Insurance-linked securities under Solvency II

It is expected that insurance-linked securities will continue to be an effective risk-mitigation tool under Solvency II.

Insurance-linked securities (ILS) are...

... a means of ceding insurance-related risks to the capital markets. Swiss Re has been fundamental in the development of the ILS market since its inception; driving the development of this sector in varied roles including sponsor, underwriter and innovation leader.

Under Solvency II...

... it is expected that ILS will continue be an attractive risk-mitigation solution for insurers. In 2009, the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS) published the Insurance Linked Securities Report, which clearly outlined the importance of Solvency II for the ILS market. According to the report: "The new principles-based Solvency II framework is very likely to be a major development for the ILS market. Solvency II will recognise securitisation and derivatives as effective risk mitigation techniques." (CEIOPS-DOC-17/09, June 2009, p 22).

What are the potential benefits of an ILS structure under Solvency II? One benefit is the possibility to pass on risks, such as natural catastrophe risks, to the capital markets. As a result of this transaction, capital requirements for the ceded risks can be lowered.

Required capital can be calculated by an internal model or the standard formula provided by the European Insurance and Occupational Pensions Authority (EIOPA, which superseded CEIOPS in 2010).  Compared to the internal model, the standard formula provides a standardised calculation approach and there are some open issues regarding potentially complex structures such as ILS. One open issue of particular relevance to the ILS market is the question of how to capture basis risk, which occurs whenever the cover is based on an index not directly related to the indemnity of the insured party in question. The results of the fifth Quantitative Impact Study (QIS5), which tested the design and calibration of the standard formula, mention this issue regarding basis risk (see below).

“...When an insurance risk mitigation technique includes basis risk (for example as might happen where payments are made according to external indicators rather than directly    related to losses) the insurance risk mitigation instruments should only be allowed in the calculation of the Solvency Capital Requirements with the standard formula if the
undertaking can demonstrate that the basis risk is either not material compared to the mitigation effect or if the risk is material that the basis risk can be appropriately reflected
in the SCR”.

Source: Quantitative Impact Study 5 (QIS 5), SCR.13.8, p. 274

Insurers can also opt to calculate capital requirements using an approved internal model. In contrast to the open questions regarding the standard formula, internal models recognise ILS structures as risk-mitigation tools, as long as the undertaking can demonstrate that all the components, such as basis risk, are adequately captured.

Swiss Re has a proven track record... an industry-leader in the development of the ILS market. This stands alongside our expertise in risk- and economic-based capital requirement models. We continue to closely monitoring the developments in both of these areas, working in close cooperation with the industry and regulatory bodies.

To provide clients with further information on ILS, Swiss Re has produced a publication titled The fundamentals of insurance-linked securities (accessible on the Swiss Re Capital Markets webpage). Numerous fact sheets on Solvency II are also available, with a relevant example being Recognition of reinsurance under Solvency II.

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