Risk-mitigation techniques (Solvency II)
Conditions under which reinsurance, derivatives and securitizations can reduce the SCR: effective transfer, legal certainty, allowance for basis risk.
A property insurer that buys EUR 200 million of catastrophe cover does not get EUR 200 million less capital. It gets what the standard formula agrees to recognize. Articles 208 to 215 of Delegated Regulation (EU) 2015/35 define the admitted risk-mitigation techniques: reinsurance, securitization through special purpose vehicles, derivatives, financial guarantees. Each has to pass several tests. The transfer of risk must be effective, in economic substance and not just in the form of the contract. It must be legally certain, enforceable in every jurisdiction concerned. Basis risk must be measured and taken into account: a parametric cover that pays from an index, while the loss is measured on the portfolio, does not cover everything, and the capital relief is reduced accordingly. The credit risk taken on the counterparty, finally, enters the default module, which nibbles at the capital saving. A cover that expires before the end of the twelve-month shock horizon is treated with reserve. The rules weigh on the design of the programs themselves, and reinsurers know how to adapt cover, with collateralized guarantees or limited termination clauses, so that it fits. Cat bond issuers, for their part, structure the vehicle so that the collateral is fully funded.
Home insurer with a gross 1-in-100 loss of EUR 600M. It buys a EUR 200M catastrophe cover above 400, paying on the portfolio loss. The SCR reduction is recognized at EUR 200M less the counterparty requirement on the reinsurer. If it replaces that contract with a parametric cat bond paying from an earthquake's magnitude, the real loss can exceed 400 without the index triggering: the supervisor accepts only a fraction of the relief, in proportion to the estimated basis risk.
risk-mitigation techniques, Solvency II risk mitigation, effective risk transfer, basis risk recognition, risk mitigation capital relief
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