Last week's consultation paper from the EU's insurance authority will help drive the industry in the right direction, argues Luca Tres
The European Insurance and Occupational Pensions Authority (Eiopa) last week published a comprehensive consultation paper, that dives deep into the mass lapse reinsurance market.
Following its release on 8 November, a client immediately rang me to ask my views. On hearing the question, I could not stop thinking about the recently wise words of Ajay Banga, president of the World Bank, during a leadership speech. And I quoted him: "Done is better than [only theoretically] perfect!".
For the aficionados of international life capital management topics, mass lapse reinsurance transactions have been a topic of keen debate since interest rates soared at the start of 2022. There are several reasons for this, but in particular the lack of a level playing field across European countries due to varying interpretations and implementations of the Solvency II framework across different jurisdictions. While Solvency II was designed to create a harmonised regulatory environment for insurance companies within the EU, significant differences exist in how member states apply the rules.
Eiopa has acknowledged these challenges several times and has called for greater convergence in regulatory practices to ensure a more consistent application of Solvency II. A lot of great work has been done already – and the mass lapse consultation paper is maintaining the momentum. Hence why, although not perfect, this Eiopa consultation is extremely valuable and helps drive the industry in the right direction.
As someone who has been entrenched in this sector, we cannot help but feel a sense of validation from this document. The guidelines laid out in this paper echo several battles of the recent past. Standing firm on principles very similar to today's Eiopa guidelines, even when the market was discussing more aggressive structures, was not easy and the temptation to "follow the flow" was there. So, allow me to say: dear Oscar Wilde, no, in capital management land, "the only way to get rid of a temptation is [NOT] to yield to it".
Now, onto some of the more technical content...
The risk window debate
Firstly, let us address the most contentious issue: the duration of the risk window. Eiopa opens the floor to a regulatory debate that has been simmering for quite some time. It presents two options – a risk window (ie. time length to calculate lapse on) longer than 12 months, or a 12-month rolling period – and asks for stakeholder feedback.
Eiopa admits that no transaction has happened with a risk window longer than 12 months. Additionally, it states: "One could argue that Solvency II is based on the risk of loss within a one-year time horizon and the concept of 'mass-lapse' refers an event consisting of a sudden but temporary increase of lapse rates, however without specifying any underlying event. And, secondly, this temporary increase of lapse rates should not be confused with the permanent increase of the lapses covered by the lapse up risk-module."
The document, while keeping the door open for market feedback on the two options, seems to provide some food for thought.
This aligns perfectly with the principles the market and Guy Carpenter has been advocating – the idea that a mass lapse event is a catastrophe event (unlike lapse up events) and should be confined to a one-year time horizon for consistency with the much wider Solvency II framework. For the record, there is a live real-world and very practical example of how mass lapse and lapse up shocks are different and have materially different dynamics and impacts.
Risk margin relief: a double-edged sword
They next point to address is risk margin relief or, how many years to include in the risk margin reduction calculation. Eiopa clarifies that this relief hinges on the ceding company's methodology and assumptions. And this is where things get interesting.
Obtaining risk margin relief in line with mass lapse treaty tenor is relatively straightforward. But the paper opens the door for cedants to argue for a longer risk-margin benefit (compared to the legal maturity of the contract), provided they can back it up with solid assumptions about renewal costs and market liquidity. Contrary to sound risk management practices, a small number of market players have pushed on the benefit calculations, calculating risk margins for the entire duration of their blocks, without deducting the full cost associated with it. It will be interesting to see how local supervisors approach this topic going forward.
Attachment points: a case-by-case basis
Another key issue to address is that of attachment points.
Eiopa has not provided a specific level for defining risk transfer but rather has confirmed the general guidelines provided previously. It would have been surprising for Eiopa to provide an absolute lapse level. This would have paved the way for simple arbitrage on low lapse portfolios. This also rightly allows local regulators to assess this on a case-by-case basis, acknowledging the diversity of products and risk levels.
As sensible as this sounds, it does however open the door to a potential but remote scenario, where this flexibility could lead to continued inconsistencies across jurisdictions.
Defining lapse: common good practices?
Eiopa's exploration of lapse definitions is another important area of focus. The principle relates to the potential existence of any basis risk resulting from lapse definitions. While many of the comments reflect sound practices, some do generate food for thought. For instance, some treaties exclude partial lapses from claims calculations. If a cedant's standard formula calculation excludes partial lapses (and the local supervisor has agreed to it), does it make sense to include them in the treaty? This could create a mismatch that leads to significant (positive) basis risk.
The paper also touches on other exclusions from the lapse definition, relating for instance (but not only) to internal switches and lapse-inducing campaigns. Eiopa rightly points out that these exclusions should fit within a cedant's risk management strategy, indirectly confirming the validity of the exclusion since both induced lapses, as well as internal product switches, do not negatively impact the company's own funds position.
Parameters in the treaty: avoiding binary pay-offs
Eiopa emphasises the need for an appropriate pay-out profile, cautioning against "binary" pay-offs. This is not just a concern for mass lapse, but is a recurring theme in non-proportional reinsurance.
We have seen this play out in the market. Not long ago, a market participant sought Guy Carpenter's views on a proposed structure. The premise? If lapses exceed 35% – a figure that not by chance also appears in Eiopa's paper – the reinsurer would cover all lapses from 0% to 35%. At first glance, one might think the potential payout could be substantial. Yet, the (obvious) reality is that the risk transfer in this scenario is minimal, insufficient frankly. It is a classic case of appearance versus reality. Needless to say, there was no further engagement beyond that call.
Risk notional definitions have been another discussion point: should the initial notional at the start of the market placement be used or the most recent one? Again, nothing new. Eiopa states that the structure needs to be consistent with the wider Solvency II and risk management framework. This confirms once again the validity of the currently employed structures.
High-water marks and rolling windows: a long-awaited confirmation
Eiopa's rejection of high-water mark clauses and endorsement of rolling risk windows is a breath of fresh air for those who have long argued for this.
Put simply, mass lapse events folding over 12 months could potentially not be captured by the treaty (hence reducing risk transfer) if the calculation window were to follow a fixed 12-month timeline (calendar year for instance). A rolling 12-month risk window can instead (all other things being appropriately structured) provide the necessary risk transfer.
The "high-water mark" clause is sometimes used where the treaty was only indemnifying the worst lapse wave during the treaty tenor (ie. after a first mass lapse payment, a second one would be paid only if worse than the previous one). As Eiopa states: "the high-water mark reduces risk transfer too much."
Termination options: a necessary caution
When looking at termination options for reinsurers, Eiopa highlights the link between ceding company creditworthiness and policyholder lapse behaviour. They caution against overly flexible reinsurer termination rights, which could materially impact risk transfer. Think about a clause that allows the reinsurer to terminate the treaty if the cedant's solvency ratio gets too close to 100%.
This is not surprising and has been common practice for some time.
A call to action
The Eiopa consultation paper is a significant development in the ongoing dialogue surrounding mass lapse reinsurance. While this is only a consultation paper, it provides valuable insights into the regulatory direction and offers a platform for industry feedback, with responses due by 7 February.
Of course, we will have to wait for the market reaction to the paper. However, as mentioned, done (now) is much better than (maybe) perfect in the future. And Eiopa's efforts to achieve convergence across supervisory interpretations are not only visible and extremely valuable, but are also very welcome in today's competitive landscape.
Luca Tres is head of EMEA Strategic Risk and Capital Life solutions at Guy Carpenter. Email: [email protected]