The European Commission is in the process of redefining insurance solvency regulations. The latest draft of this new framework shows a friendly approach to the use of capital market tools. For insurance players, who increasingly look toward securitization as a source of funding, it means better-defined reporting requirements. Moreover, the changes are likely to support the continued growth of insurance ABS.
The new system would introduce more sophisticated solvency requirements for insurers, in order to guarantee that they have sufficient capital to withstand adverse events, such as floods, storms or big car accidents. This will help to increase their financial soundness.
Currently, EU solvency requirements cover only insurance risks. Under the new framework, insurers would be required to hold capital also against market risk (such as a fall in the value of an insurer's investments), credit risk (when debt obligations are not met) and operational risk (malpractice or system failure). These types of risk pose material threats to insurers' solvency but are not covered by the current EU system, said the EU Commission.
According to the commission, the current draft, released on July 10, of the Solvency II framework recognizes the economic substance of insurance activity and focuses on risk and the management of risk. It said that securitizations in particular, as well as other risk mitigation techniques, such as reinsurance and derivatives, could be useful tools for managing risk exposures. The new solvency regime will allow insurers to use these techniques and to get commensurate solvency capital relief arising from the use of these capital market tools, provided that insurers can demonstrate that they understand the nature and limitations of such techniques, and provided that there is a real transfer of risk.
The European Securitization Forum (ESF) responded to the new changes last week and said that the outcome is one that the ESF has worked for during the past year through various advocacy initiatives with CEIOPS and the EU Commission. "The Draft Solvency II Framework Directive constitutes a milestone for both the insurance and securitization industries, as it will update the current obsolete regulatory capital regime for insurance and reinsurance companies and will create new opportunities for insurance securitization," said Rick Watson, managing director and head of the ESF. He said that the actual technical details of the new regime for securitization and derivatives as risk mitigation techniques will be hammered out in the implementing directives, and the ESF will continue monitoring these developments through its Solvency II Working Group.
The EU Commission said that after an 18-month adjustment period beginning in 2010, it plans to have the new system in operation by 2012, which will apply to all insurance companies with premium income of more than 5 million ($6.89 million) per year. Watson added that he felt the new system will encourage more active balance-sheet management. This is expected to open the market up by allowing insurers to increase the amount of products now offered, which will free up capacity and offer competitive pricing and limit counterparty risks, Watson said.
"On the investor side," he added, "insurance securitization will provide an important new asset class for sophisticated CDO investors, since insurance risk is not significantly correlated with credit risk in their existing positions."
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