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

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Authors Dr. Katja Lord Contact solvency-solutions@munichre.com 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 diver-sification between different lines of business, limiting growth or with-drawing 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 rein-surance or raise capital (see Septem-ber 2012 Knowledge Series “Cost of Capital under Solvency II”). It is much more complicated, as own funds are subject to a series of addi-tional criteria, any future changes in which could result in items no longer being eligible or their degree of eligi-bility being reduced. Eligieligi-bility also depends, for example, on the follow-ing 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. Share-holders/investors are hence fully liable up to the amount of their investment, thus providing protec-tion to creditors, and in particular policyholders.

− Availability:

Own funds must be directly availa-ble for absorption of losses, and a company must be able if necessary to cancel any payments due in con-nection 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 impor-tance, such as incentives for redemp-tion, 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 cri-teria 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 impor-tant aspects:

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Excess of assets over liabilities based on the Solvency II economic balance sheet

and reclassification Identifica-tion of ancillary own funds Adjustments (deductions and changes)

Fungibility Tier classification Assessment of eligibility

Figure 1: Determing eligible own funds/eligibility limits

Figure 2: Eligibility limits

Assets Liabilities Subordi-nated liabilities Excess of assets over liabilities Basic own

funds Own funds

Basic and ancillary own funds Available own funds Deductions SCR MCR Tier 3 Tier 2 Tier 1 Tier 2 Tier 1 ≥50% ≥80% Own funds Basic own funds Thereof hybrid capital ≥20% ≤50% ≤15% ≤20% SCR MCR Tier 3 Tier 2 Tier 1 Tier 2 Tier 1 ≥50% ≥80% Own funds Basic own funds Thereof hybrid capital ≥20% ≤50% ≤20% ≤15%

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Figure 3: Classification of subordinated debt into three capital tiers based on Level 2 implementation measures (as at November 2011)

Criteria Tier 1 Tier 2 Tier 3

Possible OF items Paid-in subordinated liabilities Subordinated liabilities Subordinated liabilities

Subordination Rank after all policyholders, beneficiaries, non-subordinated creditors and Tier 2/3 own funds items (but rank before paid-in ordinary share cap-ital 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 non- subordinated creditors

Rank after all policyholders and beneficiaries and non-sub-ordinated 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

Not within 3 years of the date of issuance

Incentives for redemption

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).

Limited incentives which can-not occur within 10 years of the date of issuance

Limited incentives

Redemption sub-ject to prior super-visory approval?

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.

Yes Yes

Suspension of redemption

In the event of non-compliance with SCR or if redemption would lead to such non- compliance

In the event of non-compliance with SCR or if redemption would lead to such non-compliance

In the event of non-compliance with SCR or if redemption would lead to such non-compliance

Distributions in relation to the OF item

(1) Cancellation in the event of non-compli-ance 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 distribu-tion for an unlimited period and on a non-cumulative basis without restriction in order to meet its obligations as they fall due

Cancellation in the event of non-compliance with SCR or if distribution would lead to such non-compliance

Deferral in the event of non-compliance with MCR or if distribution would lead to such non-compliance

Loss absorbency mechanism

(1) The principal amount can be written down, or (2) the item can be automatically converted into equity, or (3) other loss absorbency mech-anism 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

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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 struc-ture, 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 possi-ble 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 adjust-ments:

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 absor-bency. 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 “ring-fenced funds” at individual-company level for capital items that cover only losses arising out of specified liabili-ties 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.

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Comparison of reinsurance

and the capital markets

(specimen company)

To perform a quantitative compari-son 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 reinsur-ance and its solvency capital require-ment is €147m (calculated in accord-ance with the QIS5 standard formula).

Under Solvency I, coverage of sol-vency 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 require-ment). Thus, €50m of the tier 3 capi-tal 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 eligibility

under Solvency I and

Sol-vency II

In this example, we assume for sim-plicity identical solvency capital requirements of €200m and availa-ble capital of €300m, while empha-sising that in most cases there are considerable differences in valuation and risk assessment between Sol-vency I and SolSol-vency 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.

SCR

Tier 3/fixed maturity Tier 2/undated Tier 1 SCR Available Eligible (Solvency I) Eligible (Solvency II) 400 300 200 100 0

Capital/own funds and SCR (€m)

200 80 40 30 40 40 40 180 180 180

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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 invest-ment losses or a large volume of claims within the retention not cov-ered by reinsurance.

To improve its solvency ratio, the company is considering purchasing additional reinsurance or, as an alter-native, issuing a subordinated bond. Reinsurance options are a 50% quota share treaty or a retrospective rein-surance 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 reinsur-ance 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 diversifica-tion 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 third-party 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 reinsur-ance solution (€2m and €5m respec-tively) 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 eligibil-ity depending on their qualeligibil-ity. In our example, the issue amounts calculated equate to 13% and 48% of the SCR respectively if only NP rein-surance 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 eligi-bility for tier 3 either, but for the sec-ond option (LPT + NP) the limit of 15% of the SCR would be considera-bly exceeded, so that only €22m of a tier 3 subordinated bond would be eligible. The resultant solvency ratio of 124% would only be slightly differ-ent from that achieved with quota share reinsurance. The solvency ratio of 155% attained with the loss port-folio 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 mar-ket set by RI Issue amount (€m) NP 147 162 110% ML50+NP 131 160 122% 2 10.1% 19 LPT+NP 111 172 155% 5 7.1% 70

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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 advan-tages, 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 mar-ket developments and corporate decisions.

Munich Re assists its clients and enhances the efficiency and effec-tiveness of their risk management with broad portfolio diversification and attractive reinsurance solutions. Solvency Consulting has a wealth of experience in dealing with the stand-ard formula, in addition to developing and using internal stochastic risk models and linking them to value-based portfolio management. We also play an active role in industry committees looking at regulation and specialist issues and ensure that knowledge and expertise are trans-ferred and translated into practical recommendations for action on the ground. We are thus able to offer our clients real and effective help in pre-paring for Solvency II.

− What happens if there is a large-loss 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 pro-cess?

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 there-fore, 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.

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 lim-its 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 meas-ures 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 eligi-ble 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 improve-ments in SCR in the coming years should therefore be taken into account in any decisions on issuing capital.

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NOT IF, buT hOw

© 2013

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