Securitisations and Solvency II: An opportunity? Or one to be missed?

To put it mildly, securitisations did not a get a good reputation as a result of the financial crisis.  Things are now changing.   This is illustrated well in a discussion paper from the Bank of England and the European Central Bank extolling the virtues of securitisations (here).    It is difficult to disagree with the key message; securitisations can be a win-win transactions that enhances the ability to redistribute risks more efficiently in the economy while enabling institutional investors to access a wider pool of investment.  

The Solvency II Delegated Acts (‘implementing measures’) built up a more favourable capital treatment for securitisations.  It is now recognised as a category of its own for the purposes of spread risk.  This evolution can be evidenced in the Commission’s Impact Analysis published at the time of the publication draft Delegated Acts (here).  As recognised in the Delegated Acts, this even includes recognising the name ‘securitisation’ instead of the name used in the Solvency II Directive in 2009: ‘investment in tradable securities or other financial instruments based on repackaged loans’.

As one would expect, the calibration of the standard formula spread risk for securitisation reflects the maturity of the exposure and its credit rating.  However, there is an interesting innovation.  The Delegated Acts identify two types of securitisation exposures: ‘good’ and ‘bad’, or in policy terms, type 1 and type 2.  The criteria are set out in the Delegated Acts and are quite detailed.  

Exposures of type 1 must meet 20 conditions including a rating of ‘BBB’ or above, the seniority of the exposure in the securitisation, SPV arrangements, listing in an OECD or EU exchange, and backing by residential loans, commercial loans or auto loans and leases.   The list of conditions is somewhat shorter for securitisations that were issued before the Delegated Acts came into force. Type 2 securitisations are simply those not meeting these criteria.  

Figure 1 shows the significant difference that meeting the conditions for type 1 makes to the capital charges.  It is a noticeably a more important consideration than the rating or maturity of the exposure.  

Figure 2 shows an alternative view of the spread risk capital requirements for type 1 securitisations compared against the equivalent ones for corporate bonds of equivalent ratings.   The differences aren’t that large in particular for short maturities.

All this raises a number of interesting considerations for an insurer’s capital management strategy. 

Firstly, there may be tactical adjustments where insurers find that they are holding type 2 securitisation paper as part of the Solvency II implementation work.  In this case, the insurers may seek to dispose of these investments before 1 Jan 2016 to avoid the capital increases that Figure 1 suggests.  However, given insurers’ relatively small holdings of securitisations, this may not be a material issue.

The bigger issue is the extent to which there is an appetite to consider the capital treatment of type 1 securitisation as a more strategic opportunity and readjust investment strategies.  Indeed, would it be possible to do so before 1 Jan 2016 to enhance the matching of cash flows of annuity liabilities and subject to Matching Adjustment? 

In any event, Figure 2 above suggests that there may be an interesting question about the risk and return trade-off of corporate bonds versus type 1 securitisations.  Would the returns from securitisations be sufficiently higher to justify the additional capital requirements?  Figure 2 suggests that for low maturities, e.g. up to 7 to 10 years, this could be finely balanced in particular for ‘BBB’ bonds.  If so, would insurers be willing to tilt their investment strategies to include more type 1 securitisation?  The answer to this question requires appropriate consideration, cash-flow matching including risk appetite, stress testing and governance.   

However, even if the risk and return trade-off mentioned above appears appropriate, it seems that there may be a limited supply of type 1 securitisations.  If so, there would be a limited opportunity for insurers in the short to medium term.  This would be more of an opportunity for investment banks to structure securitisation transactions.

This post is part of a series of posts on Solvency II.  To see the list, click here. 

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Reverse Stress Testing (RST): The Return of ‘Adequacy’

RST is one of the additional challenges that financial regulators have added following the financial crisis.  I spoke today on the subject at an event organised by the Institute of Risk Management. 

The effective implementation of RST builds on the articulation of the underlying business model.  This is something that UK supervisors have put on the agenda recently to signal a more holistic approach to supervision.  I have written a number of posts on the subject which you can access here.   

There are a number of challenges to deliver a RST.  The return of ‘adequacy’ might seem an odd title for my presentation.  It seeks to convey a simple message about the main challenge of RST: the assessment and judgement about the resilience of the business model.  It’s a ‘return’ because the term ‘adequacy’ used to be more prominent.  You may remember the Capital Adequacy Directive before it became the Capital Requirement Directive.  Anyway, the graph below seeks to illustrate the challenge of adequacy, which also serves to bring on a page the various stress and scenario tests that banks and insurers are considering on a regular basis. 

The key message from the graph is that if business failure scenarios are ‘close’ to the 1-in-200 scenarios, the adequacy of the business model and the strategy could be challenged.  Management may need to consider how to mitigate the risks to the business model. 

The full set of slides is available here.

If you found this post useful, you may want to subscribe and receive further posts by email – see box on the right hand side of the screen or click here.  My target is to post on a weekly basis so I will not be flooding your inbox.  

The European Commission’s Impact Assessment of Solvency II: Some Useful Points

The European Commission recently published a draft of the Solvency II ‘implementing measures’.  The ‘implementing measures’ expand on the requirements set out in the Solvency II directive.  Alongside the ‘implementing measures’, the European Commission also published a draft impact assessment.  This is one the many procedural requirements that apply to the policy-making process in the Commission. 

I thought it would be interesting to review the impact assessment.  As a user, I want to consider the extent to which the impact assessment can help me to understand Solvency II. 

What did I learn from this exercise?

1.    The importance of objectives in the EU policy-making process

The impact analysis is structured around a definition of problems that the policy making will address.  During the discussions about the directive, these objectives were enhancing policyholders’ protection and the integration of insurance markets in the EU. 

The Commission’s impact analysis acknowledges that there is now a third objective that has been taken into account: fostering growth and recovery in Europe by promoting long-term investment.  In the case of insurance, the main challenges that arise relate to the low interest rate environment and the volatility of asset prices. 

2.    A useful summary of how the calibration of asset risk has evolved

The third objective mentioned above has shaped the structure and calibration of capital requirements for assets risk which has evolved over a number of years.  However, it is not easy to see in a succinct way the end product where the answer is set out over a number of articles in the implementing measures.  Surprisingly, this can be summarised in a simple table (below).

3.    The scope of impact analysis remains a tricky issue

The Commission seems to have overcome the challenge of undertaking an impact analysis that seeks to cover the impact of all rules.  The Commission states,

“The options assessed have been selected to cover the most important and representative issues from each of the three pillars of Solvency II and each of the areas of the objectives and problem trees. The areas that are merely technical, have been settled in the Directive or are uncontroversial are not assessed in detail …”

This is reasonable and can result in a more productive use of scarce analytical resources but it can also have unintended consequences.  As far as I can see, the impact analysis did not cover the treatment of long-term guarantees.  I am frankly not sure if this is because it was settled in the Directive or because it turned out to be uncontroversial.

4.    The relative priorities of the Commission: the importance of reducing over-reliance on ratings

The concern about over-reliance on ratings is not new if you have been following the development of Solvency II.  However, given the breadth of Solvency II and the focused impact assessment, I found it surprising that the Commission went out of its way to include a full two-page annex summarising the requirements aimed at reducing reliance on external ratings in the risk management of insurance “such as

          ▪ external ratings shall not prevail in risk management;

          ▪ as part of their investment risk management policy, insurers and 
          reinsurers should have their own assessment of all counterparties;

          ▪ as part of their reinsurance (or other risk mitigation techniques) policy, 
          insurers and reinsurers should have their own assessment of all 
          counterparties.”

5.    And finally, a puzzle about policy making

The Commission’s impact assessment notes that one of the issues that emerged from the QIS5 was the application of a limit to the amount of Tier 2 capital (i.e. debt) that would be allowed.  This issue has remained unclear since then. 

Interestingly, if all you read is the relevant section of the impact analysis on pages 38 to 46 which also summarises EIOPA’s recommendations, you could be forgiven for thinking that the limit would not apply.  It is only the summary on pages 50 to 51 that suggested that I might need to reconsider my initial views.  Indeed, the draft implementing measures clarify that the sum of Tier 2 and Tier 3 capital must not exceed 50% of the SCR, which is an interesting development. 

This illustrates one of the key operational challenges of impact analysis: the need to keep up with the policy.

This was a selective but nonetheless in-depth reading of the impact assessment.  Have you read the impact assessment?  Did you learn any useful points from it?

You can subscribe to future posts here.

Solvency II: The Beginning of the End?

This week I spoke at a client breakfast event organised by Protiviti in London. 

The ‘beginning of the end’ is not just a rhetorical question about Solvency II but the challenging issue I had to address about Solvency II becoming effective on 1 Jan 2016.  I spoke about the ‘end point’ and focused on two issues:

• whether this is the end point we expected from a policy perspective (a measured yes, though it feels more different from the current ICA regime than expected, partly because of the financial crisis), and  

• whether insurers are engaging in contingency planning to reflect regulatory uncertainties around the end point that they are targeting.

I suggested that instead of thinking that this is the ‘beginning of the end’, we consider whether this is in fact the ‘end of the beginning’ – the implementation.  Now the real challenge begins: operating Solvency II in a BAU environment.  I offered a few suggestions to facilitate that transition; take a look at the slides. 

You can subscribe to future posts here.

Guest Post: Risk Cycles and the Use-Test (Part 2)

One of the lessons from my post on the objective of risk management was that there are number of perspectives about it.  I asked a number of leading industry experts to share their perspective.

Today, I am sharing the second part of Jim Suttcliffe’s contribution reflecting a Board perspective as Chairman of Sun Life Financial (Canada) and Chairman of BaxterBruce (UK) and former CEO of Old Mutual Group.  Jim explains how the concept of risk cycles can be used to implement the use test. (The first part on the use-test is here.) 

Previous posts on this series shared the views of James Tufts, Group CRO of Guardian Financial Services (here) and Carlos Montalvo Rebuelta, Executive Director of EIOPA (here). I will continue sharing these perspectives in the next few weeks.

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Implementing the use-test: risk cycles

Jim Suttcliffe, Chairman of Sun Life Financial (Canada), and Chairman BaxterBruce (UK)

There are a number of risk cycles in use at the big consultancies, but I find that few have the ring of reality about them. We can all recite Identify, Assess, Monitor, Maintain, Report etc, but this kind of cycle, at least from the perspective of a non-executive is likely to the use test not being complied with.

For me, the first step in the process is a number of actions that are all to do with "Understanding" your risks and their shape and texture. The difference between identifying and assessing is often academic - it's the process of assessing that leads to the identification, or at least the recognition of importance. Stress tests, reverse stress tests and scenario tests are all part of understanding, and from a non-executive perspective, making sure that the executive understands, as much as ensuring the board understands.

Some risks are easily measured, others have pretend-accurate models around them, and discussion need to recognize these differences, and not bury them under pseudo-science.

But once you've understood your risks, the next step for the Risk Committee is to get them into the context of the strategy, and set up the necessary "Policy". This will include risk appetite statements, risk targets, limits on activity, statements of desired and unwanted risks, control activities and a number of similar items, all aimed at ensuring the risk reward balance in the business is what is required. From a Non-Executive perspective, this is the crucial step. Once these policies are in place, you hand over to the executive, and say, "operate within these bounds", and tell me when you step out, and how you are going to rectify it.

The next useful thing to do, is to check that "Management Action" is building the sub-blocks that are high reward/low risk and shrinking the other blocks. This is of course a hard problem, but that's why management is paid a lot. This then can also help lead you to understand she the incentives are and whether they are working properly, as well as be very informative. It will also tell you whether your Use Test is being met.

After that, check "Compliance". This should be a big dashboard maintained by the CRO and his/her team. And as with any dashboard, you should expect a lot of green, and pay attention to any reds that appear. The rules should be very firm. If you breach, report, and no exceptions or stories that it didn't matter or is about to be fixed. Report all breaches!

And lastly you are in a position to "Report". You have all the facts, your Principal risks come out of Understanding, your Going Concern Statements come from there too. You can report on the policies you have in places and the actions taken to improve the business, and you can show the use test in action.

It's a far simpler cycle, and much more realistic.

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If you work in financial services, I would be keen to hear your thoughts about this perspective on the objective of risk management.  If you don’t, I would be keen to know if these lessons resonate with your experience. 

You can subscribe to future posts here.  

Guest Post: the Use of the Use-Test (Part 1)

One of the lessons from my post on the objective of risk management was that there are number of perspectives about it.  I asked a number of leading industry experts to share their perspective.

Today, I am sharing the views of Jim Suttcliffe, Chairman of Sun Life Financial (Canada) and Chairman of BaxterBruce (UK) and former CEO of Old Mutual Group.  Jim sets out the objective of risk management in terms of the 'use test'.  His next post will consider how to implement it in a meaningful manner.

Previous posts on this series shared the views of James Tufts, Group CRO of Guardian Financial Services (here) and Carlos Montalvo Rebuelta, Executive Director of EIOPA (here). I will continue sharing these perspectives in the next few weeks.

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Defining the use-test

Jim Suttcliffe, Chairman of Sun Life Financial (Canada), and Chairman of BaxterBruce (UK)

The Use Test is a simple but powerful concept to think about the objective of risk management. You should actually use your risk management system as part of your business, not as an afterthought.

But it's still true in many places that the risk department are those interfering people from Head Office whom we have to placate occasionally, but whom we basically avoid. Grrr.

Happily, in some of my interests, this era has passed and the power of doing things properly is showing through in the share price. 

Actually there are two sides to this story. Risk departments need to be staffed by potential CEOs and not Dr No's. Risk people need to be able to contribute to the development of these organizations, not just inhibit. But with the right people in place, good first lines will welcome the second pair of eyes, and the help in avoiding pitfalls, that risk departments with their broader vision can contribute. Bad first lines put up boundaries around their activities, and restrict access to information. They have their ears closed to different ideas, and are the weaker for it.

I sat with a lunch group of non-executive directors recently, not from the financial services industry, and found the room split between those who thought risk management was a waste of time, and those who embraced it wholeheartedly. There were few in the middle. Actually good risk management, and the embedding of risk management in the first line is not new. Good managements have always done it, and when risk is physical, as in the extractive industries, there are some very advanced techniques, and acknowledgement of the behavioural aspect of the subject.

And the Use Test has this behavioural issue at its heart. All the rules in the world won't prevent risks from crystallizing if the culture is against it. And that too needs attention. Risk managers are managers, and the art of management needs to be on the agenda as well as statistical technique and Monte Carlo simulation.

The prize is still out there to be won in many organizations. Some already have it in their hands and will be the winners in the next crunch. But beware the backwoodsmen who think that risk is for boring HO people!!

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If you work in financial services, I would be keen to hear your thoughts about this perspective on the objective of risk management.  If you don’t, I would be keen to know if these lessons resonate with your experience. 

You can subscribe to future posts here.  

Guest Post: the Objective of Risk Management – EIOPA's Perspective

One of the lessons from my post on the objective of risk management was that there are a number of perspectives on the objective of risk management.  I asked a number of leading industry experts to share their perspective.

Two weeks ago, I shared the views of James Tufts, Group CRO of Guardian Financial Services (here).  His perspective emphasised that the objective of risk management is to clarify the role of risk management of the business and of the risk function.

Today, I am delighted to share the views of Carlos Montalvo Rebuelta, Executive Director of EIOPA.  As a regulator, it is perhaps not surprising that he focuses on the extent to which Solvency II regulation changes the objective of risk management.

I will continue sharing these perspectives in the next few weeks.

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Solvency II: a revolution in risk culture?

Carlos Montalvo Rebuelta, Executive Director, EIOPA

As Executive Director of EIOPA, in charge of managing the Authority and an insurance supervisor that has faced very different approaches to risk management across national supervised entities, I would like to touch upon the topic of risk management in insurance.

If we start the topic far away from business, in Nature, we see how species try to do the best out of the environment they operate in, in order to survive, yes, but also in order to prevail and ensure a legacy. They are confronted with risks and they exploit opportunities, risk management at its best, albeit in a very primitive form.

Within the corporate world, but outside the financial sector, we may take the example of EIOPA, where different toolkits are used to anticipate and address challenges, but also to identify and grab opportunities. Risk logs, monitoring tools, clear reporting lines, allocation of ownership for action… doesn’t that sound familiar? Risk management, indeed, reinforced by the conviction from senior management on the usefulness of it; setting the tone from the top. 

A distinctive feature of insurance and reinsurance is that the business itself is all about risk. The core objective of (re)insurers is to deal with different kinds of risks making a profit out of them. So, the industry should already have a wide range of specific know-how and experience in the area of risk management, if only because this is what the business is all about i.e. risk.

However, the financial crisis has shown that financial market participants, including insurers, need to rely on stronger risk management capabilities in order to deal with the different challenges posed by the economic slowdown and the financial market volatility. In other words, their risk management frameworks were not always up to the challenge stemming from the crisis.

Self-regulation within undertakings proved insufficient. Very often, any concerns raised about long-term sustainability of the company were ignored or even ferociously denied. Wrong incentives, short term gambits, unsustainable growth… reality was far away from what undertakings claimed to be their situation, with the consequences we all have witnessed.

The upcoming supervisory and regulatory framework for insurance - Solvency II - is going to make significant changes in the current risk culture of many insurers.  It is a different way of looking at and managing risks. First of all, it presents risk management not as a point in time procedure, but as a continuous process that should be used in the implementation of the undertaking’s overall strategy.

There is a purpose, and tangible outcomes. The Solvency II framework aims at establishing high quality risk management standards that will be beneficial for insurance undertakings, shareholders and consumers. One of the main requirements of a risk-based regulatory regime is that risk and capital should not be considered separately. This approach will allow top management to ensure that the company does not take on more risks than its capital base allows. It is also an opportunity for the senior executives to anchor a risk culture in an insurer’s day-to-day operations; again, setting the tone from the top.

The Solvency II regime  requires insurers and reinsurers to have in place an effective risk management system comprising strategies, processes and reporting procedures necessary to identify, measure, monitor, manage and report, on a continuous basis the risks, both at individual and aggregated levels, they are or could be exposed, and their interdependencies. Nothing new under the sun? Unfortunately, this is not the case.

One of the most innovative changes introduced by Solvency II is the requirement that insurance companies develop their Own Risk and Solvency Assessment (ORSA) as a tool of their overall risk management system. Insurers will need to properly assess their own short- and long-term risks as well as the amount of their own funds necessary to cover them to ensure on-going compliance with capital requirements. Quoting the lyrics of a song by The Velvet Underground, “I will be your mirror, reflect what you are, in case you don’t know it”.

I believe that the Solvency II approach to risk management will allow for an enhanced understanding of the nature and significance of the risks to which a company is exposed, including its sensitivity to those risks and its ability to mitigate them. This understanding will help companies to see their real opportunities and manage their business on that basis.Strong risk management will also be beneficial also for the customers of insurance companies. It will allow insurers to better meet their claims towards clients and, thus, to promote confidence in the insurance sector.

All in all, Solvency II should lead to a win-win situation and bring a risk-based regulatory framework to a business that deals with risk.

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If you work in financial services, I would be keen to hear your thoughts about this perspective on the objective of risk management.  If you don’t, I would be keen to know if these lessons resonate with your experience. 

You can subscribe to future posts here.  

Solvency 2 Training

Solvency 2 implementation is approaching fast.  I am running a training course in early April organised by Euromoney.   Over three days, I will provide a solid overview of Solvency 2.

Further details about the course, including an overview and dates, can be found here.

The Potential Impact of Solvency 2 Regulation on Competition

One of the challenges about financial regulation is identifying the impacts so that costs can be kept to a minimum and benefits maximised.  Targeting regulation to address identified ‘market failures’ helps but it also require an analysis of the costs and benefits.  

Some impacts can easily be measured, like the cost of changes to IT systems.  Others are not so easily measured like the impact on how firms compete in the market place.  For example, regulation can create barriers to entry that can undermine the efficiency of competition. 

The potentially negative impact on competition because of market consolidation was one of the concerns at the time of the publication of the Solvency 2 directive.  There were two aspects to this concern:

(i) reducing capital requirements by taking into account the pooling of un-correlated risks could benefit disproportionally large and well-diversified insurers.

(ii) the fixed costs of risk management and compliance aspects of Solvency 2 could bear more heavily on small and medium insurers.

Relevant extracts from the Commission’s impact assessment of the Solvency 2 directive published in 2007 are below:

"The recognition of diversification effects implies that well diversified entities, or those which are part of an insurance group will, in practice have lower capital requirements than single solo entities which are less well diversified. Although this is fully in line with the basic economic principles underpinning the proposal, and does not entail lower protection for policyholders, it may nevertheless act as a catalyst to the already existing trend of consolidation in the EU insurance market and increase already existing competitive pressures on small and medium-sized insurers. This however does not mean that small and medium sized insurers would be expected to quit the market in a disorderly way following the introduction of Solvency II, but rather that they would be incentivised to look for new partnerships and alliances. Moreover, many small and medium sized insurers are specialised insurers that carefully monitor and manage their risks, and benefit greatly from being close to their customers. Where this is the case, these natural competitive advantages will be fully recognised and will result in lower capital requirements for those companies." (Commission’s Impact Analysis of the Solvency 2 directive, page 49)

"Insurers may also have incentives to consolidate further, as the implementation of Solvency II could require substantial investment in data collection, IT and risk management systems and expertise. Similarly, strengthening risk management will give rise to fixed compliance costs which are likely to fall more heavily on small firms. While this effect should be smoothed by applying the roportionality principle (limited reporting requirements for small firms), the higher weight of compliance costs for small firms could be a further driver of consolidation.  Moreover, the use of relatively sophisticated internal models for risk management could ensure lower regulatory capital requirements - and a consequent pricing advantage – for bigger insurers."  (DG ECFIN Report - Section 3.4.1)

As noted in the assessment, an important point to bear in mind is that the underlying effects mentioned above exist anyway.  So the question is really about the extent to which Solvency 2 exacerbates these trends significantly.

A few years have now gone through and I would be keen to hear your thoughts about a number of aspects of the impact of Solvency 2 on competition:

• You may have observed negative effects on competition in the product space as a result of Solvency 2.  If so, could you share details about your observations?

• If you have not observed a negative effect on competition, do you believe that it’s just a matter of time until we do?  For example, you could take the view that the reason we have not observed a negative impact is that Solvency 2 has not yet been implemented.  

• You may take the view that the absence of negative effects on competition is the result of changes in the industry landscape.  For example, a recent CSFI survey ‘Insurance Banana Skins 2013’ suggests that there is a significant amount of capital in the insurance industry (‘capital availability’ goes from the second highest concern in 2012 to number 16 in the 2013 survey).  If so, do you believe that the increased availability of capital has muted the potential impact on competition?  Are there any other relevant changes in the industry landscape that have a similar effect? 

• Finally, you may take the view that we are unlikely to see a negative effect on competition.  This could be because regulation’s marginal impact on existing trends is unlikely to be material.

I would be grateful for your thoughts.  If you want to share your thoughts privately, email me at isaacalfonblog "at" gmail.com.  

This is not intended to be a scientific poll but if there are sufficient answers I will summarise the emerging views (without attribution) in a future post. 

The Fate of Solvency 2 ...

There was today a Solvency 2 trilogue between the European Commission, the Council and the European Parliament.  Gideon at www.solvencyiiwire.com articulates very well what are the open issues (here).  Who knows tomorrow we may know the fate of Solvency 2.

Re-stating the Case for Solvency 2

In the midst of following press-reports about the tri-logue discussions about Solvency 2 and given the passing of time, I had almost forgotten what it is all about. 

I am starting to give some thought to a training course that I will be delivering in March 2014 for Euromoney (here).  As a result, I have been dusting off documents like the Sharma report from 2002 (here).

This provided a useful reminder of what it is all about:

1.  Common approaches for supervision.  

The underlying differences that challenge an agreement on Solvency 2 between the Commission, Council and Parliament: the extent of different supervisory objectives and approaches that exist(ed) are quite significant.   

The differences in the table put the progress to date in terms of legislation in perspective.(*)   This is also a useful reminder of why Solvency 2 is a European project.  You may disagree that Solvency 2 should be a European project but that's a different point. 

2.  The important role of risk management and senior management 

In the words of the report ...

"Although a well-managed firm can still fail, poor management makes a firm vulnerable and we believe that in practice it is the primary root cause of most problems in insurance firms.  We found that poor management can take one or more of the following forms:

(i) management are competent but have an excessive risk appetite or a lack of integrity or independence; or 
(ii) they operate outside their field or level of competence;
(iii) they fail to put in place adequate decision-making processes or adequate internal controls."

So perhaps there will be an agreement in the trilogue.  Then there will be a lot of detail - delegated acts, implementing technical standards - to discuss and assimilate.  However, I hope these messages about the case of Solvency 2 do not get lost ... 



Note: 
(*)  I am assuming that there haven’t been drastic changes across the EU in terms of supervisory objectives in the run-up to Solvency 2 and notwithstanding EIOPA’s work to bring about supervisory convergence, which will continue past any agreements at the trilogue.  

Freakonomics and Insurance Regulation

A post from the Freakonomics blog (here) highlights an interesting paper (here) about insurance regulation by Ralph Koijen and Motohiro Yogo.  The paper looks into the growth in the use of ‘shadow reinsurance’.  Freakonomics is concerned that there may be a bubble building up. 

I believe the underlying issue represents a good example of the law of unintended consequences that applies sometimes to financial regulation. This post will explain that and offer some thoughts from a Solvency 2 perspective.  

Some context – shadow reinsurance

There isn’t a formal definition of shadow reinsurance. Koijen and Yogo refer to shadow reinsurers as “affiliated and unauthorised reinsurers without an A.M. Best rating” in the US or offshore. (The paper used A.M. Best data, hence the reference to them in the definition.) 

The use of shadow reinsurance has also been covered in a recent report (here) from the NY State Department of Financial Services (DFS).  The DFS has a similar definition in mind, other than the ratings consideration.

Unintended consequences

The likely chain of events leading to an increased use of shadow reinsurance is set out below.   

Firstly, supervisors introduce new reserving requirements for certain term and life insurance products, so called XXX and AXXX reserving requirements respectively. 

These new reserving requirements require the use of stringent assumptions, which have been described as resulting in reserves “over eight to 10 times that of an ‘economic’ type reserve, such as a FAS 60 reserve under U.S. GAAP” (here).  I don’t really know if this estimate has passed the test of time – the paper is from 2005 – and the quote is offered as an indication of the conservativeness of the underlying assumptions.  As a footnote, it is worth noting that industry papers tend to refer to the delta between economic and AXXX / XXX reserves as ‘redundant reserves’.

Secondly, firms take action to reduce the impact of non-economic regulation. 

This requires an understanding of the prevailing regulatory environment.  Insurance companies would then realize that they can reduce the impact of these stringent reserve requirements by transferring some of these liabilities to special purpose vehicles (SPVs) in such a way that an insurance licence is not required. There are then some additional issues which give rise to the need of letter of credit to the originator. However, the key point is that if the recipient of the liability is not an insurance, the stringent valuation requirements would not apply.  

So far so good from a company's perspective.  However, what appears surprising is that state supervisors have a role in approving these transactions. There is even a sub-group of the NAIC Executive Committee called “Captive & SPV use sub-group” (see last page of this report).  It is therefore not entirely surprising that one of the DFS report recommendations is that state insurance commissioners stop approving these transactions:

“state insurance commissioners should consider an immediate national moratorium on approving additional shadow insurance transactions until […] investigations [by the Federal Insurance Office, Office of Financial Research, the NAIC and other state insurance commissioners] are complete and a fuller picture emerges.”

It would appear that the same supervisor that introduced stringent reserving requirements has a role in approving transactions aimed at reducing the impact.  This begs the question of what is the value of these onerous reserving requirements. 

Back to economic rationality, it is not entirely surprisingly, that the data in the paper also show that the (mean) reinsurance shifted to shadow reinsurers increased during the financial crisis when the uncertainty about valuations probably increased (Table 2 of the paper).

What about Solvency 2?

The essence of the unintended consequences means that it is difficult to foresee if similar transactions would happen under Solvency 2. 

The key point is that there would less incentive for these transactions to take place because it would not appear that the Solvency 2 reserving requirements would be uneconomical as in the case of AXXX and XXX requirements.  Although depending on the on-going discussion about the treatment of long-term guaranteed products, it may be argued that for certain insurances the Solvency 2 reserves are uneconomical. 

However, there are two additional considerations that would make the outcome in the paper less likely under Solvency 2. 

Firstly, there are specific articles in the directive about SPVs used for reinsurance purposes which require authorisation and the application of solvency requirements.  This would mean that shifting liabilities to SPVs would not necessarily mean a reduction in reserving and capital requirements.  (If you want to see the detail of the likely implementing measures, please check EIOPA’s advice to the Commission - here).  

Secondly, within the Solvency 2 directive a group is widely defined.  Personally, I would be surprised to hear that this could be read to exclude such SPVs.  More generally, the default approach to calculate the group solvency requirements is based on the consolidation of all exposures, which would mean that the effect of the transfer to an SPV cancels out.

The Solvency 2 implementing measures will  provide additional details about these issues but, as ever, regulation can have unintended consequences in particular when there are uneconomic requirements.