In the second episode of the Back to Basics series, “Standard Formula” podcast host and insurance partner Rob Chaplin is joined by colleague Imad Mohammed Nazar to discuss reinsurance and risk transfer, including how reinsurance can allow insurance companies to spread their risks across multiple entities, reducing the potential impact of adverse underwriting experience.
This episode of “The Standard Formula” podcast is a continuation of the Back to Basics series. Skadden partner Rob Chaplin and his colleague Imad Mohammed Nazar focus on reinsurance and risk transfer under Solvency II.
Reinsurance is a crucial aspect of the insurance industry and plays a significant role in mitigating risk. Under the Solvency II regime, insurers are subject to specific rules and regulations governing risk mitigation techniques. Mr. Chaplin and Mr. Nazar discuss the wide array of risk mitigation techniques available under Solvency II, defined by the regime as “all techniques which enable insurance and insurers to transfer part or all of their risks to another party.”
This episode also includes discussion about the implications of successful risk transfer, the standard formula for an insurer to calculate its solvency capital requirement (SCR) and the eligibility criteria that insurers must meet under Solvency II for risk mitigation techniques to be eligible.
- Reinsurance Strategically Mitigates Risk. Reinsurance is a strategic process that involves the transfer of risk from one insurance company, known as the ceding company, to another, known as the reinsurer, thus providing ceding companies with the ability to protect their financial stability and cover large losses.
- Solvency II Risk Mitigation Rules & Regulations. Under the Solvency II regime, insurers are subject to specific rules and regulations governing risk mitigation techniques. These rules aim to ensure that risk transfer is effective and reliable when needed, and they create a structured framework for assessing the eligibility of various risk mitigation techniques.
- Eligibility Criteria for Risk Mitigation Techniques. The Level 2 delegated regulation lays out the general eligibility criteria that insurers must meet under Solvency II for risk mitigation techniques to be eligible. The goal is to ensure the efficient transfer of risk. These general eligibility requirements come in two flavors: One for insurers that calculate their SCR using the standard formula and another more bespoke set for those using an internal model.
From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner Robert Chaplin leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome back to The Standard Formula Podcast. I’m your host, Rob Chaplin. Today we continue with our Back to Basic series with our second episode. For those of you joining for the first time, welcome. We’re progressing through the Solvency II regime dissecting each topic and considering relevant issues. We do recommend that you check out our previous episode on owned funds if you haven’t already. As a brief reminder, each of these episodes will ultimately be compiled into a book which will also cover how the Solvency II regime evolves into Solvency UK. Those of us on our mailing list will be the first to receive the chapters of this book, so please contact me or my guest to sign up. Today we’ll be talking about reinsurance and risk transfer. I’m pleased to be joined by my colleague, Imad Mohammed Nazar, who will begin by telling us what reinsurance is. Take it away, Imad.
Imad Mohammed Nazar (01:21):
Thanks for having me on here Rob. Reinsurance is a crucial aspect of the insurance industry, that plays a significant role in mitigating risk. It involves the transfer of risk from one insurance company known as the cedent company to another known as the reinsurer. This strategic process provides cedent companies with the ability to protect their financial stability and cover large losses, ensuring the sustainability of their operations. Under the Solvency II regime, insurers are subject to specific rules and regulations governing risk mitigation techniques. These rules aim to ensure that risk transfer is effective and reliable when needed, and they create a structured framework for assessing the eligibility of various risk mitigation techniques.
The Solvency II directive defines risk mitigation techniques as all techniques which enable insurance and insurers to transfer part or all of their risks to another party. These techniques encompass a wide array of options including reinsurance arrangements, special purpose vehicles or SPVs, financial risk mitigation techniques such as derivatives, guarantees and more. Reinsurance operates on the principle of risk transfer. It allows insurance companies to spread their risks across potentially multiple entities, reducing the potential impact of adverse underwriting experience. By engaging in reinsurance, insurers can manage their exposure and maintain a healthy balance between the risks they assume and the financial capacity to handle them. Rob, please, could you tell us more about the implications of a successful risk transfer?
Rob Chaplin (03:02):
Certainly. Let’s zoom in on how an eligible risk transfer can truly shake up the capital position of an insurer. Picture this, you’re the captain of a ship and you need to navigate safely and swiftly through financial waters, an eligible risk transfer is like hoisting a sail. It can have a profound impact, but the magnitude of that impact depends on various factors. When an insurer chooses to use the standard formula for calculating its solvency capital requirement or SCR, it’s similar to following a well-established route. The SCR in essence represents the depth of the financial waters beneath the keel, and you need to ensure it accounts for the effects of risk mitigation techniques. Let’s break it down further. Imagine you’re an insurer and you decide to cede annuity liabilities to a reinsurer for a reinsurance agreement. On the one hand, it reduces net technical provisions, the basic provisions required to meet liabilities to policy holders, and this will typically drive the economics of the transaction.
On the other hand, it may increase certain capital charges under the SCR. Whilst the capital charges for longevity risk might decrease, the counterparty default risk charge will increase. Now the plot thickens when you’re using an internal model, think of this as having a customized map for your voyage. Insurers can fine-tune their capital charges for risks associated with risk mitigation techniques. This level of flexibility is invaluable, especially when the standard formulas’ treatment might not perfectly align with the nuances of the risks you’re facing. For example, if a specific instrument triggers a counterparty default risk charge under the standard formula that appears higher than what your undertaking assesses, the internal model provides room for a more precise assessment.
In July 2021, the European Insurance and Occupational Pensions Authority or IOPA, published an opinion on the use of risk mitigation techniques by insurers. This holistic approach puts the spotlight on the need for insurers to thoroughly analyze and assess the risks being transferred through these techniques. It’s all about integrating this analysis into their broader solvency needs, making sure they’re steering in the right direction. Reinsurance is just one tool in the kit of risk mitigation. Imad, what are the other options available to insurers under the Solvency II regime?
Imad Mohammed Nazar (05:40):
Great question. As previously outlined, the Solvency II framework offers a diverse range of risk mitigation techniques to cater to the unique needs and circumstances of insurers. These techniques are like different instruments in an orchestra, each playing its part in harmonizing the world of risk management. Apart from conventional reinsurance arrangements, there are special purpose vehicles or SPVs, financial risk mitigation techniques such as derivatives and instruments like letters of credit, guarantees and similar mechanisms. Each serves a specific role in managing and mitigating risks effectively. Let’s break it down in simpler terms. Firstly, we have reinsurance agreements, arrangements. As discussed, insurance companies transfer portions of their risk to other insurers via reinsurance. It’s a bit like sharing the load. You’re not alone in dealing with potential losses. Special purpose vehicles, think of SPVs as financial entities set up specifically to manage specific risks. Typically, they raise capital by issuing securities and fully fund the risks they take on with the proceeds.
Thirdly, we have financial risk mitigation techniques. Here we dive into financial instruments like derivatives. These can be used to hedge against specific market risks. Imagine them as a shield against currency fluctuations or changes in interest rates. There is sometimes a fine line between a derivative and a contract of reinsurance. Fourthly, we have letters of credit and guarantees. These are your reliable backup plans and can be used in a wide variety of context. They don’t transfer risk per se, but provide financial security in case things go awry with a counterparty. It’s like having a guarantee that your business partner will keep their promise, but remember, while these techniques offer flexibility, they need to meet specific criteria to be considered for risk mitigation under Solvency II. It’s like having a set of rules in place to make sure everyone is playing the same tune and following the same score. Rob will now explore the general eligibility criteria that insurers must meet under Solvency II for risk mitigation techniques to be eligible.
Rob Chaplin (07:51):
Certainly. You see, the level II delegated regulation lays down the law in terms of what these techniques need to fulfill to be deemed eligible. Essentially, the goal here is to ensure that these techniques don’t just tango around risk, but instead create ironclad commitments transferring risk efficiently. These general eligibility requirements come in two flavors. One for insurers that calculate their SCR using the standard formula and another more bespoke set for those using an internal model. We’ll focus on the former. First up, let’s talk about qualitative criteria. In Articles 209 and 210 of the level II delegated regulation, the qualitative requirements take center stage. Think of these as the backbone of whether a risk mitigation technique is eligible. First, legally effective and enforceable. The contractual arrangements and the transfer of risk must be legally effective and enforceable, not just in one jurisdiction but in all relevant ones.
Essentially, no fine print should undermine the risk transfer, nor should there be any sneaky transactions that muddy the waters. Second, risk management. The insurer must take all the necessary steps to ensure these arrangements are not just effective on paper, but in practice too. Third, ongoing monitoring. Keeping a watchful eye is crucial. Insurers need to monitor the effectiveness of the arrangement and the associated risks continually. Fourth, safety net. In case of a counterparty’s default insolvency or other credit events laid out in the contract, the insurer must have a direct claim. Fifth, no double counting. You can’t double dip when it comes to risk mitigation, no double counting is allowed. When it comes to whether the arrangements are legally effective and enforceable, this is often determined through a legal review of the contract itself. Imad, what about the specific eligibility criteria, please?
Imad Mohammed Nazar (10:04):
When an insurer employs the standard formula for SCR calculation, it must meet not only the general eligibility requirements under Articles 209 and 210, but also these specific requirements defined in Articles 211, 2 12 and 214 of the level II delegated regulation. These criteria primarily revolve around who stands on the other side of the risk mitigation technique. Let’s dissect them to understand better. Starting with Article 211, this deals with risk mitigation techniques involving reinsurance contracts. Here, the counterparty to a reinsurance contract must meet one of three conditions. Number one, it’s an insurer authorized under the Solvency II directive or the UK regime is applicable, which complies with its SCR. Second, it’s a third country insurer in a country with an equivalent Solvency regime or temporarily equivalent complying with that country Solvency requirements. Third, it’s a third country insurer in a non-equivalent jurisdiction, but with a credit quality of step three or better.
Broadly speaking, this is BBB or better. I should note that we’ll talk about collateralized arrangements in a moment. If a counterparty under the first one ceases to comply with its SCR after entering the reinsurance contract, Article 211 subsection three permits partial recognition. However, the counterparty must submit a recovery plan to restore compliance within six months. During non-compliance, the SCR effect is reduced proportionally. Concerning third country equivalence, following the Brexit transition, the UK falls under third country status. No equivalence determinations have been made for the UK by the EU Commission, hence, UK reinsurers recognition in the EU depends on credit quality or qualifying collateral arrangements. SPVs are also covered under Article 211. They have to meet detailed eligibility criteria. The SPV must be fully funded and meet specific conditions for its financial instruments or to ensure that the risk transfer is robust.
Article 212 is about financial risk mitigation techniques. Besides the general requirements discussed earlier, these techniques must align with the undertakings’ risk management policies. The assets and liabilities must be valued properly and there are credit quality requirements for financial instruments used. Lastly, Article 215 specifically focuses on guarantees. For these to be eligible, they must provide direct credit protection with clearly defined scope and no clauses beyond the undertakings’ control. In case of a counterparty default, the undertaking must have a direct claim on the guarantor and the guarantee should fully cover regular payments. However, Article 214 provides exceptions to non-eligibility where eligible collateral is in place. Rob, please could you tell us more about this.
Rob Chaplin (13:01):
With pleasure, Imad. Broadly speaking, a risk mitigation technique will be eligible to the extent supported by collateral arrangements complying with Article 214. Collateral arrangements encompass full title transfers as well as collateral held by custodians or third parties. Whilst the collateral itself must meet certain requirements, for example, it must be readily identifiable and accessible by the reinsurer and if held by a custodian, one that is rated BBB or better. But broadly, eligible collateral cures nearly all. Another exception allows for combining risk mitigation techniques to collectively meet the remaining specific eligibility criteria under Article 211 or 212. This requires that counterparties for the second technique also meet their respective counterparty requirements. And on that note, I think that’s all we have time for today. Be sure to stay tuned for our book chapter on this topic, which we’ll go into some further detail. Thank you for taking the time to listen to our podcast, and as ever, feel free to get in touch if you have any questions or thoughts. Thank you, and until next time, when we’ll cover third country branches and cross-border provision of services.
Thank you for joining us on The Standard Formula. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don’t miss any future episodes. Additional information about Skadden can be found @skadden.com. The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates. Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisors on a wide variety of transactional and regulatory matters. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.