The Domino Effect

Canadian and European risk managers are warning about a potential domino effect created by the Solvency II regime that regulators are now drafting for the European property and casualty (re)insurance industry. Solvency II is a fundamental review of the capital adequacy regime for the European insurance industry. It will result in a number of new regulations to be implemented on Dec. 31, 2012.

Risk managers are warning that dominoes might be teetering based on the recent work of the Committee of European Insurance and Occupatonal Pensions Supervisors (CEIOPS), Europe’s integrated regulator for insurers. Specifically, risk managers are concerned that, in its efforts to protect policyholders, CEIOPS has set the bar for economic capital requirements too high. As a result, the Solvency II regime may in fact have a negative effect on the availability and price of insurance coverage. Also, experts warn, small-and mid-size insurers might have a hard time meeting the requirements. If so, larger insurers would likely swallow these small-and mid-sized insurers, thus reducing competition in the market place.

The Federation of European Risk Management Associations (FERMA) issued a statement in March 2010 laying out its concerns. “The fact that insurance companies are concerned that they will have to raise premium by 20% for non-life insurance is a notable development,” the statement reads. “However, our main concern is the potential reduction in the number of insurers capable of covering our risks. This could force us to retain more risks on our balance sheet, impacting our ability to invest and remain competitive in a global economy.”

Here in Canada, the Office of the Superintendent of Financial Institutions (OSFI) is carefully observing the European approach. OSFI appears to be playing a wait-and-see game before it finalizes its own approach to a risk-based capital regime, with an eye to implementation around 2014-15.

Canadian risk managers fear that should these “overly stringent” capital requirements make their way into the final draft of Solvency II, they might be enough to set the dominos tumbling overseas. Some suggest the stringent capital requirements will disrupt the flow of capital between European parent companies and their Canadian subsidiaries. Others worry OSFI will mimic the overly prudent tone of the Solvency II regime, thus raising capital requirements for all insurers, not just European-based ones.

“We operate in a global village,” says FERMA president Peter den Dekker. “The world does not stop at the borders of Canada, I am afraid. Solvency II will have an impact on the Canadian insurance market. How and what the actual impact will be is a big uncertainty and a big question mark, as it is also here in Europe.”

Solvency II — What it will Look Like

In a nutshell, Solvency II is a regulatory capital model based on an economic capital view, says Sharon Ludlow, the CEO of Swiss Re in Canada. It has a three-pillar approach:

• minimum capital requirements;

• governance and risk management requirements; and

• disclosure and transparency requirements.

As the 2012 implementation date draws near, CEIOPS is finalizing what each set of criteria will look like under each of the above pillars. The framework’s principles are very similar to those OSFI is contemplating, Ludlow continues. “It comes back to understanding the risks that you have,” she says. “It’s insurance risk (‘So do I understand the exposure?’); market risk (‘What’s happening to my investment portfolio?’ and ‘Am I heavily concentrated in Industry A versus Industry B?’); counterparty risks exposure (‘What would happen if a reinsurer or a trading partner becomes insolvent?’); and operational risk, or the risks within your own organization.”

The first of the pillars mentioned above — the minimum capital requirements — appears to have caused the Solvency II edifice to sway somewhat. Just like OSFI, CEIOPS is proposing a system in which (re)insurers will be able to choose between using a standard formula to determine their capital requirements, or developing an internal model approved by the regulator. But, as the saying goes, the devil is in the details. When CEIOPS rolled out its fifth quantitative impact study (QIS 5), insurers, reinsurers, captive insurers and risk managers alike voiced concern over the stringent requirements set forth in the criteria. QIS 5 launched at the beginning of August 2010. Insurers and reinsurers have until the autumn of 2010 to complete the study and report results; at this point, CEIOPS will review the calculations and make any required tweaks before sending off its final draft to the European Commission. But even before the study officially got underway, insurance buyers and carriers alike raised red flags.

CEIOPS issued its previous quantitative impact study (QIS 4) just as the credit crunch was unwinding, notes David Simmons, managing director of analytics for Willis Re London. “It was using the 2007 numbers, and all the factors were predicated prior to the credit crunch,” he says. “The results of that study indicated that just under 11% of companies in Europe could have been challenged by Solvency II,” Simmons says.

“Now, QIS 5 is being set post-credit crunch,” he continues. “It’s based on year-end 2009 numbers, and a lot of the ratios and tests have increased.

“It certainly is going to be a much more rigorous regime than what we have had in the past. Where regulatory capital hasn’t been an issue for companies before, it may become an issue for some, certainly not all. It may be that certain companies writing certain lines of business may have more of an issue than other companies that write a more diversified book of business. It’s a little hard to predict at this point exactly where the pressure points are going to lie.”

The controversy around QIS 5 has to do with CEIOPS’ suggestion that a factor called ‘in-force cashflows’ or ‘expected future profits’ should not be taken into consideration when calculating an institution’s core capital. An April 2010 position paper issued by the CEA, a 33-member federation of European insurance and reinsurance associations, describes CEIOPS’ decision to exclude this factor from the calculation of core capital as potentially having “a devastating impact on the industry.”

In-force cashflows include premiums already received; premiums to be received; related acquisition costs; future claims; future expenses; and future investment income. “A firm’s available capital (its own funds) is the net of these assets, less liabilities, and therefore a firm’s own funds includes its best estimate in-force cashflows for existing business,” the CEA says in its position paper. “There has been some discussion as to whether in-force cashflows should be included as Tier 1 capital in Solvency II…The total in-force cashflows for the European insurance industry is of the order of 200 billion euros; we believe that the CEIOPS concept could be in the order of 100 billion euros.” In other words, the CEIOPS proposal could potentially halve the amount of capital available for use in the European insurance marketplace.

Without commenting on the actual formulas under Solvency II, James Falle, Aviva Canada’s chief financial officer, says it was never the intention of Solvency II to “put capital requirements so high that it would put anyone out of business or at a competitive disadvantage. The intention always was to ensure that you had enough capital to run your business and to maintain through shocks that might affect your business.”

Risk-based capital modelling forces an organization to consider the consequences of a 1-in-200 year event, he continues. “And then, when you take a look at all of those shocks and those stresses, decisions are made… as to what level of capital you would need to run your business in each of those circumstances.”

Falle and Ludlow say the recent set of QIS 5 calculations are alarming, to say the least. Nevertheless, both remain confident finessing will be done to properly calibrate the formulas. “Under QIS 5, a significant majority — maybe two-thirds of the industry — would be considered insolvent under those proposed rules,” Ludlow says. “We clearly don’t agree that the [current] calibration is right because the results are quite alarming.”

Having said that, Ludlow says CEIOPS just needs to get back to the right calibration and make sure the right risk factors have been considered. “We need to make sure the right credit or recognition for the benefits of reinsurance and the correlation of risks are all in the right place,” she says.

FERMA’s den Dekker says he is already starting to see the effects of the proposed increase in capital requirements, as the industry braces itself for the stringent regime. While he notes pricing has not yet been affected, “you can see some insurers are reducing capacity in hurricane and earthquake areas. The [coverage available for] catastrophic risks is decreasing and so effectively [the coverage is] becoming more expensive. One area in which European insurers have reduced their capacity is the Gulf region for hurricane exposures, and it has everything to do with the preparation for Solvency II.”

Commercial catastrophe risks, high-volatility risks and long-tail liability risks are more expensive to underwrite than a homeowner’s policy, den Dekker adds. “We are afraid that within an insurance company, there is going to be a fight for capital. Underwriters have knowledge of their clients and their exposures. Now they have to go to their chief risk officers or chief financial officers to ask them to allocate capital to this risk. Meanwhile, at the same time, an underwriter from personal lines is asking them for capital. You might understand that the CFO of a big insurer would like to allocate less expensive capital to a customer more than very expensive capital.” den Dekker adds the fear is that catastrophic, volatile and long-tail liability exposures will be so expensive for the underwriter that insurers will be forced to raise prices considerably — or lower the availability of insurance limits.

Falle says the use of economic capital modelling in pricing will likely have an impact on the pricing and geographical mix of business. But to what degree remains unclear at the moment. “For example, you wouldn’t be assigning the same level of capital to a business that’s in Toronto to one that’s located in Vancouver and sitting on top of an earthquake fault line,” he says. “It is going to cause people to take a different look at their business. Is it going to create capacity issues? I think it’s way too early to tell. It is going to cause companies that deploy this to think about the mix of their businesses, the types of businesses in which they get involved and the types of risks they underwrite. It is going to cause all of us to go back and take a second look at all of that. How that impacts policyholders and the industry at large is too early to tell.”

For his part, den Dekker remains cautious. “If capacity runs scarce because underwriters are not able to allocate capital anymore, then we [risk managers] really have a large problem because we will not be able to insure our largest risks that we have as companies.”

Knocked out of the game

If risk managers’ concerns about the rising cost and shrinking availability of capital prove to be founded, den Dekker sees the stringent requirements under Solvency II spurring merger and acquisition activity, thus decreasing competition in the insurance marketplace.

“The smaller and medium-sized companies in Europe that fill a very important role — these are the very old and longstanding mutual and cooperative companies that carry niche products — do not have as easy access to capital markets as regular insurers,” he says. “If they have to increase their internal capital, what you are going to see is that they will likely close down or be acquired by the larger insurance companies. That observation is starting to [manifest in the European market] and it has already started to create some complications.”

Simmons agrees that smaller, less diverse companies will face a greater challenge than their larger counterparts. “It’s not just that the factors to be applied to premium, reserves and investments which have increased, but there are also changes to the handling of diversification, correlation and catastrophe risk. The combined impact will be very specific to each company.” The weight of the governance and compliance requirements may prove to be too much for these smaller companies to bear, Simmons says. “The compliance issue shouldn’t be a driver for why companies will merge but, broadly speaking, it wouldn’t surprise me.”

Simmons observes further that larger companies have the ability within Solvency II to replace either all of the standard formula for calculating capital or some of the standard formula with approved internal models. A smaller firm, on the other hand, will not have the resources to develop their own internal models. As a result, the smaller operations will be held to the standard model’s more stringent capital requirements.

Bill Panning, executive vice president with Willis Re in Philadelphia, agrees the ability to create an internal model will further divide the smaller companies from the larger ones. He also sees the potential for the use and development of internal models to exacerbate any market fluctuations in the future.

“If you look at what happened in the investment world … there was a culture that developed in which people were specialists in this area and they moved around to all of the firms, and all of the firms ended up with similar models,” Panning says. “So, if there is a blind spot in one firm’s model, all of the firms have similar blind spots.”

DOMINO EFFECT

Whether or not Solvency II causes a hard market and a rush of mergers and acquisitions activity in Europe or in Canada is yet to be determined. But here on the home front, the uncertain direction of the proposed Solvency II changes has already fanned speculation about a potential domino effect. To prevent Europe’s regulatory dominoes from falling over into North America, some argue OSFI should be applying to CEIOPS for what is called ‘equivalency status.’ If OSFI were to gain equivalent standing, essentially it means CEIOPS would recognize OSFI’s regulatory regime as being on par with its own, and therefore the requirements of Solvency II would not apply to Canadian entities. But as of press time, OSFI confirmed it had not applied for equivalent standing with CEIOPS.

Until the issue of equivalent standing among the regulators is resolved, Canadian organizations with ties to Europe should prepare themselves for the possibility that they will be held to CEIOPS’s high capital standard. And until OSFI firms up its own risk-based capital regime, Canadian entities are bracing themselves for a regime as stringent as the one to which their European counterparts are being held, says Keith Old, the managing director (Canada) of Bishop Phillips Consulting in Vancouver.

Old’s clients include organizations in the banking industry, the insurance industry, multinational corporations (one with a captive insurer in Europe) and an insurance sector regulator. “The general perspective is that there is definitely a lot of uncertainty, so that is affecting people,” he says. “The whole financial regulation sector in Europe is undergoing a fair level of change and that’s creating a level of uncertainty here. Each of [my clients] requires a fair level of resources to identify the implications and put in a process to deal with those.”

One of Old’s clients is an aerospace engineering firm with a captive based in Luxembourg. Under Solvency II, captive insurers will be held to the same standard as their regular market counterparts — a decision that has raised the eyebrows of many risk managers who rely on self-insurance as part of their organization’s risk management program.

Old says under the Solvency II regime, his client’s captive would be required to keep roughly three times its current holdings. “They’re not comfortable with that,” he says. “They only set up this captive two or three years ago; now they’re having to consider moving it, because they consider the requirements for that captive to be unrealistic.”

For Canadian branch insurers with European parent companies, the potential exists for the flow of capital between the parent company and the Canadian branches to be affected, “particularly in times when there are major events occurring and a lot of claims are being incurred,” Old says. “It’s an unknown effect, but I think potentially that could definitely happen.”

Parent companies based in Europe may benefit from the strength of their Canadian branches, but it may not necessarily be a two-way street, Simmons says. “Implicitly, if you are a European entity operating in Canada or in the United States, then you can [benefit from] the profit and the strength of your overseas operation. But unfortunately, the reverse doesn’t necessarily work.”

Ludlow points out that operating under two different regimes is really no different than how Canadian branch operations or subsidiaries already operate. If anything, the regimes will be brought closer into line with one another once all is said in done, she says. At the moment, working within the various regulatory regimes that are currently so different from one another actually inhibits the ease of exchanging capital (this is called ‘fungibility’). “Assume for a moment that the Canadian model converges quite closely with Solvency II,” she says. “We’re not there yet, but that would mean it would make our lives much easier because we would have fungibility of capital. From a regulatory burden perspective, we would be no worse off than if we were to have a separate Canadian regime. Solvency II is not going to make things worse, but we will have a transition period of a number of years that will make things complicated and confusing. But I think the ultimate goal around the world is that there is a convergence of capital tests and accounting (i. e., the conversion to IFRS), such that you end up with a much easier system, with less regulatory burden, that would allow companies to operate in a much freer manner across borders.”

Should CEIOPS not ultimately recognize OSFI as an equivalent, “it will continue to impact the credit for reinsurance/ collateral regime if we are looking for credit as a reinsurer,” Ludlow says. “If we’re not equivalents [under this scenario], then all of my comments about capital fungibility go away. I won’t have that ability. But, let’s be very clear, I don’t have that ability today.”

For those organizations able to embrace risk-based capital modelling, it would create a competitive advantage, Falle adds. “One of the things you have to do in the use test is to make use of the economic capital modelling in pricing. So, clearly it would give us a better view as to the most efficient way to deploy capital and maximize returns in Canada.”

Wait and see

To some extent, the Canadian regulator has already headed down the path of a risk-based regime, says Nigel Ayers, Zurich in Canada’s CFO. “What’s happening right now is that OSFI is working with the industry to look at certain aspects of Solvency II and how those might be implemented in Canada and how our regime might change in light of Solvency II,” Ayers says. “That’s not to say that OSFI will be adopting Solvency II in full, but certain aspects of it.”

When all is said and done, the market tends to adjust to these new regulatory regimes, Old says. Theoretically at least, as long as regulators keep the playing field even, the players competing on the field won’t change. But the worry with Solvency II is that its application “won’t be done in an even-handed manner, and it will create more inequity in the market place,” Old says. “If that happens, then risk managers will be operating on a very different purchasing landscape.”

Old believes OSFI is doing the right thing by observing the Solvency II roll-out before deciding which aspects, practices and principles it would like to adopt — or whether or not it sees a value in applying for equivalent standing. Still, he adds, “until people know what OSFI’s attitude is, there will always be that nervousness. OSFI is doing the right thing in my view. They’re not saying anything that will cause panic or set people off down the wrong path until they know what the story is. And that’s entirely appropriate. It will always be that until OSFI comes out and says, ‘Here’s our position in relation to Solvency II,’ the uncertainty and the nervousness will persist. In the meantime, the market and industry is trying to keep nimble.”

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Risk managers are concerned that European regulators, in their efforts to protect policyholders, have set the bar for economic capital requirements too high. As a result, the Solvency II regime may in fact have a negative effect on the availability and price of insurance coverage.

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Experts warn that small-and mid-size insurers might have a hard time meeting the proposed capital requirements. If so, larger insurers would likely swallow these small-and mid-sized insurers, thus reducing competition in the market place.

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We operate in a global village. The world does not stop at the borders of Canada. Solvency II will have an impact on the Canadian insurance market.

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It was never the intention of Solvency II to put capital requirements so high that it would put anyone out of business or at a competitive disadvantage. The intention always was to ensure that you had enough capital to run your business.