De-risking under solvency ii

1 De-risking under Solvency II

De-risking under Solvency II

David Kun Atradius Credit Insurance / Functional Finances

2 Pre-Conference Workshop material

Overview

Background

De-risking techniques for Insurers

Risk Mitigation and the Solvency Ratio

De-risking under Stress

Synthetic versus Actual Capital

Contents of this presentation


Risks of an Insurance Undertaking

An insurance company is trading risk

The only way to minimize risk is to stop the business

De-risking is a balancing act between Profit and Risk

Optimizing de-risking needs a Risk Appetite and some measures of Profit and Risk

In Solvency II, some Risk measures are pre-defined

Background 1


Ways to handle risk

Acceptance – an Undertaking can choose to accept the risk

Rejection – an Undertaking can reject the risk using exception clauses such as specific risks or add policy conditions such as Own Risk (aka Aggregate First Loss)

Migration – risk can be passed to another entity, e.g. in case of Reinsurance

Hedging – the risk can be matched by some internal or external hedging instrument under specific conditions

Background 2



Part of the risk carried by the Undertaking can be passed on to other parties

The largest advantage of this method is that the risk mitigation amount adapts to the risk scenario

The most typical example is Reinsurance, when the Underwriting risk is passed on to another Insurer

There are other areas of risk migration, e.g. an IRS can be used to migrate interest rate risk

Besides the obvious credit risk, Solvency II also recognizes the credit risk of Risk Mitigation

Migrating risk



Part of the risk can be matched with corresponding, opposite direction flows, resulting in lowered net risk

Hedging can be done internally, e.g. using ALM or externally, e.g. purchasing hedging instruments

Hedge instruments will always be recognized in the Balance Sheet and the SCR calculation

Hedge is only possible for specific stress levels, e.g. in Expected Value or at the VaR level

Hedging is nowadays an option for Underwriting Risk as well (e.g. Mortality / Longevity CAT Bonds)

Hedging


Risk mitigation and Solvency Ratio

Standard Formula (SF) Some risk mitigation techniques are not recognized by

Standard Formula

Some of the secondary effects (e.g. changes in Commissions) can’t be incorporated in the SF

There are major differences between the SF for various LoB’s from Risk Mitigation perspective

Undertakings may need to consider the SF effect when making Risk Mitigation decisions

Reduction of SCR I



Standard Formula continued Some Risk modules explicitly allow recognition of Risk

Mitigation such as hedge instruments Some Risk modules are explicitly gross of Risk Mitigation

(or at least gross of Reinsurance) Risk mitigation also introduces extra charges, e.g.

Counterparty Default Risk on Reinsurance Assets

(Partial) Internal models Internal Models may be necessary to fully benefit from the

Risk Mitigation applied by the Undertaking

Reduction of SCR II



Risk Mitigation techniques have a Balance Sheet effect as well Best Estimate (Technical Provisions) of the Reinsurance

Assets is a Tier 1 asset

Assets used for hedging also play an important role

The Solvency Ratio is hence impacted both on the SCR and the Own Funds side of the ratio

Reinsurance and Hedge Assets


Case study

Atradius purchases XL layers that are not expected to be used

These layers are there to reduce capital requirements and for de-risking under major (catastrophic) stress

Most of the Standard Formula doesn’t recognize the risk mitigating effect of these layers Premium and Reserve risk allows 0 benefit

Large Buyer CAT risk recognizes the benefit in full

Non-working XL layers in Standard Formula

http://blog.functionalfinances.com/?p=17


De-risking under stress

Solvency II explicitly states that secondary effects don’t imply dedicated Capital Requirements

Exception: CDR on Risk Mitigation!

Risk Mitigation techniques have different efficiency under stress scenarios Stresses may have secondary effects, e.g. Underwriting Risk stress can affect Market Risk or vice versa Longevity Risk will have a large impact on Duration Market stress can cause increase in Credit UW Risk

Secondary effects in Solvency II


Synthetic versus Actual Capital

One way of interpreting Reinsurance is as Synthetic Capital (as opposed to Risk Mitigation)

This comes in addition to the already discussed Reinsurance Asset which is actual capital

Synthetic Capital may or may not be cheaper

Synthetic Capital may vary with the level of Stress

Actual Capital is fully recognized in the Solvency Ratio

Actual Capital is easier to understand for shareholders

Pros and cons


Thank you very much for your attention!

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De-risking under solvency ii