Collateral management for reinsurance

In July 2020, Milliman professionals published the research report ‘Reinsurance as a capital management tool for life insurers.’ This report was written by our consultants Eamon Comerford, Paul Fulcher, Rosemary Maher and myself.

Capital management is an increasingly important topic for insurers as they look to find ways to manage their risks and the related capital requirements and to optimise their solvency balance sheets. Reinsurance is one of the key capital management tools available to insurers. The paper investigates common reinsurance strategies, along with new developments and innovative strategies that could be implemented by companies.

This blog post is the fifth in a series of posts about this research. Each one gives an overview of a section of the Milliman report.

Collateral

Many reinsurance transactions are collateral-backed to mitigate against counterparty default risk in respect of the reinsurer. The amount of collateral required to back a reinsurance transaction will depend on the type of reinsurance and the reinsurer’s creditworthiness. There are several different types of collateral which may be used to back reinsurance transactions, including:

  • Letters of credit
  • Funds withheld
  • Trust arrangements
  • Cash or other securities
  • Other assets, such as those that directly back the liabilities
  • Other third-party sureties

The Solvency II regulations outline various requirements that must be met for collateral arrangements to be recognised in the Solvency Capital Requirement (SCR) calculation. Some of the key requirements are that the:

  • Insurer should have access to the collateral assets in a timely manner in the event of default
  • Collateral should provide protection by being of sufficient credit quality and stable in value
  • Value of the collateral should not be materially dependent on the credit quality of the counterparty.

Collateral invested in fixed income assets can, for instance, be highly correlated with the credit risk of the counterparty. If this is the case, the collateral placed will not effectively mitigate the counterparty default risk. These requirements can be quite onerous in practice, further emphasising the need for careful consideration as part of the treaty negotiations and design.

Insurers should set strict limits and investment guidelines on the collateral account when financial investments are involved. Also, insurers should understand how any remaining uncollateralised exposure can move over time and under different possible scenarios.

It is often desirable by insurers and/or by regulators that collateralised assets do not leave the jurisdiction in which the insurer is domiciled. This is typically possible through the use of custodians operating in the insurer’s home territory.

Collateral management is a very important component of a reinsurance arrangement and is sometimes the most critical part, particularly for asset-intensive reinsurance such as a full risk reinsurance cover. Not only is collateral management an important part of obtaining regulatory approval, it is also important to maintain the effectiveness of the risk transfer because collateral can be used to reduce counterparty risk without restricting the balance sheet optimisation mechanism of the reinsurance cover.

Milliman research paper

The full research paper can be found on Milliman’s website here, where you can also find an executive summary version that notes some of the key highlights of the research and acts as a guide to the full paper.