When the First Life Assurance Directive was passed in 1979, it spelled the end for new composite insurers. Steven McEwan explains why the advent of Solvency II may bring life and general insurance back in contact again.
Since the implementation of the First Life Assurance Directive passed in the European Union in 1979, it has not been possible for any new insurers to be authorised in the EU to carry on both long-term insurance (also known as life insurance) and non-life insurance (also known as general insurance).
Insurers that were already carrying on both types of insurance — known as composite insurers — are permitted to continue to do so, and other exceptions exist for insurers carrying on only reinsurance business, and insurers authorised to carry on accident and sickness business. A member of Lloyd's can be a member of both a life syndicate and a non-life syndicate, and the same managing agent can manage both life and non-life syndicates.
The prohibition on new composite insurers was principally intended to protect life insurance policyholders, whose policies might be in place over many years, from being adversely affected as a result of the more volatile shorter-term risks incurred by non-life insurers.
For this reason, composite insurers are required to manage and report on their life insurance business separately from non-life business, and all life insurers are required to identify the assets of life insurance business (the long-term insurance fund) separately from other assets (the shareholders' fund).
The result of the prohibition on new composite insurers is a noticeable separation of the life insurance sector from the non-life insurance sector. Although life insurers and non-life insurers still have many features in common, there are distinct differences in their respective approaches in several areas.
These areas include capital management, reserving, reinsurance, asset and liability management strategies and run-off following closure to new business. Each of these areas is considered later in this article.
The differences have been amplified over time as the individuals who formulate business strategies for insurers have (with some notable exceptions) usually spent their careers serving either the life sector or the non-life sector but not both. This is particularly the case for actuaries, who must select one or other sector at the time of their training.
The introduction of Solvency II, however, is likely to bring the two sectors closer together again. This is in part because the regulation of all insurers will be subject to a single directive, rather than separate directives for life insurers, non-life insurers and pure reinsurers. There are also some specific features of Solvency II, such as discounting of technical provisions, where practices which have differed between the two sectors will now operate in a similar way for insurers in both sectors.
It is interesting to consider how each of the five areas identified above affect the life and non-life sectors. So, for example, the capital requirements under EU directives are significantly different for life insurers and non-life insurers.
For life insurers, the focus is mainly on the amount of technical provisions, while for non-life insurers the calculation is based on premiums and claims. In the UK, in 2004, the Financial Services Authority introduced the individual capital adequacy regime to apply a more risk-sensitive approach to both life and non-life insurers, and a similar approach will apply under Solvency II, bringing the sectors closer together throughout the EU.
In meeting capital requirements, the life insurance sector has been more assertive in developing innovative forms of eligible capital, including contingent loans and greater use of financial reinsurance. Some of the forms that have been developed, particularly those based on emerging surplus, are unlikely to be eligible under Solvency II, forcing many life insurers to refocus their approach to capital management. The possibility, with regulatory approval, of using guarantees and letters of credit as capital may partly fill the gap and should also be an incentive for non-life insurers to reconsider their approach here.
With regards reserving, life insurers have typically adopted more intricate reserving practices than non-life insurers, mainly because they are permitted to discount technical provisions whereas, with some exceptions, UK non-life insurers are currently not permitted to discount technical provisions for regulatory purposes.
This has led, for example, to recognition by life insurers of a liquidity premium when reserving for illiquid liabilities. Solvency II will allow non-life insurers to discount their liabilities, and even, it is currently proposed, to recognise a liquidity premium in appropriate circumstances.
Elsewhere, non-life insurers have typically been more nimble in the use of reinsurance arrangements than life insurers, particularly in the Lloyd's market.
This is partly because the investment element of life insurance policies makes credit risk a more significant issue in the life sector and the typically shorter risk period of non-life insurance policies also makes it important to reinsure them quickly. Non-life insurers have also made more use of innovative reinsurance techniques to access capital markets such as catastrophe bonds, side car transactions and industry loss warranties, all of which could be useful tools for life insurers.
Longer periods of time
The long-term nature of life insurance policies means that assets are held for longer periods of time, and this has enabled life insurers to make extensive use of derivatives to shape investment risk and return. Similarly, derivatives can be used to control exposures to factors which affect liabilities, such as inflation and interest rates.
There is less need for these techniques in the non-life sector, given the shorter term of the liabilities and the absence of discounting, though its introduction of discounting and more intense capital modelling under Solvency II may provide an incentive for non-life insurers to reconsider the use of derivatives to ensure most effective management of assets and liabilities.
Finally, in the non-life sector, insurance run-off has become a specialist industry in itself, with an array of established practices and expert service providers. The negotiating and run-off management skills of the industry participants are complemented by the legal technique of the solvent scheme of arrangement, under which claims may be compromised by court order. This technique has been used on numerous occasions in the non-life sector, but much more rarely in the life insurance sector, though it offers a valuable method of resolving problematic exposures such as guarantees built into with-profits policies, for which it has been used on two occasions.
There is considerable scope for life insurance and non-life insurance sectors to be a fertile source of ideas and expertise for one another. Each could gain from taking a more active interest in the activities of the other.
Steven McEwan is Of Counsel at Hogan Lovells International
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