Following its implementation on 1 January 2016, Solvency II should now be "business as usual" for European (re)insurers. For years, (re)insurers were focused on understanding the Solvency II requirements and putting them into operation within their businesses. Now that this has largely been achieved, companies are beginning to really turn their attention to considering ways to better manage their capital in a Solvency II world. In a new series of blog posts, we will address some ways in which companies can achieve capital efficiency under Solvency II.We have already seen some capital management techniques put into effect this year, most notably in the space of longevity risk transfer and corporate restructuring, including the use of internal reinsurance. These large-scale projects are generally undertaken by sizeable European groups, but that's not to say that they are not also relevant for smaller (re)insurers. This blog post will look at three techniques that companies may be able to use to improve capital efficiencies under Solvency II.
Contingent debt
In August, a Norwegian insurer, Gjensidige Forsikring, announced that it plans to become the first insurer to issue bonds that can be written down in the event of a breach of its Solvency II capital thresholds. The firm plans to sell approximately $120 million of these restricted tier 1 notes to enhance the structure of its own funds. The instrument is intended to aid insurers in times of stress. Bond holders will be the first to suffer any losses if the insurer breaches its capital thresholds through deferred coupon payments. Under Solvency II, up to 20% of the Solvency Capital Requirement (SCR) can be covered by bonds with high loss-absorbing capacity, which includes this type of contingent bond or "restricted tier 1 debt." Similar instruments were issued by reinsurers in the past to provide capital in the event of a major catastrophe.
Operational risk bonds are another area for consideration. In May, Credit Suisse Group issued approximately $220 million in operational risk bonds to help insure against certain risks such as cyber risk, rogue trading, system failure, and fraudulent behaviour. The bond is underwritten by Zurich Insurance Group and is designed to reduce the operational risk capital charges of the Swiss bank. The bond is similar in structure to a catastrophe bond, with the principal being written down upon the occurrence of aggregate operational losses above a certain amount.
Longevity risk transfer
The longevity risk transfer market has been growing steadily as undertakings attempt to reduce capital requirements and technical provisions in respect of longevity risk. Such deals are particularly relevant to UK annuity providers. Legal and General recently completed another longevity reinsurance deal, a key outcome of which was to reduce the insurer's risk margin. Rothesay Life has also hedged a significant amount of its longevity risk exposure through the use of reinsurance.
However, in the UK, the Prudential Regulation Authority (PRA) is concerned about the additional risks involved in annuity risk transfer, particularly where these transactions are entered into solely to reduce the Solvency II risk margin and not to genuinely transfer risk. A key concern relates to increased counterparty risk, where longevity risks are transferred to a small number of reinsurers. The PRA intends to closely monitor trends and developments in this space.
VIF monetisation
Value of in-force (VIF) is the term often given to the economic value of future profits associated with an in-force book of business. Under Solvency II, the VIF of profitable business can be recognised on the balance sheet through the calculation of the best estimate liability. VIF monetisation involves realising a portion of the value included in the best estimate liability by "selling" a share of the expected future profit stream to a third party in exchange for an up-front payment.
The main benefit of a VIF monetisation is to enhance liquidity and raise finance, and it is, therefore, a potentially attractive alternative to debt or equity issuance. It can also be used to significantly remove variability in the technical provisions over time, essentially via "hedging" a portion of the VIF asset by taking it off risk. This can protect the insurer from future variability in the risk drivers that affect future profits.
In recent years, there has been significant activity in Spain and Portugal in this space, primarily driven by the financial crisis. We have also seen transactions in other European jurisdictions, such as the UK and Ireland.
We have published a number of papers on this topic including Capital management in a Solvency II world (which focuses on life (re)insurance business), Capital management in a Solvency II World: A nonlife perspective (looking specifically at nonlife or property and casualty [P&C] issues) and Unit-linked matching considerations under Solvency II.
If you are interested in more information on capital management under Solvency II, please contact your usual Milliman consultant.