Insurance and reinsurance firms should expect “more intense” underwriting cycles as Solvency II is implemented, causing reinsurance earnings to become much more volatile, according to a report by Guy Carpenter released Thursday.
At issue are Solvency II requirements the incorporate economic capital models using value-at-risk (VaR) measures.
VaR use, combined with the implementation of fair value accounting that is part of Solvency II, will cause models measuring reinsurers’ underwriting cycles to become “more precise (or over-calibrated)” resulting in significant balance sheet swings, the report argues.
“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 titled Succeeding Under Solvency II – Special Considerations for Reinsurers and CounterpartyRisk says. “It is also based on a spurious measure of risk.”
VaR is commonly defined as measuring the risk of loss on a given portfolio for specific time period.
Using VaR measures on a reinsurance balance sheet will cause firms to sell assets and repurchase shares in soft markets, then replace capital in hard markets in order to stay within risk limits. “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 says.
The report adds that applying VaR to reinsurance firms will push the industry towards a similar fate of the banking industry during the 2008 financial crisis.
“There are a number of problems with the use of VaR as a measure of risk, many of which were illustrated over the course of the 2007-2009 credit crisis.” the report says. “For example, VaR is the foundation for risk-based capital requirements under Basel II, which not only failed to prevent bank failures, but arguably contributed to the crisis by providing a false sense of security around risky investments.”
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