Reinsurance in capital management Effect of reinsurance and tiering of own funds at insurers with little surplus capital

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1 Effect of reinsurance and tiering of own funds at insurers with little surplus capital Authors Dr. Katja Lord Contact January 2014 Introduction The solvency ratio the ratio of eligible capital ( own funds ) to the solvency capital requirement (SCR) will play a key role in determining a company s solvency situation under Solvency II. Companies can improve their solvency situation themselves by, for example, changing their investment strategy, improving diversification between different lines of business, limiting growth or withdrawing completely from lines of business involving particularly high risk. If such internal measures are not enough on their own, especially for companies with barely sufficient capital, there is the option of either transferring risk through reinsurance, which results in a reduction in the solvency capital requirement and has a smoothing effect on the balance sheet and profit and loss, or in the majority of cases as a complement to reinsurance achieving a long-term improvement in own funds by raising additional capital. Cost is not the only criterion for deciding whether to purchase reinsurance or raise capital (see September 2012 Knowledge Series Cost of Capital under Solvency II ). It is much more complicated, as own funds are subject to a series of additional criteria, any future changes in which could result in items no longer being eligible or their degree of eligibility being reduced. Eligibility also depends, for example, on the following criteria: Subordination: In the event of insolvency, all other debts and liabilities must be settled before any repayment of the capital item concerned takes place. Shareholders/investors are hence fully liable up to the amount of their investment, thus providing protection to creditors, and in particular policyholders. Availability: Own funds must be directly available for absorption of losses, and a company must be able if necessary to cancel any payments due in connection with eligible capital items. Maturity: Capital must be undated, or are at least available for a period that is sufficient in relation to liabilities. In addition, there are numerous other detailed structural aspects that can ultimately prove to be of great importance, such as incentives for redemption, unavoidable ongoing costs or any possible impairments of the capital item in question. We will now take a closer look at how eligible own funds are determined, highlighting both costs and other criteria for comparing reinsurance with raising additional capital. Determining eligible own funds A definition of available own funds as simply the excess of assets over liabilities in the economic balance sheet would disregard some important aspects:

2 Page 2/8 Figure 1: Determing eligible own funds/eligibility limits Liabilities Assets Subordinated liabilities Excess of assets over liabilities Basic own funds Own funds Basic and ancillary own funds Deductions Available own funds SCR MCR Own funds 50% 50% 15% Basic own funds 80% Tier 2 Tier 3 Thereof hybrid capital 20% 20% Tier 2 Excess of assets over liabilities based on the Solvency II economic balance sheet and reclassification Identification of ancillary own funds Adjustments (deductions and changes) Fungibility Tier classification Assessment of eligibility Figure 2: Eligibility limits Thereof hybrid capital Own funds 50% 20% SCR 50% Tier 2 15% Tier 3 Basic own funds 80% MCR 20% Tier 2

3 Page 3/8 Figure 3: Classification of subordinated debt into three capital tiers based on Level 2 implementation measures (as at November 2011) Criteria Tier 2 Tier 3 Possible OF items Paid-in subordinated liabilities Subordinated liabilities Subordinated liabilities Subordination Rank after all policyholders, beneficiaries, nonsubordinated creditors and Tier 2/3 own funds items (but rank before paid-in ordinary share capital and the related premium account, as well as paid-in initial funds, members contributions or the equivalent basic own-fund items for mutuals) Rank after all policyholders and beneficiaries and nonsubordinated creditors Rank after all policyholders and beneficiaries and non-subordinated creditors Original maturity Undated or at least 30 years Undated or at least 10 years Undated or at least 3 years Redeemable date Not within 5 years of the date of issuance Not within 5 years of the date of issuance Incentives for redemption Redemption subject to prior supervisory approval? Suspension of redemption Distributions in relation to the OF item Loss absorbency mechanism There shall be no incentives to redeem the item (one example of an incentive is an increase in coupon payment after a certain number of years from the date of issuance). Yes. If the redemption date lies between 5 and 10 years after the date of issuance, the supervisor shall make approval subject to the condition that the SCR is exceeded by an appropriate margin. In the event of non-compliance with SCR or if redemption would lead to such noncompliance (1) Cancellation in the event of non-compliance with SCR or if distribution would lead to such non-compliance; (2) the insurer is free to decide itself on the distributions, e.g. the insurer has full discretion to cancel distribution for an unlimited period and on a noncumulative basis without restriction in order to meet its obligations as they fall due (1) The principal amount can be written down, or (2) the item can be automatically converted into equity, or (3) other loss absorbency mechanism with equivalent outcomes exists if a) eligible OF <= 75% of SCR, or b) eligible OF <= MCR, c) non-compliance with SCR cannot be re-established within 3 months Limited incentives which cannot occur within 10 years of the date of issuance Yes In the event of non-compliance with SCR or if redemption would lead to such non-compliance Cancellation in the event of non-compliance with SCR or if distribution would lead to such non-compliance No loss absorbency Not within 3 years of the date of issuance Limited incentives Yes In the event of non-compliance with SCR or if redemption would lead to such non-compliance Deferral in the event of noncompliance with MCR or if distribution would lead to such non-compliance No loss absorbency

4 Page 4/8 1. It may be possible to include hybrid capital, which depending on its features is normally shown in the balance sheet as a debt instrument, i.e. a liability: Despite being classified as debt in the balance sheet, paid-up hybrid capital may, depending on its structure, possess certain properties akin to those of capital, such as loss absorbency and subordination. 2. Ancillary own funds (off balance sheet): In addition to paid-up capital shown in the balance sheet, it may be possible for ancillary capital to be used to cover solvency requirements, though the approval of the supervisory authority is required. Examples would be callable on demand hybrid capital or mutual calls. 3. Required deductions and adjustments: Some capital items, such as shares held by the company itself, are not eligible for inclusion in own funds or are not recognised in full due to their reduced capacity for loss absorbency. Hence, a deduction may be required. 4. Transferability of capital: Within a group, available own funds at a subsidiary will not necessarily be transferable via the parent company to another subsidiary that is making losses. This must be taken into account when determining group own funds. The same applies if there are ringfenced funds at individual-company level for capital items that cover only losses arising out of specified liabilities or risks. 5. Classification of capital items in tiers based on capacity for loss absorbency: The above-mentioned characteristics of subordination, availability and maturity affect the classification of a capital item. The availability of the lowest category (tier 3) in case of need is subject to restrictions, while tier 1 capital can be used to absorb losses virtually without limitation. 6. Eligibility of own funds to cover the solvency capital requirement (SCR) and the minimum capital requirement (MCR): We will now look more closely at this aspect. Eligibility limits Solvency II differs considerably from Solvency I in that there are three quality levels tiers of capital ( own funds ), ranging from tier 1 for capital of the highest quality (e.g. paid-in ordinary share capital) to tier 3 for the lowest-quality capital (e.g. certain subordinated bonds), with in some cases limits on eligibility to cover the solvency requirements. SCR: A minimum of 50% of the SCR must be covered by tier 1 capital. Subordinated tier 1 liabilities and preference shares may together account for a maximum of 20% of total tier 1 capital. A maximum of 15% of the SCR may be covered by tier 3 capital. MCR: Neither tier 3 capital nor ancillary capital is eligible. 80% of the MCR must be covered by tier 1 capital. There are already restrictions on the eligibility of certain capital items under Solvency I (Section 53c of the German Insurance Control Act), for example: A maximum of 50% of the capital requirement may be covered by subordinated bonds, a maximum of a half of which may have a fixed maturity. Thus, as can be seen from the criteria listed above, Solvency II provides for much stricter limits than Solvency I. A particularly hard restriction in the current version of Solvency II is that any excess capital (i.e. a solvency ratio of > 100%), may only be achieved with tier 1 items.

5 Page 5/8 Comparison of eligibility under Solvency I and Solvency II In this example, we assume for simplicity identical solvency capital requirements of 200m and available capital of 300m, while emphasising that in most cases there are considerable differences in valuation and risk assessment between Solvency I and Solvency II. Available capital consists of 180m of paid-in capital (tier 1) and 120m of subordinated bonds, which for Solvency I purposes are broken down into 40m undated and 80m with a redemption date, and for Solvency II 40m tier 2 and 80m tier 3 items. Under Solvency I, coverage of solvency requirements by subordinated bonds is limited to 100m. However, as only 40m of the subordinated bonds are undated, the eligibility of the subordinated bonds with a redemption date is also limited to 40m. Consequently, only a total of 80m of the subordinated bonds can be used as cover for the solvency requirements, the remaining 40m being ineligible. Under Solvency II, only a total of 100m of the solvency requirements may be covered by tier 2 and tier 3 capital, with tier 3 limited to 30m (15% of the solvency capital requirement). Thus, 50m of the tier 3 capital is not eligible, so that only 70m of the subordinated bonds can be used as cover for the SCR ( 40m tier 2 plus 30m tier 3). Comparison of reinsurance and the capital markets (specimen company) To perform a quantitative comparison of reinsurance and the capital markets under Solvency II, we will use the example from the September 2012 Knowledge Series Cost of Capital under Solvency II. Our specimen company is a typical property-casualty insurer in Europe selling motor, property and personal accident insurance cover to private individuals. The company currently has only non-proportional reinsurance and its solvency capital requirement is 147m (calculated in accordance with the QIS5 standard formula). Figure 4: Comparison of eligibility under Solvency I and Solvency II Capital/own funds and SCR ( m) SCR Tier 3/fixed maturity Tier 2/undated SCR Available Eligible (Solvency I) Eligible (Solvency II)

6 Page 6/8 In our example, the company has only own funds of the highest quality (tier 1) amounting to 162m and, with a resultant solvency ratio of 110%, has little surplus capital. A capital deficit could arise after just one bad year with a large negative result, caused for example by investment losses or a large volume of claims within the retention not covered by reinsurance. To improve its solvency ratio, the company is considering purchasing additional reinsurance or, as an alternative, issuing a subordinated bond. Reinsurance options are a 50% quota share treaty or a retrospective reinsurance solution (LPT = loss portfolio transfer, where the reinsurer takes over the reserves and the related risk) for the motor third-party liability portfolio, which has a long run-off period. The non-proportional reinsurance treaties already in place would not be affected. The additional quota share treaty would already reduce the overall SCR to 131m in the first year, due primarily to a halving of the premium risk for motor third-party liability business and improved diversification in the net portfolio. It would also produce long-term effects on the reserve risk that would only be visible in subsequent years. There would only be a small decrease of 2m in own funds to 160m, corresponding to the reinsurance costs (defined as the reinsurer s expected margin see Knowledge Series Cost of Capital under Solvency II ). The solvency ratio would therefore increase to 122%. With a loss portfolio transfer, the existing reserve risk for motor thirdparty liability business would be assumed by the reinsurer, thus also further improving diversification in the net portfolio. The SCR would fall to 111m. The risk margin, calculated as a percentage of the reserves, would be reduced by more than the reinsurance costs of 5m. As a result, unlike with the quota share treaty, own funds would actually rise to 172m, producing a substantial solvency ratio of 155%. We can use the cost of each reinsurance solution ( 2m and 5m respectively) as an upper cost of capital (CoC) benchmark for capital market products producing a comparable effect. In our example, reinsurance is more cost-effective if capital market solutions generate annual costs in excess of 10.1% or 7.1% respectively. To achieve the solvency ratios attained through reinsurance of 122% or 155%, the amount of the issue assuming these maximum cost rates would be 19m or 70m respectively. The cost of a capital-market solution does depend, however, on the quality of the capital raised. Thus, if it is not possible to raise tier 1 or tier 2 capital in the market at a cost of under 7.1%, issuance of a tier 3 subordinated bond can be considered, although, as mentioned, under Solvency II own funds are subject to limits on eligibility depending on their quality. In our example, the issue amounts calculated equate to 13% and 48% of the SCR respectively if only NP reinsurance cover is in place. There would therefore be no cap on the eligibility of tier 2 capital, as the volume issued would be below the 50% limit. The situation is different for tier 3 capital. With the first option (ML50 + NP), there would be no cap on eligibility for tier 3 either, but for the second option (LPT + NP) the limit of 15% of the SCR would be considerably exceeded, so that only 22m of a tier 3 subordinated bond would be eligible. The resultant solvency ratio of 124% would only be slightly different from that achieved with quota share reinsurance. The solvency ratio of 155% attained with the loss portfolio transfer option is not achievable with a pure tier 3 capital solution. RI SCR ( m) Own funds ( m) Solvency ratio RI costs ( m) CoC benchmark for capital market set by RI Issue amount ( m) NP % ML50+NP % % 19 LPT+NP % 5 7.1% 70

7 Page 7/8 In addition to cost, the following aspects should also be clarified when comparing reinsurance with a capital market instrument: Can the same solvency ratio as with reinsurance really be achieved with a capital market instrument? It may not be possible with the limits on eligibility due to tiering (see above). Any capital raised beyond those limits will not be considered for solvency purposes. By contrast, reinsurance always has the effect of tier 1 capital and is therefore not subject to eligibility limits. What happens if the SCR decreases in the future? Are planned long-term strategic measures compatible with each other? Further reductions in capital requirements resulting from such factors as reinsurance, changes in investment strategy, de-risking or improved diversification in the insurance portfolio can erode eligible own funds. For example, if the limit of 50% for tier 2 capital is fully utilised, a reduction in the SCR can also lead to a reduction in eligible tier 2 capital. Planned improvements in SCR in the coming years should therefore be taken into account in any decisions on issuing capital. What happens if there is a largeloss event? What would be the external effect of a large-loss event, and what would be the impact of such an event if it occurred prior to or during the capital issuance process? Capital market instruments have much less capacity for cushioning losses than reinsurance. Moreover, fluctuations in annual results affect, for example, capacity to pay dividends (limited companies) or mutual calls. Thus, shareholders cannot be guaranteed stable results. Furthermore, far more parties are involved in a capital issue than in a purchase of reinsurance. When considering raising capital therefore, it should additionally be borne in mind that it is less flexible and takes longer to put in place than reinsurance, and has greater public impact. Conclusion When comparing reinsurance with raising capital, it is necessary to have a clear long-term view of strategic corporate management measures and hence also to take the options into account in medium-term risk and solvency considerations (cf. ORSA). In addition to any cost advantages, a company needs to examine whether the target solvency situation is achievable in the light of limits on the eligibility of lower-tier capital and take account of potential future market developments and corporate decisions. Munich Re assists its clients and enhances the efficiency and effectiveness of their risk management with broad portfolio diversification and attractive reinsurance solutions. Solvency Consulting has a wealth of experience in dealing with the standard formula, in addition to developing and using internal stochastic risk models and linking them to valuebased portfolio management. We also play an active role in industry committees looking at regulation and specialist issues and ensure that knowledge and expertise are transferred and translated into practical recommendations for action on the ground. We are thus able to offer our clients real and effective help in preparing for Solvency II.

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