How does traditional reinsurance reduce required capital?

How does traditional reinsurance reduce required capital? This is mentioned under section 6 of chapter 14 (capital management).

I consider required capital to be the SCR and MCR.

I thought that traditional reinsurance increases assets and hence available capital under Solvency II where reinsurance recoveries are treated as assets.

I fail to see how they reduce the required capital.

 

The insurer purchases reinsurance. The addition of a reinsurance recoverable (an asset) is broadly offset by a reduction in the insurer's cash balance: own funds are therefore broadly unchanged (ignoring reinsurer profit loadings).
However, the insurer no longer needs to hold capital against the risk(s) that the reinsurer has now taken, which reduces the level of required capital. The insurer may need to hold reinsurance counterparty risk capital if the transaction is not collateralised.

 

hi, the solution to Q11.1 is quite helpful with this. My answer to a possible exam question like this would be that BELs would increase due to the recoveries (instead of increasing the assets). I suppose it's ok to say so, since impact and logic is the same?

 

Recoveries would not increase BEL. It would reduce BEL (net of reinsurance). I don't in-principle see why you would lose marks unless (potentially) if the question asked you to comment on the impact on the component parts of the SII balance sheet.

 

Thanks for your response. Did mean to write BELs would decrease indeed

 

Hi Christos - thanks with question 11.1. Its solution states that the BEL will not change. I think this is because reinsurance is covered on the asset side and so doesn't change the BEL calculation which is the PV of future [benefits + expenses - premiums).

The recoveries (after allowing for default risk) will increase the asset side. However this may be offset by the reinsurance premium as it includes a profit margim. So overall, own funds might reduce slightly due to the profit margin loaded into the reinsurance premium.

What reduces is the SCR - however there will be an offset from an increase to some extent by the additional counterparty default risk of the reinsurer.

Hope this helps!