April 2010

Worries Mount Over Solvency II's Impact on Europe's Insurers

PARIS March 15 (BestWire) — As the European Union pushes for implementation of its Solvency II capital adequacy standards for insurers by 2012, concerns are mounting that European insurers might not be prepared to meet those standards in time.

European insurance trade groups such as the Paris-based CEA are raising concerns that insurers, already wrestling with the financial fallout from the global debt crisis, might not be in a position to meet Solvency II's standards. In a new report, the CEA warned of the "macro-economic effects of imposing excessively prudent capital requirements on the European insurance industry" under Solvency II.

In a press conference call, CEA Director General Michaela Koller said that while the organization still maintains its position that Solvency II is an "important regulatory tool," she warns that the EU "needs to get it right."

Koller said the CEA is concerned that the proposed Solvency II directive as it now stands may impose "excessive" capital standards on insurers, particularly in the wake of the global financial crisis that has hit insurers as well as other financial institutions.

The CEA's concerns are reflected in other quarters, where studies and surveys increasingly show worries that Solvency II's standards may be too much, too soon.

Jeanette Rodbro, executive manager of the European Captive Insurance and Reinsurance Owners' Association, which represents European captives, told BestWeek Europe that there is "definitely" concern that Solvency II's impact on captives might be excessive, especially in light of the ongoing economic crisis (BestWeek Europe, March 8, 2010).

"We are continuously discussing this with the EU group working on implementing issues of the Solvency II directive," Rodbro said from her office in Luxembourg. "We are trying to get them to understand how captives are different. We welcome a new solvency regime but would like a system that does not penalize captives because of their special status."

The EU group assigned to take comment and work on implementation is the Committee of European Insurance and Occupational Pensions Supervisors. The agency has 27 members and three observers: Norway, Iceland and Liechtenstein.

A recent report by Bank of America Merrill Lynch, "Solvency II: Welcome to the Casino," concluded that the directive could heighten the divide between larger and smaller insurers and make certain securities issued by insurers less attractive to investors.

"The implications of the current proposals are negative for most of the companies in the sector, and for some, the implications look dire," the report said. "But the quoted companies, and particularly those who can prove the efficacy of their own models, will fare relatively well, in our view."

BofA Merrill Lynch added that surveys of its clients taken in September 2009 and again in December show an increasing number of respondents who believe it is "too early to say" what will be the biggest impact of Solvency II (see chart).

Voicing its own concerns has been the London-based Association of Run-off Companies Ltd., better known as ARC. It has identified "onerous capital requirements and higher expenses as significant negatives to the run-off sector of current Solvency II proposals" on the significant London-based run-off market (BestWire, Feb. 8, 2010).

In its report, "Why Excessive Capital Requirements Harm Consumers, Insurers and the Economy," the CEA said it is concerned that industry regulators may default to excessively conservative standards. "Europe's insurers are concerned that the implementing measures proposed by CEIOPS may revert to the dated and simplistic Solvency I approach of adding 'prudence on top of prudence' in the financial requirements they impose," the report said.

"We want to get Solvency II right," said Koller in the conference call. "That is why we warn about the potential detrimental effects we would have if we get the capital requirements wrong."

Angst in Germany

Carsten Zielke, senior insurance analyst and managing director with Societe Generale, said German insurers in particular are not likely to have the equity they would need to meet Solvency II standards as they now stand by the target implementation date of 2012.

The findings of Zielke's recent study on German insurers and Solvency II show that insurers are not ready. "The stresses would be so high, based on 2008 figures, that life insurers would need 54 billion euros more in risk capital," he said in an interview with BestWeek Europe.

German health insurers would need an addition 12 billion euros in risk capital. German nonlife insurers are in a better position, as they are currently over-capitalized by about 25 billion euros, he said.

Zielke said the situation improved for German insurers in 2009, due to the recovery of fixed-income markets. "But in the long run, we still think [German insurers] need about 25% more in equity," he said.

According to Zielke, one of the problems facing German insurers is that they don't have access to refinancing through equity markets, as most are not publicly-listed and many are mutuals. And with most of the insurers earning about 6% to 7% return on equity, "it wouldn't be attractive for shareholders to invest in these companies."

Another problem with Solvency II implementation is that national accounting standards across Europe are not likely to be reconciled with the new principles in time. "They have to be reconciled with national accounting standards," he said.

"The dream of the European Commission" was to have Solvency II principles reconciled with the International Financial Reporting Standard, "but most companies in Europe do not apply IFRS," he said. Aside from publicly-listed companies, which must apply IFRS, most insurers are only bound to apply their national standard. In Germany, this means only seven out of more than 100 insurers are bound to use IFRS.

Zielke, who is also a member of the European Financial Reporting Advisory Group (EFRAG), the European Commission's advisory group on insurance and accounting, said the necessary reconciliation work on Germany's accounting standard hasn't started. "There needs to be a consultation process to get the national standards changed," he said. "This cannot be met within two years."

He added that the idea was for regulators to use unaudited numbers to meet Solvency II measures, but "I think this is a bad idea, because everybody could make up their own numbers, which couldn't be used as official solvency measures."

Zielke spotted recent trends in the German market that also point to problems for insurers trying to meet Solvency II. On the life side, single-premium products dominated the market in 2009, as consumers opted for the short-term contracts in a volatile market. With contract terms typically of six to 12 months, policyholders can cash in and get their returns quickly, as opposed to those invested in 30-year or more contracts.

"They have big lump sums paid in, and they are invested only for a year and get the same return as long-term regular premium investors," said Zielke. "This is really unhealthy because the insurance companies that get these investments cannot invest into long-term securities, so they make a loss on these contracts."

The sale of these short-term contracts has been driven by the sales forces of life insurers over the past year, who were not able to sell long-term regular premiums due to market conditions. Since the sales people had to sell something to make their commissions, they sold the single-premium contracts.

German life insurers also need to better balance their investment portfolios to achieve higher returns, said Zielke. Currently, they have about 15% of their investments in corporate bonds, 5% in equities and 4% in real estate, and the rest in fixed-income securities. This is not a well-diversified mix, and leaves life insurers exposed should inflation pick up across Europe, he said.

A pick-up of interest rates could mean latent losses for life insurers, which according to German insurance law cannot be shared with policyholders, he added. That would put a strain on the insurers' solvency position, he said.

Health insurers in Germany are constrained by regulations that require that they show they can meet their long-term obligations. With regard to investments, the only real proof of long-term returns health insurers can meet is with long-term bonds, at 3.5%.

"With any other asset class, you cannot prove it," said Zielke. "This is somewhat irrational. It also means [health insurers] are exposed to interest-rate risk and they're not hedged against inflation."

Health insurers also have to raise premiums every year, sometimes by double digits, which in the long run make many private plans unaffordable, he added.

Nonlife insurers look much better in Germany, as they are currently over-capitalized, said Zielke. But nonlife insurers, too, need a more aggressive investment approach, and they are exposed to unexpected claims, such as Windstorm Xynthia, which hit two weeks ago and promises to generate significant claims, he said.

(By David Pilla, international editor, BestWeek: ) BN-NJ-03-15-2010 0534 ET #

Article reproduced by kind permission of AM Best, an Associate member.

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