With implementation deadlines for Solvency II fast approaching, Sam Barrett looks at how these are driving market developments and insurer action.
With 2012 fast approaching, preparations for Solvency II are well underway in the insurance industry. Although the final regulatory detail is yet to be agreed, firms are busy assessing the requirements, implementing change and examining their business models in light of the new regime. "Last year was about understanding the requirements and planning," says Greg Shepherd, director of risk management at Markel International. "It's a tight schedule, so 2010 has got to be a year of achievement."
While firms are focusing on what they need to do to achieve compliance under Solvency II, one area causing particular concern is the calibrations being used to determine capital requirements. Many of these have increased significantly in the third, and final, wave of draft advice from the Committee of European Insurance and Occupational Pensions Supervisors.
For example, in its response to the draft advice, the Association of British Insurers highlighted that proposed calibrations for non-life underwriting risk have increased by at least 35%, adding that this is overly prudent and would most likely lead to higher premiums for policyholders. These calibrations, it said, would result in a rise in the solvency capital requirement of around 63% for general insurers.
Although an understandable reaction to the current financial crisis and problems encountered in the banking sector, this conservatism is far from welcome in the insurance industry. "There was talk of well-managed insurers being able to secure a reduction in capital as a result of Solvency II but this seems much less likely now," says George Stratford, financial director at Allianz Insurance. "The figures for the standard model have gone up a lot."
Luke Savage, finance director at Lloyd's, is also concerned about the change. "Some increases are justified," he says. "Recent experience has shown that equities are more volatile, so increases to reflect this are fine. But in other areas it feels like they've decided to turn the dials up a little just to play safe."
He is not alone in feeling that some of the increases aren't justified. John Hume, chief finance officer at XL Re, points to the initial efforts undertaken to determine requirements. "A lot of work was done on the calibration levels and they were thought to be set at a reasonable level," he says. "It's difficult to see where the parameter changes have come from." By way of an example, he says that some of the volatility factors for reinsurance have doubled, which would force insurers to hold significantly more capital.
Unsurprisingly, many would like to see these requirements revised downwards to more accurately reflect the risks involved. For instance, Mr Savage says: "The present situation is becoming almost farcical. If you don't have sufficient risk management in place then you should have more capital, but there's a difference between providing an incentive to improve risk management and a number that's so high it's prohibitive. The European Commission didn't start out with the view that the insurance industry is undercapitalised."
Opinion is split as to whether the requirements will be scaled back. Many have highlighted this concern in their response to CEIOPS' third wave but, with tight deadlines in the run up to 2012, a revision may be unlikely. Furthermore, against the current backdrop of prudence, relaxing the requirements might not be palatable. Mr Stratford, for one, isn't convinced any downward movement will occur. "It's difficult to see any political will to reduce the capital requirements," he explains. "The government's had to bail out the banks, so to have an insurer come into difficulty after Solvency II comes into force would be unthinkable."
Others believe the regulators will have to revise these levels, as leaving them in their current form would have serious ramifications for the insurance industry. Not only could they prompt premium increases — clearly not an outcome the regulators intended — but they might, ironically, affect the viability of the insurers themselves. "If they leave the requirements at this level it would bankrupt a large proportion of insurers in the European Union," warns Margarita von Tautphoeus, head of Solvency II consulting at Munich Re.
Internal model incentive
For many insurers, especially the larger ones and those with multiple lines of business, the higher requirements make it even more important to achieve internal model approval. Without this, they could find they need to hold such a large amount of capital it restricts their business activities.
But, according to Financial Services Authority figures, of the 460 firms it contacted, less than a quarter — 99 firms — intend to adopt an internal model. Of these, there are eight composites, 63 general and 28 life offices. So far, four have been involved in a pilot scheme that began in late 2009 and the remainder will be phased into the pre-application process between April and October 2010.
Although this indicates a significant number of firms will adopt the standard model, Mr Savage doesn't believe it will affect all to the same degree. He comments: "Building an internal model requires a lot of work, which might be a greater burden for smaller players than adopting the standard model. Additionally, as the detail within the standard model affects the larger players more, the small niche insurers might be relatively better off with the standard model anyway."
Given both the possibility of greater capital requirements and the likelihood of heightened transparency, the role of reinsurance could also change. Ms von Tautphoeus expects Solvency II to give insurers greater clarity about their risk exposure, which could lead to changes in reinsurance buying strategies. "If a company is strongly undercapitalised, this is invisible at the moment. Once they have a clearer picture they might see that one side of their business is too dominant and wish to harmonise the risk capital amounts. This could be a trigger for buying more reinsurance," she explains.
As well as providing support to the less well-capitalised insurers, reinsurance could become a more important part of other insurers' risk management strategies too. If the capital levels currently proposed aren't significantly scaled back then insurers may find themselves forced to pass risk to the reinsurers. "Under the proposals, reinsurance becomes a much more attractive alternative to equity investment or issuing debt," adds Ms von Tautphoeus.
As well as getting to grips with what the new regulations will involve in terms of paperwork, infrastructure and capital, many insurers are examining how it could affect their business model and the way they conduct business. Mr Shepherd believes there will be movement in the market as insurers prepare for the regime's introduction. "I expect there will be some consolidation as insurers look to deal with one rather than several regulators," he says.
In the past year there has already been considerable movement by insurers, with Brit Insurance decamping to the Netherlands, Beazley redomiciling to Dublin and RSA setting up a reinsurance company in Dublin after exploring a wholesale move out of the UK. As well as companies exiting the UK, XL Capital decided to move its legal domicile from Bermuda in January, choosing Dublin rather than the UK as its new home.
However, although Solvency II is looming and will make relocating across the EU easier, these moves aren't necessarily linked to the new regulatory regime. Ms von Tautphoeus says: "Where insurers are redomiciling it's about company structure rather than different regulatory checks," she says. Tax also plays a part, especially as lower equity returns mean every percentage point that can be saved on tax is essential. It's not only the lower rates that are attractive though. With a general election imminent, there's a lack of certainty about future levels of taxation in the UK.
To illustrate the tax burden, figures from the ABI found that UK insurers paid only 8.4% less corporation tax in 2008/2009 than the previous tax year, in spite of a 39% fall for the financial services sector as a whole. Its research also found that 80% of insurance executives believed there would be a reduction in the number of insurance firms based in the UK if the government didn't improve competitiveness.
Certainly, for one of last year's movers, Brit Insurance, Solvency II had little bearing on its decision to move its holding company from the UK to the Netherlands. "We'd been considering the organisation of the group for the last 10 years and this move is really about consistency and certainty around tax and regulation," says Toby Ducker, programme director for Solvency II at Brit Insurance. "We'd been liaising with the UK government for some time but we were unable to get reassurance about consistency."
While Solvency II might not be the driver behind such relocations, many believe the new capital regime will have greater influence on the shape of the market as 2012 approaches. Although the rules are yet to be finalised, the current interpretation of them suggests there are disadvantages to having a large number of subsidiaries within a company structure. Ms von Tautphoeus explains: "The classification of these subsidiary companies is much more conservative, giving a lot less diversification benefit." If this doesn't change, firms will restructure to create more regulation-friendly entities.
As well as forcing firms to examine their corporate structures, Solvency II is also likely to have broader ramifications for the market. In particular, consolidation is a distinct possibility as some firms find the new requirements too onerous or others become increasingly acquisitive as they look to balance the lines they write. For the acquisitive folk at QBE this is good news. "It will make acquiring businesses easier," says Justin Skinner, head of enterprise risk management at QBE. "For smaller players, building a capital model will be onerous. Ultimately, where reinsurance isn't an option, this will mean some will be forced out of the market."
So, although some shrinkage is anticipated, the new regulatory regime could also nurture new players. Mr Ducker believes there will be opportunities for start-ups. "When there's a major change in the market that forces consolidation you often see new businesses emerging as the principals of former companies seek out new opportunities. There will be gaps in the market once Solvency II comes into force," he says. Additionally, although new players will obviously need to meet the regulatory requirements, achieving compliance may be less of an ordeal than for some of the more well-established companies due to them being unhampered by legacy systems.
As well as focusing on what needs to be done to achieve compliance with Solvency II, insurers are also considering the broader picture. Although the new regime creates a level playing field for insurers operating in EU countries, the same won't be true for other markets. Mr Shepherd explains: "If the capital requirements for EU insurers are higher than for those in the US, it could make it more difficult to compete for international business."
While the US is set to introduce a new regulatory framework with similar standards to Solvency II at some point, this could be several years down the line as it grapples with the different regulation in each of its 51 states. Despite this risk of increased competition, Mr Savage sees the situation more positively. For him, having Solvency II in place will mean global standards are raised. "Solvency II will become a standard around the world," he says. "Other countries, such as the US and Bermuda, will have to raise their game to compete. This will create a bigger level playing field."
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