insurance and society: how regulation affects the insurance industry’s ability to fulfil its role

8/2/2019 Insurance and Society: How regulation affects the insurance industrys ability to fulfil its role

1/32 The Economist Intelligence Unit Limited 2012

How regulation affects the insuranceindustrys ability to full its role

Insurersand societyA report from the Economist Intelligence Unit

Sponsored by:


2/32

INSURERS AND SOCIETY: HOW REGULATION AFFECTS THE INSURANCE INDUSTRYS ABILITY TO FULFIL ITS ROLE

The Economist Intelligence Unit Limited 2012

contents

Executive summary 2

Introduction 5

Preface 4

Striking the right balance 6

Shifting down the risk spectrum 14

Conclusion 21

About this report 4

Who will pay the price? 9

5 Predicting the unintended consequences 19

Implications for companies seeking nancing 17

Appendix 22

3

1

4

2



executivesummary

As discussion of the details of the Solvency II regime rolls on, insurers are

thinking long and hard about how they will manage and monitor their risk

strategies and capital bases. But the implications of their decisions will reach

far beyond the boardroom, affecting both their relationships with corporate

and individual policyholders, and also their role as major investors in the debt

and euity capital markets.

The new regulations were designed to ensure better protection for policyholders,

but raise important uestions about the extent to which consumers and

corporates will ultimately foot the bill for Solvency II, either directly through

higher costs or indirectly via less comprehensive products.

Meanwhile, the demands of the new regime threaten to disrupt the key role

played by insurers as investors in the capital markets, by pushing them towards

safer assets with lower capital charges, and away from the euities and non-

investment grade debt on which much private industry depends for nancing.

This could be a particularly troubling outcome for businesses seeking to raise

capital, given that banks remain reluctant to lend because of their own balance

sheet constraints.

The Economist Intelligence Unit, on behalf of BNY Mellon, conducted a survey

of 254 EU-based companies, including insurers, other nancial institutions

(FIs, excluding insurers) and corporates (non-nancial institutions, or non-FIs).

The ndings shed light, from a broad range of perspectives, on the potential

impact of Solvency II on the retail consumer, the insurance industr y itself and

industry more broadly, including how insurers are likely to behave as debt and

euity investors.

Key ndings include:

Solvency II goes too far in its requirementsSurvey respondents believe that Solvency II oversteps the mark, with only

16% agreeing that it strikes the right balance in ensuring insurers have

sufcient capital to meet their guarantees. Insurers and FIs (excluding

insurers) are more critical of Solvency II, with 55% believing the directive

goes too far compared with 39% of corporates (non-FIs). Less than one

in ve insurance respondents believe that most insurers are insufciently

capitalised under the present regime.


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Policyholders will ultimatelybear the costs

Almost three-uarters (73%) of

survey respondents agree that the

costs to insurers of compliance with

the new regulations will be passed

on to policyholders, and there is

concern that both corporates and

individuals may choose to be under-

insured as a conseuence. However,

insurers are markedly less convinced

(57%) than FIs (excluding insurers)

(82%) and corporates (non-FIs)

(69%) that policyholders will pick up

the tab, raising the uestion of how

they see the costs of regime change

being met. Also, over one-half (51%)

of respondents believe the shift to

unit-linked policies, which put the

investment risk on the policyholder,

will have a negative long-term affect

on pension and long-term savings

provision, with life insurance and

annuities considered the products

most likely to be affected.

Insurers expect to further de-risktheir asset allocationsA clear shift down the risk spectrum

is anticipated by respondents. Assetsexpected to attract more interest

include investment-grade corporate

bonds, cash and short-dated debt,

at the expense of non-investment-

grade bonds, euities and long-dated

debt. Almost three in ve (58%)

respondents overall believe that shift

will happen gradually, giving time

for market adjustment. But nearly

one-third of corporates (non-FIs)

(32%) do not believe the changes

will have an adverse impact on anyasset class, suggesting they may not

fully understand the wider nancial

implications of the new regime.

Corporates seem less aware ofthe impact Solvency II will have ondebt issuance

Among insurers and FIs (excluding

insurers) there is a strong consensus

that Solvency II will make the tenor

and rating of bonds from corporate

issuers more signicant, as insurers,

driven by capital charge considerations,

are increasingly pushed towards

investment-grade debt. However,

corporates (non-FIs) seem less aware

of this shift, with just 48% agreeing

compared with 62% of insurers and 79%

of FIs (excluding insurers). The reality

is that companies are likely to have to

either adjust their capital structure to

achieve investment-grade status or

offer higher yields in compensation for

the capital cost to insurers.

Regulators should revisittheir capital charge levels

Given the economic risks attached to

many EU countries at present, there

is strong support, particularly among

insurers (50%), for regulators to

reassess the ero capital charge for

sovereign bondsdespite the fact that

a readjustment would mean they would

be reuired to hold further capital. A

further 41% of insurers would like to

see the capital charges for all assets

reconsidered. Overall, less than one-

uarter (22%) of respondents believe

that regulators should maintain the

current capital charges.

Is Solvency II creating a squeezedmiddle among insurers?While large insurers are able to

absorb the costs of preparation for

Solvency II and enjoy the benets of

economies of scale, and the small,

local or specialist providers prevalent

in continental Europe may either

fall outside the scope of Solvency II

altogether or have a sufciently strong

niche market to survive and thrive, themid-sied mutual insurers could be at a

disadvantage. Only 16% of respondents

expect no material impact from

Solvency II on the structure of smaller

friendlies and mutuals, and more than

one-half (54%) believe the pressures of

the new regime will result in a spate of

consolidations to achieve scale, while

36% of insurers believe these players

will outsource more in order to access

scale.



aboutthis report

preface

In January 2012, the Economist Intelligence Unit, on behalf of BNY Mellon,

surveyed 254 respondents from companies in Europe to get their views on

how regulation is changing insurers role in society.

The survey reached insurers, nancial institutions (FIs, excluding insurers)

as well as corporates (non-nancial institutions, or non-FIs).

Respondents are very senior, with over one-half (133) coming from the C-suite

or board level. They were drawn from Europe, with the UK, Spain, Germany, the

Netherlands, Denmark and Sweden each having over 20 respondents.

In addition, in-depth interviews were conducted with six experts. Our thanks aredue to the following for their time and insight (listed alphabetically):

Jenny Carter-Vaughan, managing director of the Expert Insurance Group

James Hughes, chief investment ofcer at HSBC Insurance

Julian James, UK CEO of broker Lockton International and president of the

Chartered Insurance Institute (CII)

Ravi Rastogi, senior investment consultant at Towers Watson

Jay Shah, head of business origination at the Pension Insurance Corporation

Randle Williams, group investment actuary at Legal & General

Insurers and Society is an Economist Intelligence Unit report, sponsored

by BNY Mellon. The ndings and views expressed in the report do not

necessarily reect the views of the sponsor. The author was Faith Glasgow

and the editor was Monica Woodley.


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introduction

Insurance companies have

traditionally been viewed by widersociety as the bearers and managers

of formalised risk, freeing individual

policyholders from nancial worries

in the event that things go wrong,

and providing institut ions with

an efcient mechanism by which

to transfer risk. They have also

historically played a central role

as institutional investors,

channelling funds into the capital

markets and providing industry

with crucial ows of both euityand debt capital.

Are those longstanding roles

under threat with the impending

introduction of Solvency II in the

European Union? Solvency II aims,

among other things, to provide

policyholders with more robust

protection by reuir ing insurers

to hold capital according to all

their business risksincluding

the differing risks attached to thevarious asset classes in which they

invest clients cash.

But these changes are set to upset

the status uo, not just for insurersbut for policyholders and also

for companies looking to attract

investors through the capital

markets. Policyholders are likely, for

example, to see the cost of premiums

risepotentially pushing some to

opt to reduce or ditch their cover

rather than pay more. Companies

seeking investors, meanwhile, may

nd it harder to raise funds in the

capital marketsat the very time

when banks, for their own reasons,are reluctant to lend. Insurers

themselves are likely to have to

adjust their investment timescales

and strategies of asset allocation,

potentially nding themselves under

conicting strains as they try to

nd the best balance between risk,

return and capital efciency.

In this report, we explore the danger

that regulation may, ironically, force

insurers to reduce the amount of riskthey takeand instead ofoad that

risk on to their stakeholders.



As insurers play a central economic and

social role in modern Western societies, it hasbeen accepted since the 1970s that some form

of prudential supervision by the authorities

is necessary.

Until now, the focus has tended to be on measures

to guarantee the solvency of insurers or minimise

the disruption caused by their insolvency.

Solvency II raises the st akes across the board

by introducing a r isk-based capital approach,

measuring risk on consistent principles and linking

capital reuirements directly to those principles.They will apply throughout the EU, harmonising

standards and providing a level playing eld for

insurers across the euro one.

But our survey ndings indicate that although

there is a perception that something needs to

be done to improve the current situation and

harmonisation should bring its own benets,

the proposed regime could be overly cautious.

Striking the right balance1

Chart 1: Do you agree or disagree with the following st atement?

Most insurers already have sufcient capital to meet their guarantees.

36%agree

40%neutral

24%disagree

44%agree

38%neutral

18%disagree

33%agree 36%neutral 31%disagree

36%agree

39%neutral

25%disagree

Corporates (non-FIs)

All respondents

Insurers

FIs (excluding insurers)


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On the one hand, just over one-third (36%) of

respondents believe that most insurers already

have enough capital to meet their guarantees,

and even among insurers themselves that

condence only rises to 44%. So there is a

broad acknowledgement that measures to

improve the capital cover of insurance companies

are in order.

On the other hand, just 16% of all respondents

agree that Solvency II w ill strike the r ight balance

in ensuring that insurers are properly capitalised in

line with their guarantees, and over one-half (51%)

say that it goes too far. As Jenny Carter-Vaughan,

managing director of the Expert Insurance Group,

observes: No one has gone down in the insurance

industry for a very long t ime; Id say the current

solvency regime is very robust.

Randle Williams, group investment actuary at Legal

& General, points out that it is unsurprising that

the industry feels that the authorities are setting

the capital charges too high. Its important to

remember that some EU countries dont have any

compensation net comparable to the UKs Financial

Services Compensation Scheme in place to protect

consumers. But the tendency of regulators is to go

too farthey always want more capital, he says.

However, Julian James, UK CEO of LocktonInternational, a broker, and president of the

Chartered Insurance Institute (CII), observes that

harmonisation across the EU means that there

will be both winners and losers, so it is difcult to


Most insurers already have sufcient capital to meet their guarantees.

50%agree

43%neutral

7%disagree

50%agree

27%neutral

23%disagree

32%agree

47%neutral

21%disagree

Life

General

Composite


Solvency II goes too far in ensuring insurers have sufcient

capital to meet their guarantees.

allrespondents

FIs (excluding insurers)InsurersCorporates (non-FIs)

51%agree

34%neutral

16%disagree

31%

40%

55%

33%

21%

15%

13% 39%

55%



generalise. Some insurers will see their capital

reuirements increase, but others will see a

decrease, he says. For consumers, though,

the important thing is the knowledge that the

insurer will have the same level of capital cover

if they buy in France or Germany as if they were

buying in the UK.

Insurers and FIs (excluding insurers) are markedly

more critical of the looming regime than corporates

(non-FIs), with 55% believing it will go too far and

insurers will be over-capitalised for the level of

guarantees they have to meet, compared with 39%

of corporates (non-FIs). This raises the uestion

of whether corporates, while attracted by the idea

of greater security, fully understand the potential

implications of an over-capitalised insurance

industry for their future activities in the nancial

markets.

Looking specically at the capital charges that

Solvency II will institute for different asset

classes, survey respondents are in favour of a

reassessmentjust 22% say the current charges

should be maintained. Most are in favour of an

across the board reassessment (43%), but 35%

say that only the ero capital charge for euro one

sovereign debt should be reconsidereda sensible

suggestion in the light of the self-evident mismatch

between these supposedly risk-free government-

issue assets and continuing deep uncertainty over

the extremely fragile economic situation in some

EU states.

Insurers are less likely than other survey

respondents to support the proposed capital

charges of Solvency IIjust 9% compared with

22% of FIs (excluding insurers) and 26% of

corporates (non-FIs). But what is surprising is

that one-half of insurers favour just reassessing

the capital charge for euro one debt, compared

with 41% who would like to see charges for all asset

classes reconsidered.

The dramatic events in Europe over the past

months, reected in a series of bond market

crises, have made it clear that it is not realistic,

nor sensible, to talk about a ero risk rate at the

present time. However, any alteration to the

capital charge of this debt will have to be upward

which will certainly not be in insurers interests.

I cant see why any insurer would want to see a

reassessment, says Ms Carter-Vaughan of Expert

Insurance Group.

FIs (excluding insurers)All respondents Insurers Corporates (non-FIs)


Solvency II sets capital charges for different assets according to their risk level,with EEA sovereign bonds given a zero-credit risk charge. In light of the eurozone debt

crisis, what do you think should happen to the capital charges of Solvency II?

Regulators should maintain the current capital charges

Regulators should reconsider the capital charges for all asset classes

Regulators should reconsider the capital charge for sovereign bonds

22%22%

42%43%

36%35%

9%

48%

26%

41%

50% 26%


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Who will pay the price?2There is a clear feeling that the bill for Solvency

IIboth the costs of test ing and implementation

and the ongoing costs of holding a greater amount

of capitalwill have to be absorbed by insurance

companies customers. Almost three-uarters

(73%) of survey respondents see it as inevitable

that Solvency II will ult imately be paid for

by policyholders through higher costs,

although one-half feel that pr ice increases

are an acceptable trade-of f for the additional

security provided by enhanced capital

guarantees.

Its inevitable that the new regulations will be

paid for by policyholders. Greater security is a

quid pro quo [for the higher cost], but people


Solvency II will ultimately be paid for by policyholders through higher costs.

allrespondents 73%

agree

16%neutral

11%disagree

15

%

26%

12%

16%1

7%7%

69%

57

%

82%

FIs (excluding insurers)InsurersCorporates (non-FIs)



Insurers



probably wont feel they get value from itI think

it will depend on how much more they have to

pay, comments Mr Williams of Legal & General.

He points out that long-term products with

greater reuirements for extra capital charges

will be part icularly hard-hit. Annuity prices, for

example, could well rise and theyll feed through

to consumers.

Ms Carter-Vaughan agrees. A few years ago,insurers could make a loss on their underwr iting

book because they could rely on investment prots

to off set itbut low interest rates and a poor

investment climate have put an end to that. So now

they have to make a prot on the underwriting,

which means premiums have to go up anyway,

regardless of the regulatory changes. Solvency

II will exacerbate that trend because its likely to

result in fewer small and medium rms, so therell

be less supply to meet demand.

Rising premiums are likely to bring their own

ramications. The survey shows there is some

concern that policyholders faced with price rises

they consider unacceptable may simply reviewtheir insurance needs and cut corners: 41% of

respondents expect companies to choose to be

under-insured in the wake of Solvency II, with

a similar percentage (39%) anticipating that

individual policyholders will take such action.

Chart 6: Do you agree

or disagree with the

following statement?

Solvency II will lead

to higher costs for

policyholders but thisis acceptable in view

of the additional

security provided by

the capital guarantees.

Chart 7: Do you agree or disagree with the following statements?

Solvency II will lead to higher costs to

individual policyholders, which will lead to

more people choosing to be under-insured.


corporate policyholders, which will lead to more

companies choosing to be under-insured.

39%agree

30%neutral

31%disagree

41%agree

28%neutral

31%disagree

allrespondents 50%

agree

30%neutral

20%disagree

2

1%

27%

15%

46%

41 %

29%

34% 57%

44%


12/32



But Mr James of Lockton gives that idea short

shrift. I think under-insurance is highly unlikely,

he responds. There is a highly competitive

insurance market across the EU, and consumers

will be able to shop around. The harmonisation

of EU capital standards is a worthy goal, in that it

makes that option possible.

The survey suggests that it is less likely that

insurers will respond to higher costs by reducing

the uality of their product sfor instance, by

incorporating less-extensive guaranteeswith

only 29% overall expecting the emergence of

inferior products.

The interviewees are divided in their views on this

hypothesis. Mr Jamess view is that there will be

a rebalancing of product ranges in response to

the new parameters of Solvency II, but there is

no reason to assume those products should be of

poorer uality.

But Ms Carter-Vaughan is emphatic that product

ranges and uality will deteriorate, although she

anticipates that relatively commoditised products

such as motor insurance will be less affected than

more unusual or bespoke cover. Its bound to



Chart 8: Do you agree or disagree

with the following statement?

Solvency II will ultimately be

paid for by policyholders through

inferior products.

Chart 9: Do you agree or disagree with the following st atements?

INSURERS

Insurers

allrespondents

29%agree

39%neutral

32%disagree


corporate policyholders, which will lead to

more companies choosing to be under-insured.

Solvency II will ultimately be paid for by

policyholders through inferior products.

Solvency II will ultimately be paid for by

policyholders through higher costs.


individual policyholders, which will lead to

more people choosing to be under-insured.

57%agree

17%disagree

27%agree

19%agree

22%agree

35%neutral

37%neutral

35%neutral

38%disagree

44%disagree

43%disagree

26%neutral

23%

44%

28% 36%

19%

31%

43%

37%

43%



happen because we will lose medium and smaller

insurers, and that is where more innovative, exible

underwriting goes on, in contrast to the very by-the-

book approach of the big insurers, she explains.

Interestingly, insurers responding to the survey

are markedly more optimistic across the board that

the nancial fallout from Solvency II will not have

an adverse impact on policyholders. Given that

insurers are likely to have thought more about the

cost implications of the new regime than any other

group, are these surprising ndings? Are the FIs

(excluding insurers) and corporates (non-FIs) being

overly cynical in their assessment of the obvious

outcome? Are the insurers being nave or do they

have a solution up their sleeves?

Our interviewees are convinced that there is only

one, inevitable outcome. Policyholders will

undoubtedly end up shouldering the coststhe

bottom line is that theres nothing free on any

balance sheet, says Mr James.

Concerns over how increased costs will affect

different types of insurance products show

that the longer-duration products are expected

to be hit hardest. As seen in the chart below,

shorter-duration products such as personal lines,

commercial and catastrophe are predicted to be less

negatively affected than longer-term products such

as life insurance and annuities.

Looking at the effect of regulation on insurers

savings products and a broader shift to unit-

linked policies, which put the investment risk on

the policyholder, over one-half (51%) of survey

respondents believe that a shift (to unit-linked

products) will have a negative long-term effect on

pension and savings provision. The survey also nds

some regrets at the demise of with-prots products

in favour of unit-linked policies, with 45% saying

with-prots policies would be valued by retail

customers, given the turbulence of current market

conditions. But 39% concur with the idea that they

have been driven out of existence by excessive

capital charges and accounting rules.

When unit-linked policies came onto the market,

they were seen as cheaper and more transparent,

and customers preferred them, comments

Mr Williams. With-prots are still very popular in

other EU countries such as Germany, because of the

guaranteed returns always offered there, but L&G

wont be offering new with-prots products.

Chart 10: Which products do you think will be most negatively

affected by Solvency II? Select up to two.

Chart 11:

Do you agree or disagree with the following statements?

The shift to unit-linked

policies, which put the

investment risk on the

policyholder, will have anegative long-term affect

on pension and long-

term savings provision.

With-prots policies,

which smooth the

volatility of returns,

would be valued byretail customers in

todays turbulent

market conditions.

With-prots policies

have been largely driven

out of existence because

of capital charges andaccounting rules.

39%agree

38%neutral

23%disagree 16%

disagree

18%disagree

45%agree

39%neutral

51%agree

31%neutral

67%

43%

26%

25%

15%

1%Other, pleasespecify

Personal linesof insurance

Commercialinsurance

Catastropheinsurance

Annuities

Lifeinsurance


14/32



The European Commission is keen to introducea Solvency II-style regime for dened benet

(DB) occupational pensions as well, forcing

pension schemes to account for their liabilities

by using a risk-free rate of return. At present,

the proposals are still being considered, but

it is clear that pension funds in general are

against such a proposal. Two-thirds of pension

funds responding to the survey agree with

the idea that pensions should be separately

regulated from insurers.

As Jay Shah, head of business origination atthe Pension Insurance Corporation, observes:

This is set to be hugely controversial over the

next two years. Pension schemes are concerned

because their funding position is likely to

look worse as a conseuence of Solvency II.

Of course, unlike insurers who have to be

fully funded, pension schemes can rely on a

corporate sponsor, and they would have to

work out what the value of that sponsorship

amounted to.

But the liability side doesnt differ between

the two, he adds. Insurance companies and

dened benet schemes are promising the same

thing to the individual member, so why should

there be a need for different regulation?

He expects that although the Solvency II rules

will not be applied precisely to DB pension

schemes, the principles will, so that in an

adverse scenario the scheme could meet

100% of its liabilit ies to members.

Will pensionschemes also

be subjected toSolvency II-style

regulation?



Shifting down therisk spectrum

3 The survey also examined the impact of SolvencyII on insurers role as investors in capital markets.Respondents were asked to indicate, from a lengthy

list, those assets they expected to become less

popular with insurers in the light of the new regime,

and those they thought would grow in popularity.

The assets most widely expected to lose

favour are euit ies, non-investment-grade

corporate bonds, hedge funds and long-

dated debt. The top beneciaries include

investment-grade corporate bonds, cash

and short-dated debt.

NON-INVESTMENT-GRADE

CORPORATE BONDS

INVESTMENT-GRADE

CORPORATE BONDS

EqUITIES

LONG-DATED DEBT

SHORT-DATED DEBT

EMERGING MARKET

SOVEREIGN DEBT

DEVELOPED BUT NON-

EUROzONE SOVEREIGN DEBT


HEDGE FUNDS

INFRASTRUCTURE

INVESTMENT

PROPERTY

PRIVATE EqUITY

CASH

OTHER, PLEASE SPECIFY

Chart 12: Because of Solvency II, insurers will have a reduced/increased appetite

for which of the following assets? Select all that apply

reduced increased

8%55%

43%17%

9%56%

24%44%

39%17%

16%30%

16%21%

21%26%

8%45%

15%26%

29%25%

14%37%

40%16%

1%1%


16/32



Specically in the case of insurers responses,

that reduced appetite for euit ies and lower-grade

corporate debt is even more pronounced. Insurers

are also markedly more negative on infrastructure

and property investment than respondents overall,

with 44% anticipat ing a downturn in demand for

both those asset classes. That said, they are more

comfortable with euro one sovereign debt and

somewhat more enthusiastic about investment-

grade bonds.

So there are indications of a clear shift down the

risk spectrum by insurers. Is there a concern that

such a shift could leave insurers looking at their

market capital reuirements in isolat ion, rather

than in the wider context of return on capital? Ravi

Rastogi, senior investment consultant at Towers

Watson, believes that in practice insurers will not

be able to afford to ignore investment return.

They will have to make trade-offs between return

on capital and capital charges, he comments.

One possible outcome, indicated by respondents

views on likely shifts in asset allocation, is that

they may move away from investing right through

the cycle on a buy and hold basis, and towards a

more active approach to asset allocation, moving

into capital-intensive assets only when the

outlook is particularly posit ive. The uestion is

then, is Solvency II a force for good in that it forcesinsurers to become sufciently sophist icated to

look at risk-return against capital charge, with

an eye to where a given asset class is in its cycle,

or will it promote a less posit ive but more easily

implemented short-termist agenda?

Mr Rastogi believes that, in some respects,

changing regulations may actually work to

insurers benet as investors provide a broader

potential investment choice for them. Solvency

I favours yield-producing assets so insurers

have a bias towards them even if non-yieldingassets make macro-economic sense; there is also

an inbuilt bias towards sticking with the home

currency, he explains.

Solvency II has no such constraintsthere

is no bias towards yield, and the risk capital

reuirements will not vary according to territory

(although there will of course be differences

between the credit-worthiness of dif ferent

countries). That means insurers should

have better opportunities for economically

NON-INVESTMENT-GRADE CORPORATE BONDS

INVESTMENT-GRADE CORPORATE BONDS

EqUITIES

LONG-DATED DEBT

SHORT-DATED DEBT

EMERGING MARKET SOVEREIGN DEBT

DEVELOPED BUT NON-EUROzONE SOVEREIGN DEBT


HEDGE FUNDS

INFRASTRUCTURE INVESTMENT

PROPERTY

PRIVATE EqUITY

CASH

OTHER, PLEASE SPECIFY

reduced increased

49%24%

16%42%

35%26%

40%24%

18%44%

24%29%

36%27%

0% 2%

44% 7%

47% 6%

35% 9%

42% 16%

64% 11%

67% 6%

Chart 13: Because of Solvency II,

insurers will have a reduced/increased

appetite or which of the following

assets? Select all that apply.

INSURERS



driven diversication, and also for more

globalised investment.

Nonetheless, although insurers are allowed

in principle to hold a range of risk assets, in

practice their decisions under Solvency II will

be constrained by the need to match assets

and liabilities and to optimise returns within a

limited capital charge budgetand that will have

implications for the make-up of their port folios.

There is a risk that the Solvency II regulations

might push many insurers towards a narrow

range of investment options, which could lead to

increased volatility in those areas. But nimbler

insurers could exploit that herd mentality

by making use of less popular asset classes,

comments Jay Shah, head of business origination

at the Pension Insurance Corporation (PIC).

For James Hughes, chief investment of cer

at HSBC Insurance, the issue is not just about

regulation forcing insurers in and out of dif ferent

asset classes, but also how to make assets more

capital-efcient. Solvency II is making everyone

think very hard about every strategyit is not just

about risk and return but now has a greater focus

on capital implications, he says. Ive seen fund of

hedge funds marketing themselves as potentially

more capital-efcient because they are offeringgreater transparency through risk analyt ics,

allowing clients to show more detailed analysis on

their entire portfolio.

Mr Shah makes the additional point that there is a

danger that the new regime will not be sufciently

exible to allow the ne-tuned treatment of

different asset classes. Solvency II needs to be

written to allow the emergence of new assets such

as infrastructure. These investments tend to be

secure, very long-term ones; they pay a high yield

because the money is tied up dur ing that time, not

just because there is an element of capital risk.

Solvency II could prejudice such investments if it

penalises them with excessive capital charges.

The fact is that the rules are not yet set in stone,

and until they are it is not clear how asset

allocation will be affec ted. The survey gives some

hope that the transition may not be too painful.

A majority (58%) of respondents are condent

that changes to asset allocation will be phased

in gradually by insurers, which should give the

corporates hoping to attract their capital time

to adjust to the new funding paradigm. But there

is less reassurance from the nding that almost

one-third (32%) of corporates (non-FIs) are

condent that the changes will have no adverse

effec t on demand for any asset classagain raising

the uestion of whether they have fully grasped

the wider implications of the new regime fornancial markets.

In different ways, so no asset class is adversely impacted.

On a phased basis over a long period of time, with no shock effect to markets.

All at once, directly impacting asset markets over a short period of time.

Chart 14: How do you think insurers will implement

any changes to asset allocation?

23%

58%

19% 19% 19% 23%

65% 57% 45%

16% 25% 32%


All respondents

Insurers


26%


18/32



There is a strong consensus among FIs (excluding

insurers) and insurers that the new regulations

will make the tenor and rating of corporatebonds more signicant, as insurers, driven by

capital charge considerations, are increasingly

pushed towards investment-grade debt at the

expense of lower-grade debt. Insurers obviously

understand their own capital considerations and

FIs (excluding insurers), looking at their own

funding reuirements under Basel III, will be very

aware of the importance of tenor. Basel III aims to

improve banks stability by reuiring them to hold

more long-term debt funding than in the past. But

that reuirement is at odds with Solvency II, which

makes holding long-dated debt less attractive toinsurers. In other words, there is the risk that banks

and insurers are set to nd themselves pulling in

opposite directions.

However, corporates (non-FIs) do not seem to see

at this stage the connection between regulatory

reuirements and their own funding preferences:

only 48% concur, and 21% disagree outright.

Over time, however, it is likely that debt-issuing

companies will adjust their behaviour to try to align

with insurers reuirements. They may have to issue

shorter-dated debt on a more freuent basis. They

may also adjust their capital structure to achieve

investment-grade status, or offer higher yields in

compensation for the capital costs to insurers.

Most notably, a clear majority (60%) of survey

respondents agree that unrated companies may

have to pay higher yields to attract insurers in the

aftermath of Solvency II. But insurers as a group

are markedly less convinced. Only 39% agree,

compared with 73% of FIs (excluding insurers) and

53% of corporates (non-FIs) This suggests that,

Implications for companiesseeking nancing4

Chart 15: Do you agree or disagree with

the following statement about corporatedebt issuance? Solvency II makes

the tenor and rating of bonds from

corporate debt issuers more signicant.

Corp

orates(non-FIs)

Insurers

FIs(excludinginsurers)62%

agree

31%neutral

7%disagree

79%agree

17%neutral

3% disagree

48%agree

31%neutral

21%disagree



unlike other groups with less knowledge of the

implications of the new regulations, they know

they may be unable to afford the capital charges

associated with such companies debt, no matter

how generous the yield.

Of course, insurers will have to assess the risk

versus reward prole for any corporate debt they

consider buying, but they will only have a nite

amount of capital available as cover, comments

Mr Rastogi of Towers Watson. It will be a uestion

of nding the optimal mix of assets within their

specic risk budget.

Mr Williams of Legal & General speculates that

insurers may be allowed to appeal to the authorities

on the grounds that they have built up a strong

portfolio of BBB-rated debt and therefore have the

expertise to make distinctions on the grounds of a

companys security and uality. He believes that the

shift away from non-investment-grade debt could

cause signicant difculties for many companies.

EIOPA wants to see a lower chance of default on

insurers investments, through the use of higher-

grade debt. But many smaller, well-established

industrial rms across the EU are graded BBB. Of

course they are not as secure as blue-chips, and

they pay higher yields to compensate, but they are

not inherently risky propositions. Importantly, its

these companies that tend to lead their countries

out of recession, and if the banks are not lending

and the insurers are penalised for buying their debt,

they will face a big problem.

An examination of the implications of Solvency

II for companies trying to raise debt throws up

another concernthat the regulators may have

failed to consider the big picture, and that there

is a mismatch between the aims of this piece of

regulation and those of Basel III.

When asked whether the two directives represent a

conict of interests for banks and insurers, and if

so what the conseuences might be, the majority

of survey participants who offered an opinion were

in agreement, although they gave a wide range of

possible outcomes.

I think these regulations might create conict;

they may increase demand for sovereign debt

from both banks and insurers, commented one

UK-based bank respondent. Others suggested that

the main conseuence could be a more volatile

market. The potential conict between these two

directives could put EU banks and their funding at

risk, added a composite insurance respondent

from the UK.

A number were more cautious, admitting

that until Solvency II comes into force, it

will be very difcult to predict how the clash

of interests will affect those involved. I think

that these regulations are going to create

conicting goals, but the conseuences are

still unknown. We will have to wait until their

implementation, said a bank respondent based

3in Denmark.

Chart 16: Do you agree or disagree with the following statement about corporate debt issuance?

Unrated corporates will be forced into paying higher yields as that will make their debt more

attractive to insurers post-Solvency II.

Allrespondents

Corporates(non-FIs)

Insurers

FIs(excludinginsurers)

60%agree

25%neutral

15%disagree

53%agree

31%neutral

16%disagree

39%agree

37%neutral

24%disagree

73%agree

16%neutral

11% disagree


20/32



Predicting the unintended

consequences5 There are fears that the regulatory regime ofSolvency II will introduce a host of unforeseen

problems. The survey ndings indicate that there

is little sense of any profound need for additional

regulation in terms of insurers meeting their

obligations to policyholders. Most respondents

particularly insurers (62%) and pension funds

(64%), unsurprisinglyconsider the current level

of regulation sufcient.

Moreover, there are serious concerns among

respondents that regulators have not thought

through the broader impact of the new legislat ion

on capital markets. Answers to an open uestion

in the survey highlight the sheer range of

potential problems.

A number of respondents are worried about the

idea of introducing a complex and potentially

restrictive regime at a time when both EU

economies and markets are so fragile. As one bank

respondent from Denmark puts it: Capital markets

are in a bad shape right now and are not ready for

a major change. Several voice concerns about the

negative impact on w ider economic growth, and

one, another bank respondent from Denmark,

adds that it is not only macroeconomic factors

that are at risk, but also the pressure put on the

nancial sector due to the timing of Basel III and

Solvency II.

Others highlight the impact on particular asset

classes. My main concern is that insurers are

All respondents


Insurers


Chart 17: Do you agree or disagree with

the following st atement on regulation?

The current level of regulation is

sufcient to ensure that the insurance

industry is able to full its obligations

to policyholders.



48%agree

21%neutral

31%disagree

58%agree

16%neutral

26%disagree



being dissuaded from buying long-term bonds

under the EU Solvency II rules, says a life

insurance respondent from the UK. But others

are worried about the impact on euity markets,

growth in demand for derivatives, the trend

towards a more concentrated range of assetclasses and the risk of a further credit crunch as a

conseuence of over-regulation.

A further area of uncertainty focuses on the impact

of the new regime on smaller friendly societ ies,

mutuals and monoline insurers. Mr Williams of

Legal & General makes the point that large insurers

with a range of products have the resources to

absorb additional overhead costs, and that at

the other end of the spectrum the industry in

Europe is much more skewed towards small mutual

specialists serving a local community, who have

their own well-established niches and may be

below the minimum sie to ualify for Solvency II

regulation anyway. Its the monoline providers in

the middle who are likely to be more disadvantaged

than either of these groups, he says.

More than one-half (53%) of all respondents

expect to see a spate of consolidation as smaller

insurers try to achieve economies of scale; a

further 20% anticipate that they will move towards

outsourcing more functions.

Ms Carter-Vaughan of Expert Insurance Company

agrees that the insurance giants are in a stronger

position because of their resource base. Medium-

sied rms, especially broker-only businesses

without their own direct distribution arm, are in a

particularly difcult position, exacerbated by theeconomic climate.

These businesses may be well-capitalised, with

generous solvency marginsbut if theyre invested

in government bonds and banks, and the ratings

agencies take a view on that investment base and

downgrade their ratings, as has happened already to

some rms, the insurance brokers will have to drop

away, she explains. Solvency II will make this much

worseit couldnt be happening at a worse time.

However, Mr Shah of PIC disagrees that it is all a

matter of scale, observing that large multi-national

insurers with subsidiaries in different EU countries

are likely to face their own problems. Before

Solvency II, local regimes often understated the

amount of capital needed by insurers, on the

grounds that the multi-national parent was holding

a sensible amount at group level, albeit in other

jurisdictions. Solvency II will push the obligation

to hold the right amount down to subsidiary level,

and limit companies ability to move capital around

between countries as needed.

Chart 18:

How will Solvency II impact the structure of smaller friendly societies and mutuals?

16%11%54%20%

They will

outsource more

to access scale

They will

consolidate to

achieve scale

They will

close to new

business

There will be

no material

impact


22/32



conclusion

It is clear that while some boost to the current

regulatory situat ion may be necessary, both the

potential conseuences and the timing of Solvency

II are a source of considerable concern. Indeed,

it seems that while the new regime would be

bound to have ramications regardless of when

it is introduced, the euro ones current difcult

political and economic climate and wider tough

investment conditions are all set to make things

worse for insurers and their stakeholders alike.

There are various implications for polic yholders,

but the bottom line is that premiums are

likely to increase in priceas a result of the

implementation and overhead costs of Solvency

II, the further reliance on underwriting prot

rather than investment return and because the

range of providers may shrink as rms are pushed

into consolidation. Some policyholders may be

forced to reduce their levels of cover or drop some

insurances altogether because of pr ice increases.

There is also a risk that they will nd it harder to

source more unusual types of cover because of the

contraction in the number of middle-sied rms,

which have traditionally played an innovative role

in the insurance marketplace.

Savings and investment products are also likely

to be affec ted. As the costs of guarantees become

clearer, they w ill inevitably increase. Investors

generally see guarantees as attract ive but do not

place the same value on them as the cost to hedge

those guaranteesthe challenge to the industry

will be to nd the right balance.

The possible conseuences are arguably also

serious for companies seeking to raise money in

the capital markets, where insurance companies

are major institutional investors. Insurers are

likely to shift their portfolios down the risk

spectrum, away from euit ies and lower-uality

corporate debt and towards safer assets such

as cash and investment-grade debt. But that

may leave a tranche of smaller companies

companies that could be leading European

economies back towards growthwith ser ious

funding problems because they do not have a

high enough debt rating.

So what is the prognosis for the future, and for

Solvency IIs progress onto the statute books?

Mr James of Lockton emphasises that what

the insurance market really wants is absolute

clarity as to how the rules w ill be applied.

Implementation is still two years away, in 2014,

and clearly there will be many discussions before

everything is claried, particularly given the

highly uncertain polit ical and economic backdrop

against which decisions must be made.

One area where regulators must consider the

implications of Solvency II is the impact on

the cost of guarantees. EU regulators seem to

want safety at all cost s and appear to be more

comfortable with people being under-insured

rather than properly insured but somewhat at

risk of the guarantee not being met by the insurer.

Mr Shah of PIC believes that the European

authorities are likely to have to agree on

substantial compromises to make it more workable

and acceptable to national regulators and the

industry, if it is to be in place roughly on time.

There is also pressure to get things right as

Solvency IIs reach has potential to go beyond the

EU. Many foreign regulators, part icularly those in

developing markets, look to the EU and the US for

guidance on key principles as they dont want to be

out of sync with these major markets, comments

Mr Hughes of HSBC Insurance. This could make

Solvency II even more far-reaching in the future.



appendix:surveyresults

Spain

United Kingdom

Denmark

Germany

Netherlands

Sweden

Finland

France

Luxembourg

Belgium

Ireland1

13

6

6

12

1

5

11

18

10

16

0

In which country are you personally located?(% respondents)

Note: numbers do not add to 100% due to rounding

Finance

Risk

IT

General management

Operations and production

72

24

2

2

1

1

What is your primary job function?(% respondents)


24/32



CFO/Treasurer/Comptroller

Head of department

SVP/VP/Director

Other C-level executive

CEO/President/Managing director

Board member

Head of business unit

CIO/Technology director

Other

6

8

30

1

9

15

4

28

1

0

Which of the following best describes your job title?(% respondents)


(% respondents)

What is your primary industry?

2

Government/Public sector

Automotive

1

Chemicals

1

Construction and real estate

1

Power & utilities

2

Professional services

2

Retailing

1

Telecommunications

1

Transportation, travel and tourism

2

Consumer goods

2

Financial services

71

2

Healthcare, pharmaceuticals and biotechnology

2

IT and technology

2

Manufacturing

10



Pension fund

Bank

Non-financial corporates

General

Life

Composite - both life and general

Asset manager

Other, please specify

8

9

6

25

25

25

25

1

1 25

(% respondents)

What is your main business?

500m or less

500m to 1bn

1bn to 5bn

5bn to 10bn

10bn or more

21

44

15

9

11

(% respondents)

What are your company's annual global revenues?

100m or less

100m to 500m

500m to 1bn

1bn to 10bn

10bn to 25bn

25bn to 50bn

50bn or more

2

14

11

30

6

3

34

(% respondents)

What are your organisations assets under management (AUM)?


26/32



Allowing individuals to protect themselves from risk

Allowing institutions to protect themselves from risk

Acting responsibly in their dealings with policyholders

Acting responsibly as shareholders of corporations

Complying with regulations set by government

Acting responsibly as providers of debt and equity capital to corporations

Generating tax revenues for central government

74

56

35

34

32

30

3

(% respondents)

What are the most important roles the insurance industry plays in society? Select up to three.

Take the same level of investment risk as pre-Solvency II

Achieve similar investment returns as pre-Solvency II

Achieve investment returns suff icient to maintain current consumer pricing (such as insurance premiums)

Deliver a similar return on capital to shareholders as pre-Solvency II

Deliver a return on capital sufficient to satisfy most shareholders

57

54

52

56

43

(% respondents)

Will Solvency II make it more difficult for insurers to do any of the following? Select all that apply.

Agree Neutral Disagree

It is the duty of insurers to contribute positively to society.

It is the duty of insurers to deliver returns to shareholders.

It is the duty of insurers to provide financial stability to policy holders/customers.

It is the duty of insurers to comply with all applicable laws and regulations, but beyond that, they have no duty to contribute positively to society.

The insurance industry in the European Union generally contributes positiv ely to society.

82 13 5

67 20 13

79 14 7

41 30 30

69 22 9

0

(% respondents)Do you agree or disagree with the following statements?





Solvency II goes too far in ensuring insurers have sufficient capital to meet their guarantees.

Most insurers already have sufficient capital to meet their guarantees.

Solvency II will lead to higher costs for policyholders but this is acceptable in vi ew of the additional security provided by the capital guarantees.

Solvency II will lead to higher costs to corporate policyholders, which will lead to more companies choosing to be under-insured.

Solvency II will ultimately be paid for by policyholders through higher costs.

Solvency II will ultimately be paid for by policyholders through inferior products.

Solvency II will lead to higher costs to individual policyholders, which will lead to more people choosing to be under-insured.

The shift to unit-linked policies, which put the investment risk on the policyholder, will have a negative long-term affect on pension and long-term savings provision.

With-profits policies, which smooth the volatility of returns, would be valued by retail customers in today's turbulent market conditions.

With-profits policies have been largely driven out of existence because of capital charges and accounting rules.

51 34 16

36 39 25

50 30 20

41 28 31

73 16 11

29 40 32

39 30 31

51 31 18

45 39 16

39 38 23

0

(% respondents)



Life insurance

Annuities

Catastrophe insurance

Commercial insurance

Personal lines insurance


43

67

15

25

26

1

(% respondents)

Which products do you think will be most negatively affected by Solvency II? Select up to two.


28/32



(% respondents)

Because of Solvency II, insurers will have an increased/reduced appetite for these assets? Select all that apply.

Non-investment-grade corporate bonds

Investment-grade corporate bonds

Equities

Long-dated debt

Short-dated debt

Emerging market sovereign debt

Developed but non-eurozone sovereign debt

Eurozone sovereign debt

Hedge funds

Infrastructure investment

Property

Private equity

Cash


17 43

56 9

44 24

17 39

30 16

21 16

26 21

45 8

26

25

26 15

29

37 14

16 40

1 1

55 8

IncreasedReduced

All at once, directly impacting asset markets over a short period of time

On a phased basis over a long period of time, with no shock effect to markets

In different ways, so no asset class is adversely impacted

19

58

23

(% respondents)

How do you think insurers will implement any changes to asset allocation?


Solvency II makes the tenor and rating of bonds from corporate debt issuers more signif icant.

Corporates will be required to come to market for debt issuance more frequently post-Solvency II.

Corporates will be forced into paying for ratings as that will make their debt more attractive to insurers post-Solvency II.

Unrated corporates will be forced into paying higher yields as that will make their debt more attractive to insurers post-Solvency II.

66 25 8

59 28 13

59 29 12

60 25 15

69 22 9

(% respondents)





Regulators should reconsider the capital charge for sovereign bonds

Regulators should reconsider the capital charges for all asset classes

Regulators should maintain the current capital charges

35

43

22

(% respondents)

Solvency II sets capital charges for different assets according to their risk level, with EEA sovereign bondsgiven a zero credit r isk charge (meaning insurers do not need to hold capital against these assets).In light of the eurozone debt crisis, what do you think should happen to the capital charges of Solvency II?

It will add significantly to schemes funding requirements

It will lead to more defined benefit schemes to reduce investment risk

It will lead to the closure of many defined benefit schemes

It will lead to more buy-outs of occupational pension schemes

55

53

41

29

0

(% respondents)

The European regulator is currently considering whether to introduce a Solvency II-style prudential regimefor occupational pension schemes. What do you think would be the impact of this? Select all that apply.


It is appropriate to regulate occupational pension fund provision under a separate regime from that which insurers have to comply.

The current level of regulation is sufficient to ensure that the insurance industry is able to fulfil its obligations to policyholders.

61 27 12

56 18 26

(% respondents)


They will outsource more to access scale

They will consolidate to achieve scale

They will close to new business

There will be no material impact

20

54

11

16

0

(% respondents)

How will Solvency II impact the structure of smaller friendly societies and mutuals?



30/32



notes



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insurance and society: how regulation affects the insurance industry’s ability to fulfil its role

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