How the Italian market is dealing with mass lapse reinsurance

The Russian invasion of Ukraine. The ensuing energy crisis. Rising inflation. The ECB’s quantitative tightening. And worsening economic and financial uncertainty, intensified by the Israeli-Palestinian conflict and the Suez Canal crisis.

In the last few years, global conditions have radically affected the financial variables that influence the insurance sector.

In the life insurance business, the sudden increase in interest rates improved companies’ solvency, reducing the value of the best estimate liabilities (BEL) for the discounting component. But the same increase in rates led to the depreciation of government bonds held by companies. It progressively determined the absorption of a large part of the capital gains on investment portfolios. And it finally led to the emergence of significant latent capital losses.

Life insurance companies’ vulnerability to the risk of “massive” redemptions (lapse risk) has led to an increase in liquidity risk, requiring greater capital absorption.

The Italian insurance market has a higher exposure to lapse risk than the European average. This is mainly because of the higher proportion of redeemable life contracts, the reduced penalties in the event of early contract redemption, and the tax regime applicable to life insurance.

Life liabilities, measured according to EIOPA methodologies, show a high vulnerability to liquidity risk, because all best-estimate reserves relate to products with a surrender option.

EIOPA, in its document on methodological principles for liquidity stress testing, ranks the best estimate reserves of insurance products according to the degree of contractual and tax penalties. It assigns a high vulnerability to products with no penalty, a medium-high vulnerability to products with penalties, and a zero vulnerability to products with no surrender option (see EIOPA report on insurers’ asset and liability management, December 2019).

To cope with these tensions, in the last two years, companies have resorted to capital strengthening operations (for a total of EUR2,202 million in 2022 alone, IVASS data), including through a significant share of subordinated liability issuance. And they’ve drawn on the reinsurance instrument, which, in addition to allowing the transfer of risks, determines effects in terms of capital absorption.

Traditionally, the Italian reinsurance market has a risk profile focused on non-life lines of business. Reinsurance cessions mainly concern non-life lines of business (96% of ceded premiums) and are generally implemented through non-proportional treaties.

But since the second half of 2022, demand for mass lapse reinsurance has increased in the life insurance sector.

The solutions identified by the market involve transferring the risk arising from an increase in surrenders exceeding the assumptions used in the BEL calculation to the reinsurer.

Treaty wordings specify that the reinsurer will compensate the ceding company, within certain thresholds, the amounts equivalent to the negative effects on its own funds. The amount is calculated based on the difference between the observed increased rate of surrenders, exceeding a predefined threshold (known as the attachment point), and that used to calculate the BEL.

The treaty operates up to a maximum level of the observed redemption rate, called the detachment point.

The attachment point in the stressed scenario, with respect to the central BEL scenario, is set at a redemption rate which, according to the assessments of the individual companies, can guarantee an effective transfer of risk, generally between 15% and 17.5%.

The detachment point is generally equal to the frequency of the mass lapse scenario of the standard formula, ie the instantaneous termination of 40% of the policies in force at the time of the BEL calculation.

IVASS has scrutinised these contracts to verify the adequacy of the proposed solutions with the regulatory framework and the EIOPA Opinion of 9 July 2021. They looked at the effective transfer of risk and its consistency in terms of benefits on capital absorption.

IVASS wants to check the consistency between the method used to calculate the reinsurance benefit and the assumptions underlying the calculation of the BEL and SCR lapse. It also checks that the attachment/detachment thresholds are based on realistic surrender frequency increase assumptions with respect to the company's portfolio. The assessment is to make sure the treaty mitigates the volatility of the Solvency ratio even in difficult situations, consistent with the thresholds defined by the companies in the Risk Appetite Framework.