Evolution or Revolution? How Solvency II Will Change the Balance Between Reinsurance and ILS

The introduction of Solvency II has decreased regulatory frictions for insurance-linked securities (ILS) and thus redefined how insurance and reinsurance companies can use these instruments for coverage against natural catastrophe risk. We introduce a theoretical framework and run an empirical analysis to assess the potential impact of Solvency II on the market volume of ILS compared to traditional reinsurance. Our key model parameter captures all determinants of the relative attractiveness of these two risk mitigation instruments other than market prices. It is estimated by means of OLS, decomposed into a trend and cyclical component using the Hodrick-Prescott filter, and forecasted with an ARMA(3,3) model. We complement the resulting baseline prediction by a scenario analysis, the probabilities for which are based on a Gumbel distribution. Judging by our findings, we expect Solvency II to increase the volume of ILS to more than 24 percent of the global property-catastrophe reinsurance limit or approximately USD 101.14 billion by the end of 2018.