UK: Insurance Market Update - The Deloitte View For Non-Life Insurers, May 2009

Welcome to the May edition of the Insurance Market Update, in which we focus on issues in the non-life insurance industry.

Solvency II remains high on many insurers' agendas as they begin their planning activities in earnest and consider whether they are going to take part in the FSA's dry run of the internal models approval process. Our first article highlights areas of focus for insurers over the coming months and the wider impact Solvency II will have on the business.

Takaful is the Islamic counterpart of conventional insurance. It is carried out on a mutual basis whereby the participants agree to support one another jointly against a specified loss. The market for Takaful has been relatively slow to develop but is now attracting international players and regulatory attention. In our second article we look at the drivers behind the growth of Takaful and highlight some factors which firms should consider in order to prosper in this current market.

We hope you find this edition informative and, as always, your comments and suggestions for future themes or topics are welcome.

Kevin Elliott


The Solvency II Directive has been officially adopted and is set to change the way the insurance sector operates. The framework, which will be implemented across the European Union in 2012, will mean significant changes in everything from the way a firm calculates its capital requirements to its strategy for product development and pricing. The FSA is also increasing the tempo and has released a Feedback Statement 09/1 in response to the Discussion paper DP08/4 Insurance Risk Management: The Path to Solvency II.

Preparing for Solvency II – an update

But while 2012 may seem a long way off, and some of the detail is still to be finalised, the nature of the changes required to comply with the Solvency II requirements means firms should already be preparing for the regulatory change and have effective implementation plans in place.

Although the Individual Capital Adequacy Standards (ICAS) process has led to improvements in the way insurers identify and manage their risks, it is accepted that the Solvency II Own Risk and Solvency Assessment (ORSA) requirement is intended to go a step further.

The FSA expects firms to have completed or be in the process of completing a detailed gap analysis to identify any shortfalls in expected compliance with the Solvency II requirements. To achieve this, firms will need to have thought about what the new regime means to their business, how they would like to operate under the new requirements and what they need to do to satisfy them.

The FSA recognises that, as noted in DP 08/4, proportionality, in terms of taking account of the nature, scale and complexity of the firm will be a key consideration in the design and application of the regime.

To emphasise the importance of early engagement, the FSA is inviting firms to respond to their recent Communications Package by the end of June.

Firms will also need to confirm whether they want to take part in the first dry run of the internal models approval process. This is particularly important. Under Solvency II, firms will be able to choose between a standard model or seek approval for an internal model that more accurately reflects the risks involved in their activities.

But making this decision now is critical. Although the FSA is offering two waves of trials for its approval process, it only expects to be able to give a decision on approval in time for the 2012 implementation date for those firms that are in the first wave. Waiting until the second wave, which is expected late in 2011, could mean having to adopt the standard model temporarily before approval is granted.

Firms should also note that the FSA is planning a QIS 5 exercise in mid 2010, participation in which will be a qualifying criteria to enter the dry run. However, all firms should be including QIS 5 in their planned activities for Solvency II. It is also recommended that any firm which did not participate in QIS 4 should now perform a dry run using the QIS 4 parameters to assess the impact it may have on the business.

Within the Feedback statement, firms acknowledged that the work needed to calculate technical provisions under Solvency II would not necessarily be linked to the implementation of IFRS, because of differing objectives, but implementation would be helped once synergies can be identified. An exposure draft to be issued by the International Accounting Standards Board (IASB) on valuing liabilities under IFRS is not expected until the end of 2009.

Firms should also be aware that whilst the supplementary legislation to operationalise the new solvency regime will be drafted by the EU it has asked the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) for help in developing the necessary standards. As part of this process CEIOPS is publishing a number of consultation papers in 2009 seeking views from stakeholders.

Recent market events have demonstrated and further reinforced the importance of firms having the right amount of the right quality of capital. The FSA will be seeking to secure such requirement and do not believe that a low amount of Tier 1 that would allow unlimited amount of non-core capital to be included is consistent with this objective. Some existing capital instruments may not necessarily be eligible and consequently firms should give early consideration to the possible implications.

It is important that firms monitor the developments and papers issued by the FSA, CEIOPS and the IASB and participate in any ensuing consultation.

How Solvency II will affect business

Although the focus on capital may make Solvency II seem an exercise based in the finance, actuarial and risk departments of a firm, its ramifications will be felt throughout the business. As well as operational changes affecting everything from reporting to product sales, it will also lead to cultural changes affecting the day-to-day workings of the firm.

A company's strategy about which products to sell and their design will be influenced by the new regime. Firms will need to understand the risk, value and capital implications of selling particular products and ensure that this is aligned with their risk appetite as well as being reflected in their pricing and business planning. As a result, firms will have a clearer vision of the amount of business they can write which could see them changing their product mix in line with their risk appetite. It should also enable firms to be more proactive in optimising diversification benefits across different products.

Changes to capital requirements will also provide the impetus to review location and structure of insurance operations including books of business in run-off, especially where tax considerations are relevant.

Solvency II will also drive greater transparency in the sector. Firms will be required to disclose much more information to their stakeholders and potential investors. While this greater openness will be a significant change for many firms, those prepared to embrace it will find it offers opportunities to demonstrate the strengths of their business.

For many firms Solvency II will be the catalyst for making other changes. As an example, following years of acquisition and merger activity and reflecting product development, many insurers have a number of legacy IT systems. These can be unwieldy and cause data and reporting problems. Meeting data standards and reporting timelines required under Solvency II will put further pressure on them and some firms may decide that this justifies upgrading their technology.

On top of this, firms will also need to invest in training to help embed the new requirements into their business. This may also mean recruiting additional employees to reflect the shift in processes.

How much a firm adopts the new regime, and when, will vary. While some are already well advanced in their planning and looking to implement some of the processes ahead of October 2012, others have come to the planning later.

While there is time to catch up, for those companies well prepared and taking a comprehensive approach to adopting the new requirements there are greater rewards. These include the reputational benefits of being an early adopter, or the business benefits of exceeding the compliance requirements. Furthermore, as the new regime becomes more established, those companies that only do sufficient to comply could find it becomes harder and harder to compete.


A global downturn has impacted economies where Takaful potential is high

Step back to 2007 and the global economy was on the crest of a wave. Major industrial economies were powering ahead. In the Middle East, strongly increasing oil prices, which passed $150/barrel, supplied the funds for investment in the region which experienced a boom in construction activity and development of the financial services industry in hubs like Dubai and Qatar.

A major strand of the development of financial services in the Gulf region was the emergence of Islamic finance as a credible means to make sophisticated financial instruments widely available to consumers and businesses in a way that is acceptable to Sharia Scholars.

In this environment, and with the support of governments and regulators in the region, Takaful markets attracted significant interest and investment. Takaful is the Islamic counterpart of conventional insurance. It is carried out on a mutual basis whereby the participants agree to support one another jointly against a specified loss. Many local investors developed Takaful start ups and major international insurers sought to develop their Takaful capability, in some cases across a broad range of countries. In Saudi Arabia, the largest market in the Gulf, a new regulatory framework was developed that sought to move the entire insurance industry towards an Islam compliant model.

Fast forward to 2009 and the global economic picture looks profoundly different. Most of the major industrial economies are in recession and the banking system is under significant duress.

In the Middle East, significantly reduced oil prices and deterioration in external financing conditions, among other things have reduced economic activity across the region with the IMF now forecasting a recession in Saudi Arabia and the UAE for 2009. Other major Takaful markets such as Malaysia and Pakistan are also experiencing a slowdown.

Given the dramatic change in circumstances across the globe and in high potential Takaful markets in particular, it is important now to consider what the implications are for Takaful markets over the next few years.

The growth in Takaful markets is likely to be strong in the medium term

It is reasonably clear that many of the economies of the Gulf region are stressed, including the major markets of Saudi Arabia and UAE along with other high potential markets such as Pakistan and Malaysia.

In the short term, this will likely mean less investment in Takaful businesses as international players think twice about entering or expanding in new markets. This can be due to a reluctance to take risk in the short term or a focus on resolving problems in their broader portfolio of businesses. Additionally the availability of funding for local Takaful start-ups and businesses is also likely to be constrained by the general reduction in availability of funds in these markets.

In this context, it's not unreasonable to question whether Takaful markets will deliver on the strong growth forecast by many market observers in recent years. There is reason for optimism here. Much of the future growth in Takaful markets is likely to be the result of a number of structural factors that are unlikely to be heavily impacted by current economic and financial market turmoil:

  • Strong government and regulatory support.
  • Underpenetration of insurance in key markets.
  • Increasing consumer familiarity with Takaful concepts and advantages.

Strong government and regulatory support

Governments in the region appear to recognise the benefits of developing functioning private insurance markets. This is, in part, due to a perceived need to reduce the cost to government of providing the security that private insurance products offer. It is likely that this motivation will be strengthened by the reduced availability of oil revenues to countries such as Saudi Arabia, UAE and Kuwait.

Saudi Arabia has recently been at the forefront in seeking to develop its insurance markets, passing new legislation which establishes a framework for effective regulation of insurance activities in Saudi Arabia. The legislation also facilitates the development of insurance markets as it offers a government approved model for insurers to follow. In addition, increasing use of compulsion for certain classes of insurance, for example motor insurance in Saudi Arabia, will support future growth.

International standard setters such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) are also seeking to improve harmonisation of standards across markets. As a relatively young market, standards and the effectiveness with which they are implemented vary significantly across countries. Moves to improve standardisation are likely to improve clarity for businesses seeking to invest in Takaful.

Underpenetration of insurance in key markets

While this is a familiar and well rehearsed argument, it bears repeating as this remains a long term driver of growth. The development and increasing awareness of Takaful has removed a long standing barrier to the development of insurance markets in Islamic countries.

Penetration of insurance products in these markets remains far below that of major industrialised economies and it remains reasonable to expect significant growth from what is a low base level of insurance take up.

Increasing consumer familiarity with Takaful concepts and advantages

Another barrier to development of the market is customer awareness of the products. Takaful as a concept has been around for a number of years but initially failed to deliver to its potential as customers were unfamiliar with the concept and its advantages.

The strong growth in the number of Takaful businesses in the Gulf region is beginning to overcome this barrier by explaining the benefits of Takaful insurance and as customers become more familiar with the concept, so penetration is likely to grow in the medium term.

Takaful operators must offer strong propositions and establish strong governance and control costs to succeed

So there are strong underlying drivers of growth in Takaful markets that are likely to mean that Takaful will see significant growth in the medium term. Not all players in the market will succeed however and there will be some losers.

There are three important factors that Takaful operators need to consider during the next few years to position themselves to succeed:

  • Offering a compelling proposition and letting customers know about it.
  • Developing a robust governance and cost control framework.
  • Positioning to take advantage of consolidation in the marketplace.

Offering a compelling proposition and letting customers know about it

It is not enough, today, to build a 'me too' Takaful business and wait for customers. It is critical to ensure that there is a proposition that appeals, and is communicated, to the target audience.

Part of this proposition is likely to be price. Experience appears to show that while establishing a Takaful insurance operation is somewhat more expensive than conventional insurance, potential customers are unwilling to pay a premium for Takaful products over conventional ones. Ensuring the pricing strategy is correct and considering other proposition attributes such as convenience, simplicity and features will also be important.

Developing a robust governance and cost control framework Governance is likely to become more important.

This is partly due to a renewed focus on regulation and governance in financial markets worldwide. There are also Takaful specific drivers. Regulatory frameworks in some jurisdictions are not yet mature. As they develop, compliance with rules is likely to be more closely monitored. AAOIFI and IFSB are also active in this space seeking improved regulation of Takaful markets.

In addition given customers are price sensitive, managing costs effectively will be essential to delivering a price competitive product as well as offering an acceptable return to shareholders.

Positioning to take advantage of consolidation in the marketplace

In the medium term there is likely to be consolidation in the industry as it matures. There are a large number of Takaful operators in the Gulf region today and not all of them will survive. It is likely to be possible to use acquisition to drive growth and market share but it will be important to have the skills to identify opportunities and execute on them.

To conclude, even though these are economically challenging times, the medium to long term case for further development of Takaful markets remains positive. Opportunities do and will continue to exist. Taking advantage of these opportunities will require Takaful operators to focus on positioning for success as not all current players will prosper.

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.

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