New EU regulations will place a heavy burden on reinsurers, with one estimate suggesting that capital reserves will have to increase by around 150%. But amid the stringency, there are some opportunities to be had

Peter Skinner, the MEP for the South East of England, senses a change of mood in Brussels. Gone are the days of prevarication: the financial crisis has galvanised and emboldened the European parliament.

Skinner steered Solvency II, the incoming regulatory requirements for insurers and reinsurers across the EU, through the parliament. Determined to avoid any further systemic failure in the financial services and banking sectors, MEPs proposed tougher regulation than was originally anticipated when Solvency II was first mooted at the start of the millennium. “The shadow of the crisis is cast on all financial services businesses,” Skinner says, grimly.

Under Solvency II, insurance companies will have to hold far more capital on their balance sheets than under previous rules, so that they have a 99.5% security against failure. For example, it should be nearly impossible for an insurer to not be able to pay up in the wake of a one-in-200-years natural disaster.

Owing to the sheer scale and global reach of reinsurers, compliance with Solvency II could be even tougher than for their primary market counterparts.

“Reinsurance is event-based,” Skinner explains. “People want to make sure that there is no crisis to which a reinsurer cannot respond, so that the taxpayer doesn’t end up having to intervene.”

Just how stringent these new rules will be should become clear later this year. The Committee of European Insurance and Occupational Pensions Supervisors (Ceiops), the advisory body that will flesh out the details of Solvency II, completed a major consultation with industry on 11 December 2009.

Early indications, though, are that Ceiops will recommend an extremely tough regulatory regime, meaning that reinsurers must start gearing up for sweeping changes across their industry.

A basic Solvency II ‘survival guide’ would include drafting detailed, highly nuanced business models; training top brass to be as knowledgeable of the subtleties of such models as their actuaries; and assessing whether the reinsurer’s portfolio mix, be that either by geography or type of cover provided, needs to be rebalanced.

Risky business

“Solvency II is due to come into effect in October 2012, so you could say: ‘That’s three years away, why the big panic?’” Lloyd’s finance director Luke Savage remarks. “But this year companies will have to go through a kind of dress rehearsal with their local regulator to prove that they will be ready.”

Solvency II is split into three ‘pillars’, which cover measures that are both quantitative, such as having enough cash on the balance sheet to cover a major payout, and qualitative, such as ensuring that internal processes properly evaluate potential risk.

The latter involves producing an own risk and solvency assessment (Orsa). One source describes this as a “pretty damned comprehensive risk management framework”, likely to run to several hundred pages.

If the local regulatory body is not convinced of the Orsa’s strength, it will reject the document and apply what is known as the ‘standard formula’. This is an extraordinarily tough way of assessing just how much capital should be held on the balance sheet.

Savage estimates that reinsurers in Lloyd’s would each have to increase their current capital by around 150% from £16bn to £25bn, should they all use the standard formula. “To say that would make us commercially unattractive is an understatement,” Savage says. An increase of 50% in capital would mean a fall in return of nearly one-third.

Swiss Re head of group regulatory affairs Philippe Brahin says that the sheer amount of extra information that a company will need to provide will be hugely demanding on the industry. “The thought processes and data flow that this will require will be quite a change,” he says, though adds that Swiss Re has not brought in consultants to help the group ahead of the changes. “We are working things out internally, such as engaging our actuaries and risk managers to get processes ready for the increased data flow.”

Meanwhile, a spokeswoman for Munich Re says that the company is gearing up for this process by forming a Solvency II team of eight actuaries under the leadership of Margarita von Tautphoeus, who joined at the start of 2008. The team has already trained hundreds of client managers in the intricacies of Solvency II.

Brains at the top

Specifically, the senior management, right up to board level, will have to prove to the regulators that they fully understand the risk management models that underpin their business decisions. This could involve the domestic regulator quizzing them on areas such as understanding what the model would show if there were a natural catastrophe.

The ABI’s assistant director of financial regulation, Paul Barrett, argues: “No longer will it be enough for managers to just say: ‘We have very clever actuaries working on this.’

“This will be easier for bread-and-butter insurers where a lot of their business doesn’t change year-to-year. For reinsurers, it will be more difficult [to be au fait], as they have to react quickly to major events, so things can change rapidly and the [risk] data constantly changes.”

Just as the FSA now screens senior appointments of many of Britain’s banks, it will have a similar jurisdiction over reinsurers. If the executives aren’t good enough, the FSA will stymie their actions by imposing the standard formula. Such an outcome will surely result in their dismissals. “Regulators will want to know that boards genuinely understand the factors that lead to their business decisions,” Barrett argues.

National law firm Eversheds financial services partner Michael Wainwright says that the reinsurers he has spoken to are “quietly getting on” with their preparations for tests such as these. He hints at the challenge for executives of understanding all of the variables that could impact a reinsurer’s business model when he says: “The problem with the current European requirements is that they are out of date, from the 1970s. Solvency II comes up with a much more flexible – and therefore sensitive – model.”

Diversity

One of the great controversies of Solvency II is its treatment of global companies. In essence, it does not trust non-EU regulators. For example, if a reinsurer has a book in both the UK and Australia, it will have to account for the latter to the same standards as Solvency II. If there is reserved capital of 100 for the UK book, there should also be 100 on the balance sheet for the Australian business.

The argument against this is that major reinsurers have actually diluted risk by diversifying the portfolios. If there is a catastrophe in the UK, the Australian business would cross-subsidise the payouts. As such, the capital requirement for both businesses should be perhaps 150 rather than 200 combined, so as to reflect the reduced risk.

Indeed, Hannover Re chief risk officer Eberhard Müller points out that some geographies have been nearly as strict, and therefore as safe, as Solvency II for many years. “We have been following US regulations since the mid-’90s, as we are very active there,” he says. “The USA was the first country worldwide to introduce effective economic capital considerations.”

He suggests that reinsurers’ internal modelling should be more sophisticated than Solvency II’s basic idea, which is simply to take a company’s market share and multiply it by a factor, such as the consequences of a hurricane, to calculate the capital needed.

Several knock-on effects, such as life insurance payouts resulting from people killed in a storm as well as building damage, should be incorporated. “You could combine non-life and life risk. Life insurance might offset non-life losses and so there is less risk and less capital needed.”

If the regulator can be convinced that this portfolio mix is less risky, such a nuanced model might be approved, resulting in less capital being required on the balance sheet.

Guy Carpenter managing director Frank Achtert says he believes that this blend of cover is a crucial question for the reinsurance industry to answer in the next two to three years. Companies might even have to consider reducing exposure in other jurisdictions if Ceiops and regulators fail to understand the advantages of diversification.

“[Reinsurers need to] make an early assessment as to whether the diversification benefits translate into reduced regulatory capital requirements. Is a modification of the portfolio mix suitable?”

Not all doom and gloom

There is a major plus for reinsurers here, one that might mean they will need to identify and hire skilled extra staff ahead of a potential upswing in business. It seems likely that insurers will be unable to meet their extra capital requirements by raising cash through the debt markets, as they are largely closed at the moment.

Instead, they might have to fill the balance sheet by signing up for large amounts of reinsurance, protecting their capital position.

A spokesman for French reinsurer SCOR explains: “There are indications that some insurers – at least in the short term – will need additional capital to meet Solvency II requirements, and reinsurance may be one option open to them.”

And while reinsurers seem to be well prepared for the worst of Solvency II, they ultimately exist to make money – so they must also not miss this profit-making opportunity. GR

Where we’re at

Solvency II has been under development since the turn of the millennium, a slow-burning process that has frustrated proponents of greater regulatory control. And still there are around three years to go, even though it was initially anticipated that the regulations would have already been implemented by member states by now. Here is a brief rundown of the timetable and a who’s who of European bodies that reinsurers should be keeping their eyes on as the process evolves.

2009

Last year was a crunch time for Solvency II, with the European parliament finally giving the go-ahead to the proposals on 22 April. There had been much squabbling over Solvency II, which consolidates 14 disparate insurance and reinsurance directives into one set of regulations, but in the end the vote in favour was overwhelming: 593 for to just 80 against.

The Committee of European Insurance and Occupational Pension Supervisors (Ceiops) is in its final round of consultation with the industry over the implementation of Solvency II. Responses to the body’s latest recommendations, which are particularly harsh on the potential level of capital the industry will need, were submitted last December. There have been three waves of consultation, with 50 papers totalling 1,200 pages. The second round alone resulted in 20,000 comments.

December 2009

The ABI argued that Ceiops appears to have not considered “the aggregate impact of the [industry’s] consultation document at all”.

The association fears that Ceiops will continue with a burdensome reporting and business model approval processes, as well as treat historically acceptable forms of capital, such as own funds, as ineligible to buttress the balance sheet.

But Munich Re chief risk officer Joachim Oechslin argued in November: “We are optimistic that in the end regulators won’t calibrate the system in an overly conservative manner.”

This year

Reinsurers and their primary market peers must draw up and present their risk management models, known as an own risk and solvency assessment (Orsa), to domestic regulators this year. The companies must prove to the regulators that these internal measures are sufficient to mitigate risk to the stringent levels suggested in Ceiops’ guidelines.

One leading reinsurance lawyer says that this could be a process drawn out over several months. “The presentation of the Orsa is not the final part of the deal – it is just the start.”

In other words, regulators are likely to return to the groups with demands for vast changes to their proposed risk controls. It is estimated that what is in effect a dry run at implementation, could continue to be refined throughout 2011.

Actuarial consultant EMB has advised that groups need to have assembled specialist Solvency II teams, including representatives from the finance, IT, risk and actuary functions, by the time the Orsas are presented.

Ceiops will further flesh out the details of some of the implementing measures that it will propose, in a process known as ‘level three’.

By the end of the year, draft legislation by the Commission should be completed. Ernst & Young director of European actuarial services David Paul says: “The key thing is that the Commission has to have this draft ready by the end of 2010, as it is obliged to give national governments around 18 months to get ready to implement the directive.”

January-May 2011

Not to be confused with Ceiops, the European Insurance and Occupational Pensions Committees, will hold formal discussions regarding Solvency II. The body will then present what is described as a formal opinion. The European Council and parliament will then spend four months finalising the plans.

Autumn 2011

The European Commission has stated that it is determined to have all measures in place a year before the industry has to adopt Solvency II. Finance ministers are therefore expected to sign off on the proposals by October 2011.

31 October 2012

The directive finally comes into force. Member states must have put Solvency II in place by this date, meaning that reinsurers should have already been adhering to its key points for several months ahead of this date.

* Mark Leftly is senior business reporter at the Independent on Sunday