UK: Strategic Implications: Consequences And Opportunities Arising From Solvency II

Solvency II is the forthcoming risk based capital adequacy directive for European insurers. It is based on a ‘three pillar’ solvency supervisory regime akin to Basel II and seeks to introduce new rigour and risk sensitivity to the quantification of regulatory capital as well as incentivise enhanced risk management and market discipline.

But who will Solvency II impact and what are the strategic implications of the European wide directive?

The ramifications of Solvency II are widespread and we can perhaps best outline the future changes to the industry by considering the strategic implication to the range of market participants from insurers, and customers, to rating agencies, regulators and the investment banks.

This paper seeks to bring to the discussion forum our hypotheses for these market participants, to identify some of the key implications and to flag where opportunities may potentially exist as a result of Solvency II. It is an eye on what might result from Solvency II in the not too distant future.

Solvency II will introduce regulatory risk based capital adequacy requirements for insurers across Europe.

This will be a significant step change for many jurisdictions and the cost of compliance for insurers is likely to be significant. Adopting a risk based framework for insurers will also require a significant change in mindset. Even for jurisdictions which have accelerated the introduction of risk based capital for insurers, such as the UK with the ICAS regime, there is likely to be change required to address Solvency II, particularly around Pillar 2 and 3 requirements.

On the flip side of the effort to implement Solvency II is the value derived. One group of ‘winners’ from a capital perspective is likely to be those insurers with a diversified portfolio. Other ‘winners’ will also be the bancassurers who have already broadened risk based approaches developed for Basel II to their insurance operations. Here some of the implementation investment will have already been made and again where a diversified portfolio is offered capital benefit can be derived. For bancassurers there may be further diversification benefit gained at the group level by having both an insurance risk and credit risk portfolio. ‘Winners’ in general will be those that seek to implement Solvency II in a proactive manner, seeking to take advantage where possible and adding it to their other market differentiating factors.

Niche players and monoline businesses, however, will not benefit from capital diversification leading to imbalances in capital supporting similar products across the industry. There will still be a role for monoline and niche businesses, as has been proven by the monoline annuity businesses in the UK, but other factors become prevalent in driving business success rather than capital efficiency.

These dynamics, as well as other factors, will drive the demand for consolidation of insurers across Europe. Activity will centre around 2009, 2010 and the initial years subsequent to the new regime as firms seek to prepare and capitalise as best they can. However, there has already been some evidence of consolidation in the UK in the capital intensive with profits market, which is partly driven by better understanding by senior managers of risk and reward under risk based capital adequacy regulations.

Solvency II is a risk sensitive approach to determining capital adequacy and insurers’ internal models will rely heavily on data and as the granularity of this data improves across the product portfolios, insurers are more likely to be in a position to reflect capital consumption in product pricing.

This will not necessarily mean that premiums will fall, indeed implementation costs of Solvency II are expected to be high and these costs may in the short term be passed on to consumers and the pricing impact of the new capital requirement on any given product could be nil, increase or decrease depending on whether capital was appropriately allocated to these products in the past.

But over time customers will increasingly ‘get what they pay for’ and the concept of a ‘valued product’ i.e. a product in which customers see real benefit in purchasing and the risk-reward trade-off is more clearly understood than today, may emerge. Those insurers who can best price their products based on capital consumption will be strategically advantaged in a competitive marketplace. A word of caution however: this evolution will take some time and some companies may still go for increased growth/ market share even if the capital implications are unpleasant.

Rating agencies such as Standard and Poor’s have developed specific frameworks to evaluate the enterprise risk management of insurers and this will now be a key feature in the rating evaluation process. Insurers’ credit ratings will become further linked to the sophistication and effectiveness of their risk management capabilities.

Solvency II will also focus on the qualitative aspects of risk management and risk governance in Pillar 2. Insurers will need to put in practice reconciling quantitative and qualitative risk management initiatives to fully comply with Solvency II regulations. Insurers’ failure to implement and communicate effective risk management approaches to the regulator will lead to additional regulatory capital charges under Pillar 2: failure to do so with rating agencies may lead to credit down grade.

Demonstrating the robustness of risk management approaches to rating agencies and regulators will become increasingly important for insurers. Other participants such as equity analysts will also focus significant interest and the transparency provided through public disclosures under Pillar 3 will become a key area for insurers to demonstrate their risk management capability to a wide audience.

In short, insurers’ risk management disclosures will become a competition ground as they seek to influence third party views of their risk management approaches. This can already be seen, with some bancassurers being early adopters and seeking competitive first mover advantage with the disclosures they are making as a result of Basel II.

Solvency II comes hot on the heels of Basel II, implemented in the EU as a risk based capital adequacy directive for banks and investment firms. The skills demanded by the banks and now the insurers target a limited talent pool. There is truly a ‘war for talent’ in the risk and regulatory space with top rated risk and regulatory specialists commanding high salaries and bonuses at all levels of seniority.

The regulators across Europe are also fighting to access this talent pool. Their ability to supervise in a consistent manner across Europe, the increasingly complex approaches to calculating regulatory capital as well as the qualitative aspects of risk management, whilst engaging with senior bank and insurer personnel, requires strong specialist skill sets.

Regulators will increasingly need to adopt approaches to best align their specialist resource with the supervisory agenda. Risk based approaches such as the FSA’s Arrow approach will become the norm across Europe with other innovative approaches to supervision emerging.

Further, the drive for other innovative approaches as well as the need for a level playing field in European supervision of insurers may provide added stimulus towards a single pan European regulator.

We have discussed above the drivers for organisation consolidation in the European insurance industry, either to take advantage of diversification of portfolios or to cope better with the implementation effort. Such consolidation will stock the pipeline for M&A teams of investment banks as well as associated legal advisors.

The investment banking activity is unlikely to be only reactive (i.e. servicing insurers M&A demand) but will also be proactive, taking opportunities to the market place. Private equity houses are also likely to become interested.

Under Solvency II the definition of capital is aligning to different tiers of capital used in the banking sector. As insurers seek to optimise their capital funding in response to regulatory capital calculation requirements and capital resource definitions, some capital restructuring is likely. Again this will provide a healthy pipeline of work for the investment banks.

It is not just capital restructuring that will be impacted. As insurers better understand their risk appetite in both quantitative and qualitative terms there is likely to be increased activity in the risk transfer market as firms try to optimise the risk reward of their portfolio. Reinsurance is one established traditional mechanism, but investment banks will also be able to take advantage of developing risk transfer markets such as insurance securitisation as these approaches become more prevalent.

There are significant strategic implications and opportunities that may arise from Solvency II, some of which are highlighted above. They range from how the insurers may consolidate and tackle diversification issues to capital restructuring opportunities for investment banks. Inevitable consolidation as a result of risk based capital system will see the number of insurers falling to perhaps broadly mirroring the lower number of banks currently operating in the EU.

However, the challenges of maximising the stakeholders’ value will not cease with consolidation alone because the relentless market forces will continue to drive the industry to adopt more innovative risk based capital management system to satisfy customer and product focused service demand in an ever increasing competitive world. Implementing and operating a risk based capital system under Solvency II will be a journey for the 5000 or so EU insurers and it will be fascinating to observe and support the leading firms in the market as they capitalise on the opportunities in the forthcoming years.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.