March 17, 2011 by Canadian Underwriter
Small and mid-size firms, the most vulnerable to Solvency II’s heightened capital requirements, may consider diversification and divestiture to lessen the impact of capital charges, reports Guy Carpenter.
Increasing reliance on reinsurance is an obvious solution to meeting additional capital requirements, but firms may “also be able to impact their capital charges by either increasing writings on a more diversified portfolio or simply divesting their participation in some lines of business where capital charges exacerbate potential returns,” Guy Carpenter reported in its report, Succeeding Under Solvency II: Pillar One, Capital Requirements.
Diversification can potentially reduce capital charges by 25 to 35%, but since the standard capital adequacy formula under Solvency II does not provide the flexibility to reflect the true value of diversification, maximizing this effect will require the use of an internal model.
“Composite insurers are expected to benefit the most [from diversification], owing to low correlation between their mixed life and non-life risks,” the report says. “Reinsurers benefit because of their typically wide range of reinsured risks and geographical diversification.”
The lack of geographic diversification of some mutuals is an important issue, the report continued. “One possible solution may be to allow mutuals to regroup across country borders in order to receive the benefit of geographical diversification.”