Insurers and society how regulation affects the insurance industrys ability to fulfil its role

Key findings include: Solvency II goes too far in its requirements Survey respondents believe that Solvency II oversteps the mark, with only 16% agreeing that it strikes the right bal

How regulation affects the insurance industry’s ability to fulfil its role

Insurers and society

A report from the Economist Intelligence Unit

Sponsored by:

3 1

4 2

executive summary

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 equity capital markets

The new regulations were designed to ensure better protection for policyholders, but raise important questions 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 equities and investment grade debt on which much private industry depends for financing

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

The findings shed light, from a broad range of perspectives, on the potential impact of Solvency II on the retail consumer, the insurance industry itself and industry more broadly, including how insurers are likely to behave as debt and equity investors

Key findings include:

Solvency II goes too far in its requirements

Survey respondents believe that Solvency II oversteps the mark, with only 16% agreeing that it strikes the right balance in ensuring insurers have sufficient capital to meet their guarantees Insurers and FIs (excluding insurers) are more critical of Solvency II, with 55% believing the directive

Policyholders will ultimately bear the costs

Almost three-quarters (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 consequence 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 question 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-risk their asset allocations

A clear shift down the risk spectrum

is anticipated by respondents Assets expected to attract more interest include investment-grade corporate bonds, cash and short-dated debt,

at the expense of grade bonds, equities and long-dated debt Almost three in five (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 any asset class, suggesting they may not fully understand the wider financial implications of the new regime

Corporates seem less aware of the impact Solvency II will have on debt 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 significant, 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 revisit their 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 zero capital charge for sovereign bonds—despite the fact that

a readjustment would mean they would

be required to hold further capital A further 41% of insurers would like to see the capital charges for all assets reconsidered Overall, less than one-quarter (22%) of respondents believe that regulators should maintain the current capital charges

Is Solvency II creating a ‘squeezed middle’ among insurers?

While large insurers are able to absorb the costs of preparation for Solvency II and enjoy the benefits 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 sufficiently strong niche market to survive and thrive, the mid-sized 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

about this 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, financial institutions (FIs, excluding insurers)

as well as corporates (non-financial 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 are due to the following for their time and insight (listed alphabetically):

Jenny Carter-Vaughan, managing director of the Expert Insurance Group James Hughes, chief investment officer 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

Insurers and Society is an Economist Intelligence Unit report, sponsored

by BNY Mellon The findings and views expressed in the report do not necessarily reflect the views of the sponsor The author was Faith Glasgow and the editor was Monica Woodley

Insurance companies have traditionally been viewed by wider society as the bearers and managers

of formalised risk, freeing individual policyholders from financial worries

in the event that things go wrong, and providing institutions with

an efficient 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 flows of both equity and 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 requiring insurers

to hold capital according to all their business risks—including the differing risks attached to the various asset classes in which they invest clients’ cash

But these changes are set to upset the status quo, not just for insurers but 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 rise—potentially pushing some to opt to reduce or ditch their cover rather than pay more Companies seeking investors, meanwhile, may find it harder to raise funds in the capital markets—at 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 finding themselves under conflicting strains as they try to find the best balance between risk, return and capital efficiency

In this report, we explore the danger that regulation may, ironically, force insurers to reduce the amount of risk they take—and instead offload that risk on to their stakeholders

As insurers play a central economic and social role in modern Western societies, it has been 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 stakes across the board

by introducing a risk-based capital approach,

measuring risk on consistent principles and linking capital requirements directly to those principles They will apply throughout the EU, harmonising standards and providing a level playing field for insurers across the euro zone

But our survey findings indicate that although there is a perception that something needs to

be done to improve the current situation and harmonisation should bring its own benefits, the proposed regime could be overly cautious

Striking the right balance

1

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

Most insurers already have sufficient capital to meet their guarantees.

Insurers

FIs (excluding insurers)

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 confidence 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 will strike the right 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 time; I’d 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 “It’s important to remember that some EU countries don’t have any compensation net comparable to the UK’s Financial Services Compensation Scheme in place to protect consumers But the tendency of regulators is to go too far—they always want more capital,” he says However, Julian James, UK CEO of Lockton International, 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 difficult to

Chart 3: Do you agree or disagree with the following statement?

Most insurers already have sufficient capital to meet their guarantees.

Chart 2: Do you agree or disagree with the following statement?

Solvency II goes too far in ensuring insurers have sufficient

capital to meet their guarantees.

generalise “Some insurers will see their capital requirements 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 question

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 financial markets

Looking specifically at the capital charges that Solvency II will institute for different asset classes, survey respondents are in favour of a reassessment—just 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 zero capital charge for euro zone

sovereign debt should be reconsidered—a 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 II—just 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 zone debt, compared with 41% who would like to see charges for all asset classes reconsidered

The dramatic events in Europe over the past months, reflected in a series of bond market crises, have made it clear that it is not realistic, nor sensible, to talk about a zero 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 can’t see why any insurer would want to see a reassessment,” says Ms Carter-Vaughan of Expert Insurance Group

FIs (excluding insurers)

Chart 4: Do you agree or disagree with the following statement?

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

Who will pay the price?

2

There is a clear feeling that the bill for Solvency II—both the costs of testing and implementation and the ongoing costs of holding a greater amount

of capital—will have to be absorbed by insurance companies’ customers Almost three-quarters (73%) of survey respondents see it as inevitable that Solvency II will ultimately be paid for

by policyholders through higher costs,

although one-half feel that price increases are an acceptable trade-off for the additional security provided by enhanced capital guarantees

“It’s inevitable that the new regulations will be paid for by policyholders Greater security is a

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

Chart 5: Do you agree or disagree with the following statement?

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

all respondents 73% agree

57

Insurers Corporates (non-FIs)

FIs (excluding insurers)

probably won’t feel they get value from it—I 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 requirements for extra capital charges will be particularly hard-hit “Annuity prices, for example, could well rise and they’ll feed through

to consumers.”

Ms Carter-Vaughan agrees “A few years ago, insurers could make a loss on their underwriting book because they could rely on investment profits

to offset it—but low interest rates and a poor investment climate have put an end to that So now they have to make a profit on the underwriting,

which means premiums have to go up anyway, regardless of the regulatory changes Solvency

II will exacerbate that trend because it’s likely to result in fewer small and medium firms, so there’ll

be less supply to meet demand.”

Rising premiums are likely to bring their own ramifications The survey shows there is some concern that policyholders faced with price rises they consider unacceptable may simply review their 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 this

is 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.

Solvency II will lead to higher costs to 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

% 2 9%

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 quality of their products—for instance, by incorporating less-extensive guarantees—with only 29% overall expecting the emergence of inferior products

The interviewees are divided in their views on this hypothesis Mr James’s 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 quality

But Ms Carter-Vaughan is emphatic that product ranges and quality will deteriorate, although she anticipates that relatively commoditised products such as motor insurance will be less affected than more unusual or bespoke cover “It’s bound to

Corporates (non-FIs) FIs (excluding insurers)

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 statements?

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

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

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

43%disagree26%neutral

44 %

28% 36%

1 9% 3

43

% 37%

43

%

happen because we will lose medium and smaller insurers, and that is where more innovative, flexible 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 financial 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 findings? Are the FIs (excluding insurers) and corporates (non-FIs) being overly cynical in their assessment of the obvious outcome? Are the insurers being nạve 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 costs—the bottom line is that there’s 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 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 finds some regrets at the demise of with-profits products

unit-in favour of unit-lunit-inked policies, with 45% sayunit-ing with-profits 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-profits are still very popular in

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 a negative long-term affect

on pension and term savings provision.

long-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.

of insurance Commercial insurance Catastrophe insurance Annuities Life insurance

The European Commission is keen to introduce

a Solvency II-style regime for defined benefit (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 at the 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 consequence 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 doesn’t differ between the two,” he adds “Insurance companies and defined benefit 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 liabilities to members

Will pension schemes also

be subjected to Solvency II-style regulation?

Shifting down the risk spectrum

3

The survey also examined the impact of Solvency

II 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 equities, non-investment-grade corporate bonds, hedge funds and long- dated debt The top beneficiaries 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 EUROzONE SOVEREIGN DEBT HEDGE FUNDS

INFRASTRUCTURE INVESTMENT PROPERTY PRIVATE EqUITY CASH

Chart 12: Because of Solvency II, insurers will have a reduced/increased appetite for which of the following assets? Select all that apply

Specifically in the case of insurers’ responses, that reduced appetite for equities 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% anticipating a downturn in demand for both those asset classes That said, they are more comfortable with euro zone 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 requirements in isolation, 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 positive The question is then, is Solvency II a force for good in that it forces insurers to become sufficiently sophisticated 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 positive but more easily implemented short-termist agenda?

Mr Rastogi believes that, in some respects, changing regulations may actually work to insurers’ benefit 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-yielding assets make macro-economic sense; there is also

an inbuilt bias towards sticking with the home currency,” he explains

“Solvency II has no such constraints—there

is no bias towards yield, and the risk capital requirements will not vary according to territory (although there will of course be differences between the credit-worthiness of different 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

EUROzONE SOVEREIGN DEBT

16%

42%

35% 26%

40% 24%

INSURERS