Category Archives: Solvency II

The emergence of lapse risk transfer

This blog post is part of an ongoing series of blog posts on capital efficiency. To see past posts in this series, please click here.

In recent months, we have seen the emergence of lapse risk reinsurance following the introduction of Solvency II. Lapse risk is one of the key risks that life insurers, and particularly unit-linked life insurers, are exposed to and it is a key component of the Solvency II Solvency Capital Requirement (SCR) for many life insurers. One of the benefits of lapse risk reinsurance is that it can be used to reduce the life underwriting risk capital charge, in addition to reducing the undertaking’s exposure to lapse risk. Many reinsurers are active in this area, and as undertakings begin to consider Solvency II capital efficiency in more detail, it may be an area where we will see further growth during 2017.

Reinsurance treaties
The nature of lapse risk transfer will depend on the most material lapse risk exposure of the cedant—either mass lapse, lapse up, or lapse down.

The mass lapse scenario under Solvency II is calibrated as an instantaneous loss of 40% of the in-force business (for retail business). While the actual occurrences of mass lapse scenarios are difficult to predict, the risk of lapses exceeding 20% to 30% in a given period may be low based on historical data. Reinsurers can therefore offer treaties that cover losses caused by lapses in excess of 20% to 30% in a given period, often setting a maximum threshold of 45% to 50%. In reinsurance parlance, the reinsurance treaty attaches at a level of 20% or 30% and detaches at 45% or 50%. The relevant period would be defined in the reinsurance treaty. The cedant would retain the risk exposure to lapses below the attachment point and above the detachment point.

We are also aware of some reinsurers considering lapse up and lapse down reinsurance. However, there may be significant practical challenges associated with lapse reinsurance of this nature, in particular with regard to defining when an increase or decrease from the long-term average, or best estimate, lapse rates has occurred.

Considerations
There are a number of general considerations in respect of lapse risk reinsurance (as well as other potential considerations, depending on the specific terms of an individual treaty). First of all, there is the premium charged by the reinsurer for transferring lapse risk. The cost is generally set with reference to the reduction in SCR achieved by the transaction. We understand that costs generally vary between around 2% to 3% per annum of the reduction in the lapse risk SCR, depending on the type of deal and the availability of data.

Buy-in from the regulators will be key for these contracts to be effective. There is likely to be a concern that reinsurance could be used to reduce the SCR without a real reduction in the underlying risk. It is difficult to argue that there is no reduction in lapse risk exposure in the example attachment points outlined above. However, it may be more difficult to justify real risk transfer where the treaty is set up in such a way as to only indemnify insurers when a mass lapse of exactly 40% occurs.

Other considerations include the following:
• The interaction between the different lapse risk components of the SCR needs to be considered. If the risk exposure to mass lapse is reduced through the use of reinsurance, the lapse up or lapse down risk module may bite instead. Therefore, the impact of mass lapse reinsurance will be limited to the margin over which the mass lapse SCR capital charge exceeds the next-highest lapse risk capital charge. Understanding this interaction will be an important factor in determining the optimal attachment point for a mass lapse reinsurance treaty.
• Reinsurance introduces additional risks to the balance sheet such as counterparty risk, which is also considered in the Solvency II SCR calculation.
• The impact of such a transaction on the financial statements or International Financial Reporting Standards (IFRS) balance sheet should also be considered.
• If the reinsurance contracts are short-term in nature, there may be a risk associated with getting renewal terms on the same basis.

An alternative
Insurance-linked securities offer an alternative approach to transferring risk compared with traditional reinsurance. Under these transactions, insurance risk is effectively securitised and bought by capital investors through an investment fund. We are aware of a number of insurance-linked security firms that are active in transferring lapse risk.

The solutions can be structured in a similar way to traditional reinsurance deals in terms of attachment and detachment points, although the deals tend to be longer in term than traditional reinsurance contracts (circa three to five years, as opposed to 12 to 18 months). This provides additional benefits in terms of impact on the Solvency II risk margin and also may be more preferable to regulators than short-term contracts. However, this results in slightly higher costs compared with traditional reinsurance deals.

One disadvantage is that insurance-linked security firms generally do not have credit ratings, which can result in a high capital charge for counterparty risk under Solvency II. However, it is possible to reduce this through the use of collateral.

SFCR: A taste of what’s out there

This blog is the first part of a series on Pillar 3 reporting for Solvency II.

For most companies with a 31 December year-end, the first annual reporting deadline under Solvency II is on 20 May 2017. In preparation for this I think it’s interesting to look at some of the first examples of published Solvency and Financial Condition Reports (SFCRs).

What does an SFCR really look like?

To date, a number of companies with year-ends before 31 December have published their reports and I have included links below:

Company Link Country Reporting Date
Evolution Insurance Company Ltd Link Gibraltar 30/06/2016
Vitality Life Ltd Link UK 30/06/2016
The Wren Insurance Association Ltd Link UK 30/06/2016
Care Insurance Co Link Gibraltar 30/06/2016
Cornish Mutual Assurance Co Ltd Link UK 30/06/2016
Euroguard Insurance Co PCC Ltd Link Gibraltar 30/06/2016
Hansard Europe dac Link Ireland 30/06/2016
International Diving Assurance Ltd Link Malta 30/06/2016
Municipal Mutual Insurance Ltd Link UK 30/06/2016

While clearly a small sample, there is a variety of company types, lines of business, and territories represented in the selection above. In addition to the Solvency II requirements themselves, looking at what others have published can provide a useful reference point as you prepare your own SFCR report. As a health warning, it should be noted that these SFCRs represent approaches taken by some individual companies and can’t yet be taken as established market practice. We also have no feedback yet on the expectations and views of the various European supervisors.

Differences in approach

While the Solvency II requirements are generally clear on what should be included in the SFCR, as always there is scope for different interpretations. Furthermore, it is a general principle that the SFCR should be proportionate to the nature, scale, and complexity of the undertaking. It is therefore reasonable to expect variations in the length and level of detail in these reports. It is worth remembering that the SFCR is a public document for policyholders and other key stakeholders.

How long is a piece of string?
Looking at the nine publicly available SFCRs mentioned above, there is a wide variation in length, with the shortest report coming in at 24 pages, while the longest is 73 pages.
The longest section on average is the System of Governance chapter (B), while the shortest section is on Capital Management (E).

 Number of pages Average Min Max
A. Business and Performance 4.1 1.5 7.0
B. System of Governance 8.9 3.0 17.0
C. Risk Profile 5.4 1.5 10.0
D. Valuation for Solvency Purposes 4.9 2.0 10.0
E. Capital Management 3.0 1.0 5.5
Appendix: Public QRTs 19.1 5.0 39.5
Total 45.3 24.0 73.0

Layout
Generally, the SFCRs follow the order of required contents set out in the Level 2 Delegated Regulations Article 292 to 297, and the corresponding Level 3 Guidelines (with Chapters A to E, and subsections A1, A2, and so on). I think this is a sensible structure as it is easy for the reader to follow and ensures consistency across the industry.

Where a particular reporting requirement doesn’t apply to a company, most SFCRs still include the section and give a reason why it is not applicable. In cases where firms simply skip the section, it becomes difficult for the reader to determine whether it is not relevant or whether they didn’t complete it for another reason.

You are required to disclose your public quantitative reporting templates (QRTs) together with your SFCR. In almost all cases, the public QRTs are included as an Appendix.

Presentation
As a publicly available document, some companies have ensured their SFCRs are consistent with their brand and other policyholder documentation—Vitality Life is a useful example here. On the other hand, a number of other companies have taken a more functional approach, with very little additional formatting. This choice probably depends on how likely policyholders are to access your SFCR and whether you view it as marketing material.

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EIOPA discussion paper on the review of Solvency II Delegated Regulation

The European Insurance and Occupational Pensions Authority (EIOPA) has launched a review of specific items in the Solvency II Delegated Regulation with a particular focus on the standard formula Solvency Capital Requirement (SCR). In this briefing note, Milliman consultants Aisling Barrett, Gillian Tucker, and John Mulvihill summarise the discussion paper EIOPA has published in order to engage with stakeholders on the topic.

Solvency II reporting: Year-end 2016 and beyond

The Solvency II annual Quantitative Reporting Templates (QRTs) is required of many European (re)insurers for the first time in May 2017, as are the Solvency and Financial Condition Report (SFCR) and the Regular Supervisory Report (RSR). In addition to the annual reporting requirements, the deadline for submission of the 2017 quarterly QRTs has been reduced by one week compared with what was required during 2016. In this briefing note, Milliman consultants Ciaráin Kelly and Sinéad Clarke provide a timeline summarising the reporting requirements in 2017 for both solo entities and groups (assuming a year-end reporting date of 31/12).

At last: Product innovation in the European life insurance market

The Solvency II requirements, combined with the low interest rate environment, have resulted in a trend toward insurers seeking innovative product structures to improve customer return, while minimising capital requirements. In Germany, a number of large insurers have effectively stopped marketing their traditional insurance products to focus on more innovative products, including Constant Proportion Portfolio Insurance (CPPI), index-linked products, static and dynamic hybrids, variable annuities, etc. However, there is often a balancing act between increasing customer return, through the inclusion of investment guarantees, and minimising capital requirements for market risk.

My colleagues in Germany recently published a research report analysing three products in the German market from a capital efficiency perspective. The products include Allianz’s “Perspektive” and “Index Select” and Zurich’s “VorsorgeInvest Premium.” Each product offers attractive investment guarantees to policyholders, with the type of guarantee varying by product. However, the guarantees are structured in such a way as to reduce market risk, compared with traditional insurance products in the German market, resulting in improved capital efficiency.

Asset management techniques need to be considered to fund the investment guarantees offered by these products. In a low interest rate environment with high volatility, the costs associated with hedging investment guarantees can be very high. However, volatility control techniques have emerged as a way to reduce the costs of hedging investment guarantees. Using such techniques, a dynamic investment strategy can be adopted to invest heavily in equities to maximise return when markets are relatively stable, but limit equity exposure during periods of high volatility. The Milliman Managed Risk Strategy (MMRS) is an example of such an investment strategy. The research report discusses this in more detail and compares MMRS to a CPPI investment strategy in terms of policyholder return and capital efficiency.

For more information on this topic, please see the Capital Efficient Products in the European Life Insurance Market research report, authored by Marco Ehlscheid and Dr. Matthias Wolf.

This blog post is part of an ongoing series of blog posts on capital efficiency. To see past posts in this series, please click here.

Solvency II Directors’ Certifications

The Central Bank of Ireland has published a guideline and a set of frequently asked questions for insurance and reinsurance undertakings on Solvency II Directors’ Certifications. In this briefing note, Milliman’s Aisling Barrett and Ciarain Kelly explain what certifications are required from directors of insurance and reinsurance undertakings under Solvency II and how Milliman can help give comfort to directors in preparing to sign these declarations.