Luca Tres reframes solvency through a corporate finance lens, redefining capital optimisation and insurance derisking strategies
"In finance, companies don't blow up because things go wrong. They blow up because management believed they couldn't." – Not a quote from Nassem Nicholas Taleb, but he'd approve.
Or put less elegantly, but equally effectively: "Everyone has a plan until they get punched in the mouth." – Mike Tyson
Walk through any industry conference today, and you'll hear the same line, delivered with serene confidence by stakeholders cocooned in high solvency ratios: "The industry is well-capitalised."
Of course it is. Solvency II ratios across Europe often exceed 200%, depending on the data cut. Boards celebrate "fortress capital". Analysts echo the message. Rating agencies enshrine it. Press releases carefully sprinkle in the comfort phrases "robust capital position" and "strong solvency ratio". But comfort is a dangerous drug. When high capital becomes a business model rather than a consequence, the system stops seeing reality.
Consider a recent example: a global composite insurer with a group solvency ratio above 200%. Solid fundamentals, a comfortable growth trajectory – yet its quarterly solvency ratio came in 4 points below market expectations. 4 points, not 40. Yet, some stakeholders felt the need to devote their attention on the "solvency below expectations". The system is often conditioned to hyperventilate at the hint of capital erosion.
The pathology of excess capital
Too much capital creates its own pathology. It depresses return on equity and encourages management to treat volatility as trivial. Excess capital signals to regulators that the firm can absorb more than it should, while convincing analysts to treat stability as permanent. Too much capital can become an addictive comfort. Let's also remember that capital is always cheapest when you don't need it, and becomes infinitely expensive the moment you do.
This is where remote hedging enters. Capital raises the mean; hedging reshapes the tail. These protections exist not to speculate, but to preserve flexibility – from forced recapitalisation to avoiding being cornered during market-wide stress. You do not buy protection for what you expect. You buy it for what you cannot predict and cannot afford.
Hedging too close to the money is a profit trap. It addresses noise, not risk: daily market moves, short-term earnings volatility or quarter-end smoothing. Hedging them sterilises optionality and burns material expected profit. You pay for convexity you should not need.
Remote, deep out-of-the-money protection is different. It is inexpensive, shields against solvency threats, lowers the cost of capital and preserves spread income and optionality in ordinary markets. In short, it protects resilience while maximising shareholder value.
The option architecture of insurance
Robert C. Merton's 1974 model offers a powerful way to think about a firm's balance sheet. Here a simplified explanation of its core intuition: the firm's assets are the underlying reality; equity is whatever remains after liabilities are paid. In this framework, equity behaves like a call option on the firm's assets, with a strike equal to the value of its liabilities.
If assets end up above that level, shareholders keep the excess. If not, equity is wiped out. Looked at from the other side, liabilities resemble a risk-free bond combined with a short put on the firm's assets (the put option's premium represents the credit spread component over risk free). Default occurs when that put finishes in the money – when assets fall below liabilities. The appeal of this framing is its clarity: upside belongs to shareholders, downside is capped by limited liability.
Clean, symmetric and intuitive. Insurance breaks this symmetry, though. Two distortions dominate:
Regulatory coercion. Shareholders cannot simply walk away at the strike. Regulators can – and do – force capital injections, recovery plans, portfolio rebalancing, dividend suspensions or transfer of control long before economic insolvency. And they begin to take actions well before the solvency approaches the danger zone. This asymmetry is often misunderstood.
Dynamic liabilities. Life insurers' obligations shift with interest rates, spreads, longevity, lapses and policyholder behaviour. During stress, the effective strike – the point at which solvency pressure accelerates – moves against the firm. Solvency depletion often stems from assumption shocks, not realised losses. Strike moves. Trigger moves. And again, this does not happen in a linear manner – anticipating ruptures is impossible when getting close to the strike.
As a result, an insurer's equity could be best thought of as a call on the firm's assets, impaired by an embedded put at the early-regulatory intervention threshold (roughly at 120-140% of solvency capital requirements or SCR). Above this strike, equity behaves like a standard call option, but once breached, shareholder autonomy is curtailed. This framework can be refined further. For example, the embedded put's payoff might be capped – a "put spread" – reflecting that in extreme scenarios shareholders will walk away. Reputational factors, however, may invalidate this reasoning, especially for local subsidiaries of international groups. Alternatively, we could further refine the framework by imagining multiple smaller puts adjusting the slope of the payoff depending on solvency level.
Either way, these refinements do not alter the strategic insight: the embedded put defines the corridor where post-stress solvency and management decisions are most critical. This view has clear implications for risk management, capital allocation and hedging strategy.
Solvency as a regulatory regime indicator
Solvency is not just a measurement – it can also be seen as a regulatory regime indicator.
To be very clear, each situation is institution-specific, and supervisory dialogue evolves continuously rather than through mechanical triggers. Still, certain solvency ranges tend to be associated with distinct supervisory stances. Above 200% SCR, regulators are relaxed, and, within the theoretical valuation framework, all the benefits of optionality flow freely. At around 140-160% SCR, supervisory dialogue intensifies, model sensitivities are scrutinised, and dividend restrictions start to appear. At 120-140% SCR, proactive intervention begins: portfolio adjustments, de-risking, dividend restrictions and capital injections. At 100% SCR, hard recovery measures take control.
If risk managers think in deltas, gammas and vegas, regulators and, often, the markets, tend to think in cliffs. Thresholds produce discontinuities, not smooth curves. Every move within this corridor matters disproportionately. Small missteps are amplified, and both the cost of capital and exposure to volatility change abruptly.
Let's also not underestimate how procyclical solvency regimes are. Constraints often loosen in bull markets, just as the risks quietly accumulate near the cliff. When stress arrives, buffers are tightened and add-ons imposed at the worst possible moment – when capital is scarce, volatility is high and optionality has already collapsed.
Vega, gamma, and why volatility hurts
For derivatives aficionados, the options-based framework can be expanded using the Greeks: vega and gamma lie at the heart of an insurer's optionality and hedging decisions.
Vega measures how much the value of an option changes when market uncertainty – i.e., volatility – changes. Gamma measures how quickly delta (the sensitivity of the option's value to changes in the underlying asset) changes; in other words, gamma captures convexity or acceleration of the payoff.
Think of an insurer's equity as a call option on assets, with an embedded regulatory put. Even in profitable scenarios, this put creates a generally negative vega position: higher volatility reduces the value of equity. More importantly however, as the firm approaches the "regulatory put strike", both gamma and vega become increasingly negative.
A highly negative vega means that a small increase in volatility can have a large negative impact on equity value, confirming that insurers near regulatory thresholds are particularly vulnerable. Similarly, a negative gamma implies that small asset losses near critical thresholds can quickly escalate, turning minor shocks into major solvency reductions.
The implication for risk management is straightforward: volatility management is not about flattening day-to-day fluctuations. It is about preserving the shape of the equity payoff and hedging precisely where it matters. The corridor around 130-150% SCR is where volatility has a disproportionately negative effect. Hedging at-the-money may destroy optionality; managing volatility where it truly matters ensures capital resilience when it is most needed.
Remote hedging as strategic advantage
The corridor around 130-140% SCR is where leverage, regulatory intervention and volatility interact most sharply. Correlations can spike, interest rate shocks amplify and capital costs escalate rapidly. Policyholder behaviours may synchronise, turning small disturbances into systemic stress. Management's challenge is twofold: to shape the convexity of solvency – managing the non-linear amplification of shocks – while simultaneously ensuring resilience by focusing precisely on this critical interval. By doing so, the firm preserves optionality, safeguards capital and maintains the flexibility to act decisively under stress.
This is precisely where remote hedges come into play. They allow insurers to pre-fund protection in the tail, ensuring that shocks within this corridor are absorbed without triggering forced recapitalisation or eroding strategic optionality. By focusing on the extreme outcomes rather than daily noise, remote hedging transforms the corridor from a zone of vulnerability into a region of controllable risk.
Remote hedges are subtle, deep and cost-effective. They do not attempt to neutralise minor daily fluctuations; rather, they protect the firm from regime shifts that could otherwise trigger recapitalisation, shrink optionality or erode returns. While near-the-money hedging addresses market noise, remote hedging addresses the tail – the very region where regulatory intervention and balance sheet fragility collide. By protecting this interval, insurers preserve spread income, reduce the chances of forced de-risking and maintain strategic flexibility across stress scenarios.
Capital raises the mean, remote hedging reshapes the tail. This is the art of modern insurance: the discipline to allocate capital where it earns, and protection where it matters most.
Part two of this article, published next week, will discuss the forms of remote protection, the importance of engaging stakeholders in these concepts – and why this discussion is so important right now
Luca Tres is head of EMEA Strategic Risk and Capital Life solutions at Guy Carpenter. Email: [email protected]