The European insurance industry is becoming increasingly aware that the Solvency II regulations, which are scheduled to take effect as of January 1, 2013, will not only impose a different set of rules for the industry, but could also fundamentally alter the industry itself.
The problem begins with the word “industry;” there are actually two of them: the life, health, pensions and benefits insurers, and the non-life insurers. A growing number of analysts now believe that grouping them together under one set of regulations may be fundamentally unworkable.
Why are they so different? Chris Boggs, the IJ’s Director of Education and the head of its Academy of Insurance, explained it as follows: “P&C insurance operates on the basis of indemnification, returning the injured party, as closely as possible, to the same financial condition that existed prior to the loss or would have existed had no loss occurred (without unjust enrichment).
“Life insurance pays a face amount that may or may not have any relationship to what has been lost by the death of the person; the amount may have little or no basis in fact. Face amounts in life insurance are a function of the amount of coverage someone is willing to purchase and, to a much lesser extent, perceived need.”
Life insurance is fundamentally an investment, the death benefit, if the insured dies before the policy matures, is an add-on. As such, the rules regarding capital and risk for life insurers are more aligned with the regulations governing banks, than they are with the P&C insurers’ regulations.
Shirley Beglinger, a former managing director at Swiss Re, is an acknowledged expert in analyzing regulations and their effects, who has written widely on the subject. Asked “what’s going on with Solvency II,” she explained that it’s “basically addressed to the life insurance industry, as P&C (or non-life) is ‘too difficult’ for them [regulators] to understand.”
The rules “were written as the financial world was blowing up,” she said. They “anticipate a worst case scenario.” The life insurers were the principal driving force – through batteries of actuaries, accountants and lawyers – who shaped the Solvency II regulations.
Their principal concerns were heightened by the financial crisis, even though with the exception of AIG, the insurance industry was pretty much unscathed. The main thrust of Solvency II was to assure that there would be sufficient funds to continue to pay benefits, and annuities on policies, especially in light of Europe’s aging population, and the consequent strain on government pension schemes that virtually every country is faced with.
As a result the proposals are far more applicable to life insurers than P&C insurers, and may well introduce onerous requirements on the non-life industry that are neither wanted nor needed. Beglinger doesn’t mince words: “They [life insurance ‘geeks’] were convinced that they could make it [Solvency II] work.” However, the rules are “unworkable and impractical [for non-life insurers], as they are designed around the life [insurance policy] renewals, investment yields and pensions.”
Non-life insurers are seriously questioning what effect(s) Solvency II will have on how they conduct their business. Foremost concerns involve capital requirements, reinsurance and captives.
Swiss Re’s analysis of Solvency II points out: Whereas Solvency I does not explicitly consider company specific exposures like natural catastrophe risk and market risk, they are considered by Solvency II and as such may lead to a significant increase in the total solvency capital requirements (SCR). On the other hand, a well-diversified asset and liability portfolio can lead to diversification effects, which lower the total SCR.”
The dispute over captives pits those who want them to be under a less rigorous regime than the rest of the industry, arguing that they are special purpose vehicles, backed by the companies who established them. The opposite point of view points out that many captives also have liabilities to third parties, who may be at risk, if they aren’t sufficiently protected.
There are also questions as to what role reinsurance, as purchased by primary carriers, should play in calculating their capital requirements. Beglinger noted that in the case of “non-proportional reinsurance, the formula for non-life capital mitigation only counts the premium(s) paid for reinsurance.”
At this point the provisions of Solvency II effectively divide the P&C insurers into two classes. There are two kinds of capital models upon which companies can calculate their SCR’s. This splits off very large companies from their smaller brethren, with the latter being most at risk of not being able to meet the SCR’s mandated by Solvency II.
Lloyd’s Chief Financial Officer, Luke Savage, explained the difference in an earlier interview. “Under Solvency II there are two ways that you can calculate your capital. One is to use the standard formula, which is effectively kind of ‘haircutting’ your balance sheet.” This would penalize insurers for holding long term corporate bonds. “You’d actually be better off holding Greek government debt, rather the ‘AAA’ corporate.” He added that this hasn’t yet been finalized, and that it may well be “fixed.”
However, he continued, “the second way to count your capital is to completely put aside the standard formula, and instead use your own internal models.” This requires the approval of local, i.e. country, regulators. If approved, then you “calculate your capital based upon your model output.”
These types of models, used by practically all of the larger insurers, as well as Lloyd’s, enable them to “actually reflect the risks and the volatility of these instruments. In which case you’ll end up with an entirely appropriate capital charge, rather than an arbitrarily high one,” Savage said.
The models, however, don’t come cheap. “We’re spending something approaching around 250 million pounds [over $400 million] in preparing for Solvency II,” he said. Part of the cost is “getting our model approved.” In his opinion most other large insurers will be doing the same. Therefore, the “80/20 rule will probably apply.” In other words “the 20 largest insurers by percentage of number probably constitute 80 percent of the [total] insurance market balance sheet.”
Their financial power will therefore lessen the impact of Solvency II. In addition most of the 20 largest European insurers and reinsurers have operations in life and health, as well as P&C, so they basically have a foot in both camps.
The major impact will be on smaller companies. “Around 25 percent of nonlife companies are probably undercapitalized [under the proposed Solvency II regulations],” Beglinger said. She pointed to smaller mutuals, co-ops and similarly structured insurers, particularly in Germany and France, as examples. “Even though there is a 10-year ‘transition period’ in the omnibus act [the implementation procedures], by 2015 one out of four could be out of business.”
There are calls to further revise the rules, even though the last request for input, QIS 5, to the insurance industry was supposed to be the last questionnaire. Some of the problems were raised by the responses, and they are being considered.
At least one thing is certain, thanks in large part to analysts like Shirley Beglinger, Europe’s non-life insurers have developed an enhanced interest in the potential impact Solvency II may have on their business, especially the smaller companies – the 80 percent who may be forced out of business, or into mergers with larger companies as a result of its implementation.