Solvency II and Reinsurance. Gesamtverband der Deutschen Versicherungswirtschaft e. V. Gesamtverband der Deutschen Versicherungswirtschaft e. V.

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1 Solvency II and Reinsurance Gesamtverband der Deutschen Versicherungswirtschaft e. V. GDV Gesamtverband der Deutschen Versicherungswirtschaft e. V. Solvency II and Reinsurance

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3 Solvency II and Reinsurance - Recognition of Risk Mitigation - Discussion Paper - Published by: German Insurance Association Friedrichstraße 191, Berlin Tel.: Fax: GDV 2007

4 2 Imprint Imprint Published by: German Insurance Association Business Administration Institute Friedrichstraße 191, Berlin Tel.: Fax: Contacts: Dr. Thomas Schubert Ulrich Stienen Mirko Kraft April

5 Contents 3 Contents Key messages Introduction Aims and structure of the brochure Significance of reinsurance under Solvency II Qualitative and quantitative recognition of reinsurance strategies in a risk-based supervision system Reinsurance strategy Difficulties that arise in the quantitative recognition of reinsurance strategies Time for Change Recognition of reinsurance in the QIS2 standard approach Recognition of reinsurance in the QIS2 standard approach Non-life Life Reinsurance credit risk Assessment of the QIS2 standard approach Non-life Life Reinsurance credit risk/rating Views on and approaches to the inclusion of reinsurance under Solvency II Notes on the inclusion of reinsurance in the Solvency II standard approach Approaches to the inclusion of reinsurance in the Solvency II standard approach Quantitative recognition of the effect of reinsurance for SCR and MCR purposes Peak exposures Changes in reinsurance structure Reinsurance credit risk/supervisory rating Treatment of Third Country Reinsurers Further possibilities for the quantitative recognition of reinsurance Partial model approach Benchmark model approach Quantitative risk analysis approach...41

6 4 Contents 5 Summary and outlook...43 Abbreviations and Glossary...45 Appendix...49 Appendix A: Allowance for reinsurance under Solvency I...49 Appendix B: Reinsurance credit risk...53

7 Key messages 5 Key messages The key messages of this brochure can be summarised as follows: 1) Solvency II should enable primary insurers to use reinsurance in the broad sense of risk mitigation as an integral component of their risk and capital management. To achieve this, it is necessary for reinsurance to enjoy economic recognition in the calculation of primary insurer capital requirements under Pillar I. The reduction in capital requirements could, for example, be calculated using a partial model, a benchmark model or a quantitative risk analysis approach as described in Chapter 4; reinsurance to be taken into account in calculating both the solvency capital requirement (SCR) and the minimum capital requirement (MCR). The reason is that reinsurance is one of the most effective instruments in the proposed supervisory ladders of intervention. This is true, especially, when an insurance company is about to fall below the SCR or has already done so; and insurance companies to describe in an internal risk report the qualitative role played by their reinsurance programme in their active risk management (Pillar II). 2) Solvency II should not stipulate any arbitrary limitations on the quantitative recognition of reinsurance, either in type (e.g. proportional or non-proportional) or in amount for the purposes of determining capital requirements under Pillar I. There should thus be no general limits of the kind found under the current solvency rules (Solvency I). At the same time, under a new riskbased supervisory regime, there should be a move away from a (purely) accounting-based view of reinsurance instruments towards a more economic approach. 3) The credit risk in reinsurance instruments should be subject to an economic assessment which fulfils the following criteria: the quality of a reinsurance programme should be assessed as a whole, taking due account of the structure and creditworthiness of the reinsurers; the determination of credit risk associated with reinsurance should be based on similar principles to those laid down in Basel II for banks and not on rules of thumb or arbitrary haircuts; and

8 6 Key messages reinsurance credit risk could be assessed on the basis of a published supervisory rating (as described in 4.2.4). A supervisory rating could compete with other indicators (such as information from rating agencies) and might replace them as the primary indicator of financial strength. 4) The recommendations made in 1) 3) above would have to be implemented in a practicable way especially for small and medium sized insurers. In particular, the requirements should not be unduly onerous for insurance companies relative to their risk profiles.

9 Introduction 7 1 Introduction 1.1 Aims and structure of the brochure The aim of this brochure is to answer questions arising out of the various waves of calls for advice ( CfA ) from the European Commission on the subject of Solvency and Reinsurance from the point of view of the German insurance industry. Especially noteworthy is CfA 12 (Reinsurance and other risk mitigation techniques) in the second call for advice and the response by CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors). 1 The review covers all types of risk transfer and the term reinsurance is thus used in a broad sense, 2 based on the risk view of the (primary) insurer, rather than on accounting standards. A feature common to all types of reinsurance as defined here is that they should provide risk mitigation for the cedant (the insurer making use of reinsurance), irrespective of the legal form of the treaty and accounting treatment. 3 For this approach, it is also of no relevance whether the provider of reinsurance is categorised as a primary insurer or as a reinsurer from a supervisory point of view. Thus, the term reinsurer is used generally to describe the counterparty of risk mitigation. Positions of the German insurance industry as regards appropriate recognition of reinsurance under the planned new supervisory regime for insurance companies under Solvency II are being formulated in this brochure within the framework of the discussions currently taking place in Europe. Recognition of reinsurance under Solvency II is extremely important, because a large proportion of reinsurers are based in the European Union and their supervision is consequently very relevant for the worldwide reinsurance market. Thus, Solvency II is also a precursor to a worldwide regulatory view of reinsurance and could become a guiding principle for the convergence of supervision in the area of reinsurance. Reinsurance should be fully recognised in the calculation of risk capital requirements (Pillar I under Solvency II). A prerequisite for the appropriate recognition of risk-mitigation measures is the adequate quantitative and qualitative integration of a reinsurance strategy in the risk management system (Pillar II under Solvency II). Consideration of reinsurance constitutes a classic example of the interaction between quantitative and qualitative risk management (Pillars I and II in Solvency II). 4 The risk situation before reinsurance forms the basis for the decision on a tailor-made reinsurance strategy. The calculation of risk-based capital requirements is then based on the risk situation after reinsurance, taking account of the associated credit risk of the particular reinsurance programme. 1 For information on the Solvency II consultation process, cf. 2 See CfA for information on the terms relating to different types of reinsurance. 3 Cf. CfA Cf. also Schubert, T./Kraft, M. [2006], Challenging design - How to clearly distinguish between quantitative and qualitative requirements of Solvency II, pp. 34 ff.

10 8 Introduction Insurers must also ensure that the strategy is transparent and Chapter 2 therefore deals with the formulation and documentation of a reinsurance strategy. The views expressed in this brochure should be considered within the context of other GDV (German Insurance Association) or CEA (Comité Européen des Assurances = association of European insurance associations) publications (see references) and are provisional, as the new, risk-based supervisory rules are as yet known only in outline. It is inherent to the subject of reinsurance that, owing to its broadness, developments in other areas may have an impact on it and should be considered accordingly. The main aims of the brochure are: to promote a basic understanding of the importance of a reinsurance policy within the framework of an insurer s risk and capital management (reinsurance strategy); to formulate qualitative requirements for reinsurance strategies as a basis for the quantitative recognition of the effect of reinsurance in the calculation of solvency capital requirements; to highlight the inappropriate incentives created by the previous Solvency I rules relating to the inclusion of reinsurance in the determination of the solvency margin; to describe the quantitative recognition of reinsurance in the standard approach tested by CEIOPS in the course of Quantitative Impact Study No. 2 (QIS2); and to propose appropriate ways of including reinsurance in the standard approach under Solvency II Pillar I, taking account of specific aspects such as credit risk. The brochure deals with insurance ceded for reinsurance by primary insurers, but not with reinsurance accepted. The subject of the extent to which a standard approach can depict a reinsurer s business is not covered. It can be generally assumed that specific reinsurer business models with their related risk profiles can only be adequately depicted and realistic capital requirements calculated using specially designed internal models. This brochure is aimed primarily at staff of primary insurers responsible for the inclusion of reinsurance issues in risk and capital management and in particular in risk models, and also at reinsurers when providing reinsurance cover. The brochure is structured according to its aims stated above. Following this introductory chapter, Chapter 2 covers the principles of reinsurance as a component of risk and capital management in insurance companies. In Chapter 3, reinsurance in the QIS2 standard approach and differences in comparison to the GDV/BaFin proposal are described. Approaches to the quantitative recognition of reinsurance in

11 Introduction 9 the standard approach under Solvency II are dealt with in Chapter 4. Chapter 5 rounds up the brochure with a summary and outlook. 1.2 Significance of reinsurance under Solvency II The significance of reinsurance under Solvency II is described below. The main features of Solvency II as the new European supervisory regime are briefly explained. Reinsurance facilitates the separation of origination (acquisition of insurance business) from portfolio composition. It constitutes an efficient capital substitute for primary insurers with low portfolio diversification, in that, as an alternative to increasing their capital, they are able to have entrepreneurial risk covered more efficiently by external capital (i.e. the reinsurer s capital). Reinsurance can also be used to absorb major single losses and market wide accumulations of losses such as those arising from natural catastrophes. Thanks to reinsurance (and of course other means), insurers can optimise their risk (volatility) and yield profiles. The stabilising effect of reinsurance facilitates the achievement of business plans and profit forecasts. In crisis situations reinsurance can prove to be a highly effective instrument in the ladders of regulatory intervention ( capital on tap ). As a key component of business and risk policy, the reinsurance strategy is a decisive element in risk management at insurance companies. As mentioned above, reinsurance is one of the main means of risk transfer for insurers. Consequently, an adequate, and as far as possible, full recognition of the transfer effect of reinsurance is of great significance for a risk-based supervisory system. The facts listed below (2004 figures) demonstrate the quantitative significance of reinsurance and the potential influence exerted by a European supervisory regime: 5 Worldwide, there are more than 150 reinsurers with a premium volume of approx. US$ 170bn. Non-life accounts for some 80% of premiums, life for the remainder. US reinsurers have a worldwide market share of around 51%, West European reinsurers around 31%. 6 Germany is the most important European location, with a world market share of 21%. The major exporters of reinsurance are Bermuda, Germany and Switzerland. 5 Cf. G30 Group [2006], A Study Group Report: Reinsurance and International Financial Markets. 6 Consequent to the sale of specific reinsurance businesses of GE Insurance Solutions to Swiss Re during 2006, the market share of European insurers has since increased further.

12 10 Introduction Solvency II is currently the European Union s most important legislative project for the insurance industry and will result in fundamental reform of insurance supervision in Europe. Whilst it is a European project initiated by the European Commission, the global nature of the reinsurance market means that it will have a worldwide impact. The current European solvency regime (Solvency I) is based on the use of relatively simple formulae to calculate capital requirements depending on premiums and/or historical claims expenditure. However, it may not be possible to adequately depict an insurer s risk profile in this way. 7 In contrast, Solvency II is based on risk: the higher the risk to which an insurance company is exposed, the greater the amount of capital it will need to allocate to cover the resultant capital requirements. Thus, the objective is to move from a quantitative to a more comprehensive, qualitative method of supervision. By recording insurers business activities in a way which better reflects the risks incurred (on both the asset and liability sides), it will be possible to take greater account of risk in calculating capital requirements. The intention is to introduce a three-pillar structure for the new supervision system for insurance companies, as in Basel II for banks. 8 In order to achieve the objective of qualitative supervision, additional supervisory tools will be included alongside the quantitative capital requirements in Pillar I. These will be supervisory review processes for qualitative aspects of risk management under Pillar II and market discipline requirements covering areas from transparency to public disclosure under Pillar III. 9 The European Commission s proposal for a fundamental reform of insurer solvency supervision is scheduled for summer 2007 (draft of the framework directive). The work currently taking place on the directive includes the Quantitative Impact Studies (QISs) which are currently being carried out by CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors), with market participants. 10 The directive is expected to be approved in the course of 2008 by the Council of Ministers and the European Parliament. There will then follow a phase in which the European Commission will lay down further implementing provisions through empowering clauses in the framework directive and the regulations will be implemented in national law. Notwithstanding the tight schedule, we expect the new regulations to apply to companies from From then if not before, an effective risk management system will be a decisive factor in a company s competitiveness. 7 Cf. Section 2.3 for examples of a possibly inadequate depiction of a risk structure (after reinsurance). 8 For information on the proposed three-pillar structure, see KPMG [2002], Study into the methodologies to assess the overall financial position of an insurance undertaking from the perspective of prudential supervision, p For a more detailed description of the Pillars, see GDV [2004], Risikosteuerung im Versicherungsunternehmen Risikoidentifizierung als Voraussetzung für ein integriertes Risikomanagementsystem (Risk management in insurance undertakings risk identification as a prerequisite for an integrated risk management system), pp. 41 ff. 10 For details of the (German) results of Qualitative Impact Study 2 (QIS2), see GDV [2006], QIS2 Ergebnisse der zweiten quantitativen Auswirkungsstudie zu Solvency II. CEIOPS has announced a further impact study for April to June 2007 (QIS3).

13 Introduction 11 According to the Solvency II supervision system planned, insurance companies will be able to calculate their capital requirements either by means of a standard formula laid down by the supervisory authority or by using an internal model which will have to be audited and approved by the supervisory authority (certification process). In either case, the question will arise as to the means of recognising the risk-mitigating effect of reinsurance. The term standard formula will be used to refer to a calculation of capital requirements based on general parameters ( standard values ) which any insurance company will in principle be able to use. In contrast, internal models will be developed by companies themselves on the basis of specific internal parameters reflecting the actual conditions pertaining to the company. The intention is that internal risk models should permit insurers to calculate solvency requirements in a way that reflects their actual risk profile, whilst at the same time being suitable for risk control (e.g. with scenario analyses). Both internal models and the standard approach will aim to measure the overall risk to which an insurance company is exposed for the purpose of determining the solvency capital requirement (SCR), which is an economic figure meant to depict a company s overall risk. The approaches use a confidence interval, which expresses the probability that the risk capital calculated will be sufficient to cover potential losses. It is planned to apply a Value at Risk (VaR) measure calibrated to a 99.5% confidence level under Solvency II, equivalent to 1 ruinous event every 200 years. 11 It will be necessary to ascertain whether the capital available ( available solvency margin ASM) exceeds the SCR, and, if not, what action must be taken. There will also be a minimum capital requirement (MCR) set at a lower level and if available capital falls below this, the company will be obliged to suspend its insurance business. Various ladders of supervisory intervention are proposed in the situation where ASM falls below the SCR but exceeds the MCR. In the standard approach, risks will be aggregated using a general formula (the standard formula ) to arrive at an overall risk figure, which will to an extent take account of diversification effects between different risk categories (e.g. through fixed correlation matrices). In contrast, in internal models the distribution of the overall risk is simulated in detail, taking account of dependencies between risks specific to the company (e.g. peculiarities in portfolio mix, asset allocation and reinsurance structure). In view of the need for conservative assumptions and the safety margins contained in the parameters, a capital requirement calculated using the future standard formula should normally exceed the risk capital determined by means of a certified internal risk model. This will provide an incentive for companies to use an internal model to calculate their capital requirements, as they may be able to compensate for the additional cost and effort of implementing and maintaining an internal model as 11 TailVaR is also under discussion as a risk measure. A VaR of 99.5% would equate approximately to a TailVaR of 99.0%. The European insurance industry is in favour of VaR as a risk measure see CEA [2006], CEA Working Paper on the risk measures VaR and TailVaR.

14 12 Introduction compared to using a standard formula. A standard formula should not be used for internal control purposes, as it is designed exclusively for the calculation of capital requirements, as opposed to risk control (e.g. managing risk policy), or for optimisation of a company s risk and return. 12 Internal (and partial) models, on the other hand, can be used in many ways for risk and capital management and control. The modelling of proportional and non-proportional reinsurance poses a challenge for the calculation of capital requirements both in internal models and in the standard approach. The multiplicity of reinsurance treaties in use and data requirements that are often at odds with reality are both problem areas. An appropriate and practicable way of including reinsurance, not only in internal models but also in the standard approach, is of considerable interest to the German insurance industry. Discussions so far on standard formulae for a new risk-based supervision system (including the GDV/BaFin proposal and QIS2) have shown that, whilst modelling methods are already available, there is a need for further clarification to enable professional solutions to be found for the inclusion of reinsurance effects under Solvency II. It is inevitable that methods of including reinsurance in the standard approach will not be able to cover all aspects and will not match internal models in their precision. Nonetheless, considering the main aspects heuristically is certainly to be preferred to neglecting them in order to avoid inappropriate risk management incentives, which sometimes arise under Solvency I (cf. Section 2.3). 13 Where reinsurance cannot be depicted in a standard formula, it may be possible to use partial models, on the assumption that no inappropriate restrictions on partial models are introduced. Since Solvency II is intended to provide a risk-based approach, the credit risk arising out of the transfer of risk from the primary insurer to the reinsurer (the reinsurance credit risk) must be appropriately depicted. As the default risk of a reinsurance programme is closely linked to the quality and number of reinsurers with which reinsurance treaties have been concluded, the qualitative and quantitative evaluation of reinsurance cover needs to be considered. 12 For example, the QIS2 standard formula is designed to be a supervisory tool, as opposed to a risk management tool. 13 For information on allowance for reinsurance under Solvency I (directive 2002/83/EC for life assurance and 2002/13/EC for non-life insurance undertakings), see Appendix A.

15 Reinsurance strategy 13 2 Qualitative and quantitative recognition of reinsurance strategies in a risk-based supervision system 2.1 Reinsurance strategy In this Section, the fundamental reinsurance concepts within the framework of risk management in insurance companies are described. The qualitative requirements of a reinsurance strategy and their inclusion in an insurance company s (risk) management processes are also examined. 14 Furthermore, compliance with qualitative requirements is a key element in the quantitative recognition of reinsurance under a solvency regime. In the context of Solvency II, this means that Pillar I and Pillar II should be viewed in tandem. Under Pillar II, use of reinsurance necessitates appropriate risk identification before and after reinsurance, whilst determination of the risk-mitigation effect of reinsurance as a constituent part of a company s risk and capital management process is a prerequisite for the calculation of risk-based capital requirements under Pillar I. It is also clear that the internal risk management system to be implemented will depend on the complexity of a company s risk profile taking account of the reinsurance instruments used. For example, the ability to reduce capital requirements through reinsurance (i.e. to obtain capital relief) will oblige companies to introduce systematic monitoring and regular reviews of their reinsurance relationships as a part of risk control within their risk management process. Small and medium-sized insurers may not have the same requirements in this area as large insurers. However, the requirements should nevertheless be proportionate to a company s risk profile irrespective of size. Further aspects are considered below from this perspective. Definition of reinsurance strategy A reinsurance strategy is part of a comprehensive risk and capital management strategy. It consists of objectives and the use of appropriate instruments. Reinsurance is a key risk and capital management tool for insurance companies and is principally used to protect insurance business against fluctuations in results. A further important purpose of reinsurance is as a capital substitute. From a supervisory point of view, the objective of an appropriate reinsurance strategy is to ensure that commitments under insurance contracts can be met at all times. 14 Cf. similar requirements in IAIS [2002], Supervisory standard on the evaluation of the reinsurance cover of primary insurers and the security of their reinsurers, Supervisory Standard No. 7, pp. 5 ff.

16 14 Reinsurance strategy The basic feature of reinsurance is risk transfer, i.e. the removal of risk from an insurance company. There are many possibilities for action in this area, depending on a company s situation, its risks and its need to transfer risk. Objectives of a reinsurance strategy Reinsurance strategy covers the totality of reinsurance measures intended to amend the risk profile of an insurance portfolio in such a way that it corresponds as far as possible to another, desired risk profile. The risk-management strategy should highlight the risks a company has and illustrate how it is to deal with the risks. The strategy may be expressed in terms of quantitative 15 and qualitative parameters. Essential parameters for a reinsurance strategy The reinsurance strategy, which should be approved by the full board of directors, should lay down the main criteria for the company s reinsurance structure, e.g.: the principle aims of the reinsurance programme; the (maximum) deductible in individual classes of business; the reinsurance programme needed to achieve the company s objectives; the financial costs/benefits of the programme; desirable/mandatory treaty clauses; and rules for effecting and monitoring payments. Documentation of the reinsurance strategy Reinsurance treaties are already documented in a number of ways. A detailed general definition of the documentation required is not possible, as it depends on the size and risk situation of each company and the complexity of the reinsurance system. In future however, it will be particularly useful to keep a complete register of reinsurance treaties as an essential part the reinsurance strategy documentation. It should be possible to clearly understand from the documentation how the reinsurance strategy has been formulated. Depending on the complexity of the business model, further documentation may not be required. 15 For example using probabilities of ruin ( capital at risk ) or earnings at risk scenarios.

17 Reinsurance strategy 15 An example of a useful document to include would be a summary section listing all reinsurance treaties. Reinsurance instruments included in a strategy Reinsurance instruments can be obligatory or facultative in nature and comprise various types of cover on a proportional or a non-proportional basis. Their suitability should be evaluated and a cost-benefit analysis performed, taking their effect on capital requirements into account. Reinsurance providers Appropriate reinsurers should be selected with due consideration given to spread and security (e.g. financial-strength rating). The number and the financial strength of the reinsurers selected are relevant to an assessment of the quality of reinsurance cover. Diversifying the portfolio of reinsurers involved in the reinsurance programme as a risk-management measure can in principle contribute to making a company less vulnerable to reinsurance credit risk losses. However, concentrating reinsurance on a single reinsurer with a good rating does not always result in a higher risk than spreading it across a number of reinsurers with inferior ratings. It does not therefore make sense to formally prescribe diversification in terms of a minimum numbers of reinsurers, when insurers purchase reinsurance with the intention that they spread their risk. (We provide a more rigorous quantitative analysis of this point in Section and Appendix B). Internal credit limits should be fixed for each reinsurer depending on their financial strength. Both actual risks arising from past reinsurance treaties concluded and potential risks arising from current treaties must be considered in calculating utilisation of the credit limit. Governance and tasks and responsibilities The board should define the reinsurance policy and the organisational measures required to implement the reinsurance strategy. Since the reinsurance strategy is a component of an insurance company s risk and capital management, definition of the reinsurance strategy is the responsibility of the full board of directors. In addition to compilation of the reinsurance strategy in consultation with the board, procedures must be in place at the operational level to ensure that the insurance contracts which feed into the reinsurance treaties can be identified and a proper link with the reinsurance treaty established. It is also important to ensure that all requirements under reinsurance treaties are fully complied with and timelines respected.

18 16 Reinsurance strategy Finally, it is important for the above-mentioned tasks and responsibilities also to be capable of being practicably implemented by small and medium-sized insurers. For example, simplified documentation could be accepted, depending on the risk profile of the insurer. 2.2 Difficulties that arise in the quantitative recognition of reinsurance strategies Reinsurance is a powerful tool for reducing the volatility of underwriting results and can be used to achieve a significant reduction in capital requirements. This is only possible if the effect of reinsurance is adequately recognised even in the standard approach under Solvency II for the calculation of the minimum capital requirement (MCR) and the solvency capital requirement (SCR). The calculation of the volatilityreducing effects of (proportional and non-proportional) reinsurance imposes a certain level of complexity on the standard approach. In particular, the evaluation of the volatility-reducing effect of certain types of non-proportional reinsurance (e.g. excess of loss or stop loss) cannot be determined linearly from the distribution of the historical loss ratios for the portfolio in question. For example, excess-of-loss reinsurance is defined on the basis of single or accumulation losses. Its effect on the volatility pattern, i.e. on the distribution function of the underwriting results (profits/losses) from the book of business concerned, is dependent on specific parameters, such as attachment point, limits, number of reinstatements, the definition of risk or loss event, the size of the reinsurance portfolio, etc. Since stop-loss reinsurance produces a direct reduction in the volatility of a portfolio s loss ratios, it is arguably easier to simulate that type of non-proportional reinsurance. Unlike non-proportional reinsurances of this type, proportional reinsurance (quota share and surplus) affects the size of the portfolio in question, but does not have a significant impact on the distribution of the loss ratios. Quota share treaties simply transfer a certain proportion of the existing portfolio to the reinsurer s books. Their recognition in a solvency system involves nothing more than the reduction of an insurer s capital requirements to the net portfolio position (the deductible/amount retained). Surplus reinsurance can be approximated using percentages in a similar way to quota share treaties, though this is more appropriate for groups with similar risks than for entire portfolios. The fact that both proportional and non-proportional reinsurance affect portions of a portfolio poses a particular challenge, as it is essential for the full risk minimisation effect of reinsurance to be determined. The main purpose of non-proportional reinsurance is to reduce the amount of the loss, whether it relates to an individual risk (facultative non-proportional reinsurance), the number of risks in a portfolio (perrisk excess), the loss on a portfolio caused by an accumulation event (catastrophe excess of loss), or the performance of a portfolio in a given period (stop loss). Even for the calculation of the MCR and the SCR, determining the aggregate effect on an

19 Reinsurance strategy 17 entire portfolio of the various types of reinsurance treaty structures involves a certain degree of complexity. As the portfolio effect resulting from reinsurance is highly non-linear, individual effects cannot simply be added up to arrive at the overall picture. It is important to remember that the objective is to determine the proportional and non-proportional effect of reinsurance treaties. Proportional reinsurance treaties can also contain provisions which make modelling difficult (e.g. loss-based commissions or multi-year structures). The crucial factor is the economic effect of the risk transfer. Appropriate account must also be taken of the risk of a reinsurer defaulting (cf ). 2.3 Time for change Under a new risk-based supervisory regime, the qualitative requirements of a reinsurance strategy described in Section 2.1 will be subject to closer examination by supervisory authorities. This is to be expected bearing in mind the fact that greater account will be taken of the quantitative effects of reinsurance in a future supervision system than at present, notwithstanding the problems mentioned (cf. 2.2). It will be necessary to ascertain the extent to which current principles can be applied to the inclusion of reinsurance in future capital requirements. As described below, the current rules do not provide a suitable framework and it is therefore time for a paradigm shift in the quantitative recognition of reinsurance for solvency calculations. Under the current Solvency I rules, reinsurance only has a general, broad-brush effect on solvency capital. Moreover, reinsurance is recognised - in full or subject an upper limit - irrespective of the quality of the reinsurance provider. Without going into the method of calculation of solvency requirements under Solvency I, we illustrate below the above-mentioned main shortcomings of the current solvency system in the area of recognition of reinsurance by means of examples of the inappropriate incentives created. Appendix A describes the rules currently applicable to the allowance made for reinsurance in determining the solvency margin in life and non-life insurance.

20 18 Reinsurance strategy First shortcoming: Broad-brush approach to recognition of the risk-mitigation effect of reinsurance on capital requirements In both life and non-life insurance, the effect of reinsurance is modelled linearly using a factor (percentage retained). Thus, the many types of reinsurance, particularly non-proportional, cannot possibly be taken into account. The following (non-life) example illustrates the problem: Company A Percentage retained: 90% Proportional reinsurance Company B Percentage retained: 90% Non-proportional reinsurance (stop loss) Required solvency margin identical, despite high underwriting result volatility probability of ruin > 0% capped underwriting result volatility probability of ruin close to 0% Fig. 1: Example of broad-brush recognition of reinsurance under Solvency I Second shortcoming: Arbitrary limits applied to reinsurance that counts for solvency purposes Capital relief through reinsurance is subject to an arbitrary limit of 50% (or 15 % cf. Appendix A).There is therefore no incentive to take out reinsurance cover beyond the limits laid down (see the simple example in Fig. 8 below, again relating to nonlife), even where it would make sense financially or from a risk management point of view. In a crisis situation, the limited recognition of the effect of reinsurance could result in further deterioration, since reinsurance solutions which might be appropriate in the circumstances would only receive limited recognition by supervisory authorities. Company A Percentage retained: 50% Proportional reinsurance Company B Percentage retained: 30% (minimum percentage stipulated by supervisor 50%) Non-proportional reinsurance Required solvency margin identical, despite higher volatility lower volatility but higher credit risk Fig. 2: Example of limitation on effect of reinsurance under Solvency I

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