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Insurance companies have built their businesses on the understanding of the merits of diversification, but regulation has been curiously blind to the benefits. Solvency II, the risk-based regime that will apply to European insurers from 2016, comes with a promise of radical change. Under the impending rules, if insurers demonstrate they are exposed to risks that are weakly or negatively correlated, they benefit from a reduction in the level of capital they are required to hold.
This innovative approach is bringing into question the nuts and bolts of insurers’ business models. In some cases it is also driving a reallocation of risk through changes in firms’ portfolios of assets and liabilities. The objective is to maximise capital efficiency.
“For the first time, the capital requirements of writing a particular contract of insurance depend not only on the risks to which that contract is exposed, but also on the interaction of those risks with the firm’s other contracts of insurance,” says Christopher Critchlow, actuary at OAC, a professional services consultancy, in London. “Firms must consider the marginal cost of capital as well as the capital requirement of that group of contracts on a stand-alone basis,” he adds, noting that the same logic applies to investments.
It is not particularly complex to identify potential sources of diversification in insurers’ exposures, but one must dig deep into the details of Solvency II to determine the capital relief a firm is due.
Diversification benefits come into play in the final stage of the calculations of the solvency capital requirement (SCR), which sets the level of capital necessary to withstand losses and ensure solvency at a 99.5% confidence level.
To calculate the SCR, actuaries have first to apply an extensive list of shocks to the balance sheet. The results quantify the buffer needed to cope with these individual shocks. In a second stage the results are aggregated, but this is a complex operation. Actuaries aggregate the results using correlation parameters. The lower the risk correlations are, the lower the aggregate result will be.
The correlation parameters for standard formula firms are set in a matrix that is published by the European Insurance and Occupational Pensions Authority (Eiopa). Internal model firms have more flexibility and can make more appropriate assumptions on risk diversification, providing they secure the blessing of supervisors.
In any case, experts agree, diversification can potentially release a substantial amount of capital, which firms are allowed to put to use by investing in more risk assets or underwriting more insurance risks. This is where the allure of diversification ultimately lies.
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