on the issues that we believe are the newest, or most relevant or interesting, in enabling the fruitful pursuit of Solvency II CMR.
We hope that the comments and arguments on the following pages resonate with you and stimulate further discussion. Modern CMR is most often a journey where you and your reinsurer design (and regularly update) the solutions that meet your needs, and we hope that this document helps you to find the best path to your destination.
1. Intimate link between risk and capital
A core concept in our new vocabulary is the recurring idea that Solvency II is founded on an intimate link between risk and capital. On the one hand, this simply reflects that Solvency II stuck to its original design principles and became a true risk-based capital framework. On the other hand, we use this terminology to distinguish Solvency II from the many risk-based capital (RBC) systems, which aren’t actually very risk-based. A key characteristic of a truly risk-based capital system is that the capital requirement is derived from detailed shocks to the integrated economic balance sheet and not just from factors (no matter how many!) applied to a disconnected historical value balance sheet. Many alleged RBC systems are missing this link.
2. Optimisation means making trade-offsOur recent CMR journeys have shown us that typical pre-Solvency II CMR transactions represented only a special subset of the full range of CMR situations. With Solvency II and the modern CMR transactions that are now needed, we see more clearly that optimisation means making trade-offs. The old situation allowed reinsurers to improve an insurer’s capital amount or solvency ratio without a material or visible effect on income. Such old-style transactions should now be very rare due to Solvency II’s intimate link between risk and capital. Instead, we now see that the relevant Solvency II CMR opportunities are those where “optimisation” means that insurers need to consider real trade-offs between capital efficiency measures (e.g., return on capital) and absolute income amounts.
3. Solvency II is only one of many bases
4. CMR is just an algebra exercise
5. Give return on capital a chance!
6. Remote risk transactions
7. Full risk transactions?
8. Sufficient risk transfer
Our 2011 CMR report observed that Solvency II did not have a risk transfer definition and went on to assert that one was not even needed. We stand by these statements today. We have, however, sometimes found ourselves debating sufficiency of risk transfer under Solvency II reinsurance transactions. (An example is a reinsurance contract on a stable portfolio that transfers the lapse risk between annual actual lapse rates of 20% and 40%.) RGA’s position remains that Solvency II’s best estimate scenario and Solvency Capital Requirement (SCR) shock scenarios define relevant zones of risk transfer that are used to evaluate the performance of the reinsurance contract by projecting the cash flow results under all those relevant scenarios. (For the example contract above, the only relevant observation is that the Solvency II standard formula shock for mass lapse risk [40%] completely covers the range of scenarios reinsured.) We see no need for subjective discussions of risk transfer under Solvency II. Our beliefs here are completely compatible with Solvency II’s requirement for “effective risk transfer,” which is about legal certainty, related transactions, credit risk and other basic issues, and not about what ranges of risk transfer are relevant.
9. Substance over form
Our 2011 CMR report also pointed out that Solvency II did not have a definition of, or criteria for, “reinsurance” and asserted that one was not needed because of the irrelevance of the risk transfer question (see prior section), and because risk mitigation impact was reflected directly via the cash flows in the relevant scenarios of the contract, regardless of the legal form it might take (e.g., reinsurance versus derivative). Recall that substance over form was one of the original Solvency II guiding principles. We were, therefore, surprised to discover that there are, in fact, some material elements of the Solvency II regulations (e.g., risk margin definition) that do implicitly or explicitly distinguish between reinsurance and other risk mitigants. We believe this was an unintended drafting oversight — which is quite understandable given the thousands of pages drafted over the years — but the resulting text has been applied literally and has led to some unfortunate conclusions, putting form ahead of substance and seemingly going contrary to the original intent of Solvency II. (Please note that this point does not relate to basis risk, which is another topic.)
10. Enablers of commercial transactions
Solvency II’s intimate link between risk and required capital means that a reinsurer likely needs to hold material capital for any of the risks it assumes from an insurer via modern CMR transactions. For such a transaction to be attractive enough to the insurer, the price needs to be low enough. These two “enoughs” hide large and complex calculations of value and assessments of alternative actions. Nonetheless, the simple fact is that an insurer wishes for a low price for CMR. Above a certain price, the insurer will simply not transact; it will pursue other alternatives (e.g., retain the risk or reduce new business written). It is therefore in all of our interests to look for situations where the CMR price will be lower.
Since a primary driver for reinsurance prices is the incremental capital that the reinsurer will be required to hold after entering into the transaction, anything that results in the reinsurer holding relatively lower reserves or capital will help. Any sources of such differentials are potential enablers of commercial transactions, and they show us where it is most promising to expend our respective commercial energies exploring new CMR transactions. These commercially helpful — or rather, essential — differentials can come from a number of sources: differences in diversification, varying risk appetite, or arbitrage.
11. Explicitly identify your alternatives
The price point referred to in the prior section is partly a function of a company’s alternatives. These alternatives are, however, often only implied. We find it very helpful in finding a viable commercial path (or to knowing when to abandon a path) if those alternatives are made explicit. Part of that exercise involves highlighting the costs or other impacts of the alternative courses of action.
A frequent alternative to CMR is to do nothing and accept the status quo; this is the winning alternative over many nice-to-have but non-critical CMR ideas. Classic alternatives are the raising of equity or subordinated debt from a parent or from investors; these alternatives to CRM have explicit costs but also other non-cost effects (e.g., inconvenience or undesirable messaging to financial markets). The cost/consequence of not using CMR skillfully could even be the failure to make an acquisition where an insurer’s equity and debt facilities have been fully exhausted; CMR is for strong companies, too. Recall that an insurer’s needs and alternatives will vary over time; a company should not make its CMR or other capital management decisions based solely on its current situation. Insurers should use CMR to reduce the impact of adverse scenarios and increase their options in positive scenarios.
12. The other advantages of reinsurance
In CMR discussions we sometimes remind our partners to remember the many non-price advantages of reinsurance over classic capital options, and that these advantages are valuable and warrant consideration. Unlike equity or debt, reinsurance is private, flexible, quick, not counted as leverage, easily updated to changing circumstances and — don’t forget — it transfers risk. Unlike decisions to forego opportunities due to lack of capital, reinsurance allows companies to keep their sales and admin channels full and happy, maintains their market presence and corresponding brand, and simply lets them maximize the value from their core strengths. Even if there isn’t an urgent need to raise the solvency ratio, recall that writing more business for the same absolute amount of capital while still maintaining a nice ratio makes shareholders happy.
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