Risk carriers can increase their solvency ratios either by increasing their capital (Solvency II’s ‘Own Funds’), or by reducing solvency capital requirements (SII’s ‘SCR’).
OF can be boosted by issuing subordinated debt (sub-debt), while reinsurance reduces SCR by providing contingent capital. Which option is better under Solvency II? The answer, as you’d probably expect, isn’t straightforward.
Reinsurance is fairly well understood amongst insurance practitioners. The buyer gets cash in return only when triggering losses happen.
Sub-debt is a little less well known and in contrast, immediately puts cash on the insurer’s balance sheet in the form of a loan note. The way the money is spent usually carries no restrictions, which makes sub-debt a useful corporate tool.
As Solvency II adopts a ‘holistic balance sheet’ approach, the impact of choosing one or the other on OF and SCR is not always linear.
Other metrics will be affected by your choice. Increasing the amount of investable money a company has to play with will enhance OF, but may impact market risk. Reinsurance may have a positive OF impact, because it reduces the additional capital required to take on the reinsured risk, but counterparty credit risk is likely to rise, perhaps materially.
Solvency II quantitative solvency calculations
SII treats the two alternatives differently. Under SII’s quantitative solvency calculations, 80% of the so-called basic OF covering the minimum capital requirement (MCR) must be Tier 1 capital. For the SCR, 50% of OF must be Tier 1. QS reinsurance resembles Tier 1 capital, which grants immediate SCR relief, but much of the sub-debt we have seen falls under Tier 2, because it is considered less readily available (like unpaid share capital).
Despite all the clear benefits of sub-debt, the benefits may depreciate because the efficiency or optimality of sub-debt is contingent on the SCR, which presents a moving target.
Cost-treatment is another difference. Sub-debt has a fixed cost, but QS does not. Treaties tend to include a profit commission paid by the reinsurer to the ceding company in return for good underwriting results. The commission structure can lead to challenges under the Solvency II framework, which in practice results in varying QS costs when regulatory stress-testing reduces the impact of treaties by easing commissions on a sliding scale.
Costs of reinsurance and sub-debt
A like-for-like comparison between of the costs of reinsurance and sub-debt is challenging to make, given all the moving parts, but it can be done – some of the variables are outlined in Table 1.
The optimal mix of reinsurance and sub-debt varies by company, circumstance and commercial objectives. When choosing how much of each to adopt, one must consider risk appetite, business and dividend strategies, shareholder expectations, and current levels of leverage. The support of an expert well-versed in both is essential. If you’d like to discuss the options, e-mail me here and for a more technical treatment, please see here.