Solvency II’s precise measure of solvency prone to volatility: Guy Carpenter

Solvency II’s more precise measure of solvency will be more prone to volatility, Guy Carpenter reports.
The widespread use of the Solvency II standard model and internal capital models, in conjunction with market-consistent accounting of assets and liabilities, could contribute to shorter, more volatile underwriting cycles, Guy Carpenter says in its report, Solvency II’s Impact on the Reinsurance Market: Drawbacks and Risks.
“It could also drive more volatile earnings and balance sheets,” the report says. “Reinsurers, guided by economic capital models based on value-at-risk, may more actively shed assets and repurchase shares in soft markets, then seek to replace capital in hard markets.
“While this practice may appear to be sound capital management to investors and some managers, it tends to amplify the market impact of large losses while increasing reinsurers’ cost of capital.”
The report pointed to the nearly 80% year-on-year average increase in pricing seen in 2006, following the shock losses of Hurricanes Katrina, Rita and Wilma the year before.
These losses were preceded by reinsurers returning several billion dollars in capital to shareholders, in response to relatively modest price declines in 2004 and 2005.
“Following these events, capital flooded into the reinsurance market in response to anticipated rate increases,” the report says. “The establishment of new markets and ‘side cars’ benefited many cedents.
“However, several reinsurers that had been actively managing capital based on value at risk and pricing trends found that they could not replace the capital that they had returned to shareholders only months earlier.”
The Solvency Capital Requirement, the risk-based capital requirement for reinsurers under Solvency II, is calibrated to a 99.5% value at risk over a one-year period, it added.