Further doubt cast on the need for Solvency II

Further doubt cast on the need for Solvency II

One of the principle stated aims of Solvency II and similar regulatory initiatives around the world – for example the NAIC’s Solvency Modernization project and Bermuda’s equivalence project – is to make sure that property/casualty insurers remain solvent after a big catastrophe. In simple terms, that means making insurers holder higher capital reserves than they used to.

Until recently, few voices have been raised to question this received wisdom. But increasingly, property/casualty industry leaders are asking what Solvency II is really for and whether it will be worth the massive investment in time and resources. 

After all, the insurance industry has withstood the financial crisis without Solvency II. It has also proved its resilience to expensive natural disasters over and over again since 9/11.

Now new academic research challenges the regulators’ implied view that mega catastrophes are potentially devastating for insurers.
A paper from Professor Jens Hagendorff, Martin Currie Professor in Finance & Investment at The University of Edinburgh Business School and Bjoern Hagendorff and Kevin Keasey at the University of Leeds examines the stock returns of US property-liability (P&L) insurers in response to a series of nineteen large US natural catastrophes (mega-catastrophes) spanning from 1996 to 2010. 

Previous studies on the market valuation effects of catastrophes have tended to focus on a single event and have reached conflicting conclusions over whether the value effect of mega-catastrophes on insurers is negative (to reflect underwriting losses) or positive (to reflect the prospect of hardening insurance markets and higher premiums). 

In their paper, Professor Hagendorff et al show that mega-catastrophes do cause negative market returns for insurers, driven by insurers with loss exposure to mega-catastrophes. But crucially, and in contrast to the market hardening view, they do not find that insurers without loss exposure experience valuation gains, unless they operate in the least competitive geographic markets. Overall, the average valuation losses linked to mega-catastrophes are of moderate magnitude. 

“This testifies to the effectiveness of insurance as an efficient mechanism to share large catastrophe risks,” the report concludes.
Summing up, the academics acknowledge that mega-catastrophes, low-frequency but high-severity events, pose great financial risks to insurance firms. Underwriting losses from mega-catastrophes are often large relative to capital reserves. Further, mega-catastrophes are extremely difficult to predict which means they cannot be fully anticipated in premium pricing. 

However, mega-catastrophes may also lead to an increase in consumer and institutional demand for catastrophe risk insurance and lead to premium increases in the catastrophe risk market.

Previous empirical work that focused on a single catastrophe event report results that are consistent with either of these explanations, they say. By examining a cross-section of 19 mega-catastrophes between 1996 and 2010, however, they shed more light on the “simple” question: what are the expected performance effects of mega-catastrophes on insurance firms?

“Overall, our results show that mega-catastrophes have negative performance implications for insurers. However, the magnitude of share price losses during the examination period is moderate on average. We interpret this as evidence that the expected performance implications of mega catastrophes are by no means devastating for insurers.”

Acknowledging that the report’s results are based on US insurers only (and that it remains to be tested whether similar results hold for non-US insurers), the academics say the results provide evidence that insurers are in a position to absorb the losses caused by mega-catastrophes and that mega catastrophes do not threaten the solvency of insurers. 

“Consequently, our results challenge the appropriateness of regulatory initiatives (such as the NAIC’s Solvency Modernisation Initiative or Solvency II) that will require insurance firms to hold substantially higher capital reserves in order to remain solvent following a catastrophe event. 

“While the results reported in this paper have little to say about the desirability of higher capital holdings against other types of underwriting risk, they show that the expected financial losses linked to natural catastrophes for US insurers do not appear of the magnitude to justify substantially higher capital holdings against catastrophe underwriting risk.”

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