Impact Assessment: Possible macroeconomic and financial effects of Solvency II

Transcription

1 DG ECFIN/C-4(2007)REP Impact Assessment: Possible macroeconomic and financial effects of Solvency II Contribution of DG ECFIN March

2 Table of content 1 Introduction The Economic and Financial Importance of the EU insurance sector The role of insurance Key economic and financial figures for the EU insurance sector Key characteristics of the EU insurance sector Impact of Solvency II on the EU insurance sector Impact on capital requirements and excess capital Balance sheet structure and the level of capital requirements Volatility of capital requirements Valuation of assets and liabilities and portfolio reallocation Greater transparency and market discipline Industry structure and business model Organisational structure and processes Insurance product design and prices Overall impact of Solvency II on insurance sector Impact of Solvency II on the EU economy and financial sector Changes in insurance products supply Availability of insurance products Impact of insurance price changes Impact of investment reallocation on financial markets Impact on asset prices Deepening of the euro area bond market Impact on competition in the insurance sector Impact on risk exposures Transferring risks from insurers to other economic agents Contagion effects Conclusion Annex

3 1 Introduction Solvency II will introduce a new regulatory capital regime and modify the principles for the risk assessment in the management of assets and liabilities in the EU insurance sector. It should also streamline prudential practices and encourage supervisory convergence across Member States. The objective of Solvency II is to improve the solvency of the insurance sector and, by extension, underpin the stability of the broader financial system, while offering policyholders a better guarantee that their contracts will be honoured. In accordance with the Lamfalussy approach, the proposed framework Directive under Solvency II (Level 1) will be complemented by implementing legislation (Level 2). As the implementing measures are unknown at this stage, the macroeconomic and financial impacts of Solvency II are difficult to assess with precision. Accordingly, this impact assessment (IA) for Solvency II should be considered as largely qualitative and preliminary and there may be a need for revision as the implementation details emerge. The purpose of an IA is to identify the expected positive and negative effects of a proposal and to assess possible trade-offs between these effects. Prima facie evidence would suggest that macroeconomic impact of Solvency II would be marginal, while the impacts on financial sector particularly in terms of stability may be more significant. The approach followed in assessing the macroeconomic and financial impact of Solvency II is to review the various possible transmission channels between the insurance sector and the economy and to infer, as far as possible, from stylised facts the importance of these channels. Positive and negative transmission effects may offset, making assessment of the overall net effects rather tentative. When considering the possible transmission channels of Solvency II to the macro-economy and financial sector, two factors should be borne in mind. First, the progressive transition from the existing national regulations to a new harmonized European regulation will imply both transition effects and longer-term steady-states effects. The transition effects - which are mainly short-term adjustment costs towards the new steadystate - may differ across Member States and across firm, reflecting different starting points. The long-term steady-state effects capture the structural implications of the new framework after full implementation. However, distinguishing between these two types of effects is not straightforward. For example, the new risk assessment methods implied by Solvency II may lead to a transient increase in risk to financial stability during a learning period while the long-run effect would be stability enhancing. As far as possible, the analysis will distinguish between these two types of effect. 1 Second, the transmission of the effects of Solvency II can be generally presented as: (1) the impact on the insurance industry; (2) the transmission of the (financial) impact from the industry to the macro-economy; and (3) the transmission of the (financial) impact from the industry to stability of the financial system 2. The impact on the industry would include the implementation of the new computation methods for capital requirement, the possible 1 It should be noted that following the first announcements relating to Solvency II (2004), some insurance companies have anticipated the forthcoming Directive and have adjusted their risk management. Therefore, to some extent, the transition period has already started. 2 See also Annex 1 for a schematic overview. 3

4 adjustment of business models etc. Subsequent impacts on the macro economy and financial sector would result from changes in assets-liability management techniques, changes in the demand for certain types of financial assets, reductions in insurance cover, changes on the budget constraint of firms and households etc. In terms of financial stability, changes in the supply of insurance products could result in a transfer of risks 3 back to the households, firms or other financial intermediaries 4. The schematic representation above applies to the majority of transmission channels but not all. Moreover, it does not account for possible feedback effects and endogeneity in the system. Possible interactions between different stages of the transmission mechanisms should also be borne in mind while reading the following sections. Moreover, the introduction of Solvency II should be seen in a broader context of rapidly changing and increasingly integrated financial markets, which would certainly influence the functioning of transmission channels from the insurance sector. The remainder of this note is structured as follows. Section 2 assesses briefly the economic importance of the EU insurance sector in the economy, while describing the main features the sector. Section 3 explores the likely impact of Solvency II on the insurance sector. Section 4 builds on the previous section and considers the likely transmission of effects from the insurance sector to the macro-economy and financial system. (A summary diagram, illustrating of the macroeconomic and financial effects, is presented in Annex 1). Section 5 concludes and assesses the scope for further and more quantitative analysis. 3 Mainly investment risk. 4 The assessment of the financial stability impact is developed in a separate note: Potential Impact of Solvency II on Financial Stability, ECB,

5 2 The Economic and Financial Importance of the EU insurance sector The role of insurance Insurance plays a role in supporting economic development and welfare by providing protection against financial losses due to the occurrence of certain contingent events. Insurance cover allows firms and households to enter into commitments that might not be possible otherwise. Without the mechanism for mitigation, pooling and transfer of risk provided by insurance, entire categories of business activity (e.g. manufacturing, shipping and aviation, the medical, legal and accounting professions and increasingly banking through credit risk transfer 6 ) would simply be precluded. Similarly, households rely on insurance cover in relation to their house, car and healthcare etc. In this section, the economic and social role of insurance is described under three main headings that are relevant for the remainder of the analysis: Improving risk management and facilitating risk taking: Insurance can cover risks incurred in any economic activity, thereby eliminating the need to maintain financial reserves to protect against contingent risks. In this way, insurance cover improves financial soundness and fosters economic activity by releasing idle capital for more productive purposes. Economic activity is also encouraged by the environment of greater certainty through sensible risk-management- that is provided by access to insurance cover. Consumption smoothing over lifetime: Insurance helps to stabilize consumption over time. Households can protect their assets in case of adverse events, thereby guaranteeing their level of wealth and living standards. Against the background of considerable demographic and social changes, insurance can also be a complement to the State as a provider of social protection, in particular in the field of retirement and health provision. Intermediation of savings and efficiency of capital allocation: Insurance companies are an important and growing segment of the financial sector. They make a pool of funds accessible to borrowers and issuers of equity. By enhancing financial intermediation, creating liquidity and mobilizing savings, they increase financial resources and facilitate firms' access to financing. Insurance companies are typically willing to invest at longer-term maturities, thereby contributing to the development and modernisation of capital markets. 5 This section draws heavily on: "The contribution of the insurance sector to economic and employment in the EU, CEA, June 2006; "European insurance in figures", CEA statistics N 24, June 2006 and "Social and economic value of general insurance", ABI, March See also, Financial Integration Monitor 2006, SEC(2006) Banks are increasingly transferring risk outside the banking sector through (sometimes very complex) structured products of credit risk transfer that are bought, among others, by the insurance sector as an investment. 5

6 2.2 Key economic and financial figures for the EU insurance sector In 2004, the EU insurance sector held approximately 37% of the total worldwide premia, having gradually caught up with North America (see Figure 1). The EU is the world leader in the reinsurance sector. Figure 1: Insurance markets worldwide 100.0% Share in worldwide premium Others 80.0% 60.0% North America 40.0% Asia 20.0% Europe (*) 0.0% Source: Source SwissRe Sigma Europe (*) = Western and Central / Eastern Europe In terms of penetration rate (i.e. the relative importance of the insurance industry in the total economy) the EU insurance sector still lags the US. The penetration rate is usually measured by the ratio of premiums collected as a percentage of GDP in a given year 7. Figure 2 reports two variants of the penetration rate (i) total gross premia in percentage of GDP (Panel A) and (ii) the non-life premia in percentage of GDP (Panel B) 8. In 2004, the ratio of total gross premium to GDP was above 10% in the US but only 8.5% in the EU. The gap is larger when measured on the basis of the non-life premium. The EU25 aggregate hides substantial differences across countries, with the UK and France having relatively high penetration rates and much lower rates in the recently acceded Member States. 7 The explanatory power of these comparisons based on penetration rate is however limited by the structural differences and framework conditions on the various national markets. 8 A comparable figure to panel A and B for the life segments is unfortunately not available. 6

7 Figure 2: Penetration rate (Panels A and B) Total gross premium to GDP ratio - % Non-life premium to GDP ratio - % 14.0% 7.0% 12.7% 6.2% 12.0% 6.0% 5.7% 10.7% 10.6% 10.0% 9.8% 9.4% 5.0% 8.5% 8.8% 8.6% 8.4% 4.3% 8.0% 6.7% 6.8% 7.0% 6.4% 7.5% 7.1% 4.0% 3.3% 3.4% 3.3% 3.4% 3.9% 3.8% 3.9% 3.3% 3.2% 3.3% 6.0% 5.7% 4.8% 3.0% 2.9% 2.6% 4.0% 3.5% 3.5% 3.3% 2.0% 2.1% 1.5% 2.2% 2.1% 1.8% 1.8% 2.0% 2.1% 1.6% 1.0% 1.1% 0.0% UE25 UE15 UE10 DE UK FR IT ES PL JP* US* 0.0% UE25 UE15 UE10 DE UK FR IT ES PL JP* US* Source: CEA 9 * OECD data for Source: CEA 10 * OECD data for Figure 3 shows the shares of countries (including Switzerland) in the total gross premia in Europe in The five largest shares are held by the UK, France, Germany, Italy and the Netherlands, comprising almost 75% of total. 9 CEA, The contribution of the insurance sector to economic growth and employment in the EU, June CEA, The contribution of the insurance sector to economic growth and employment in the EU, June

8 Figure 3: Share of EU25 countries Share of each country in the total 2004 premium SE 2.1% BE 3.1% Other EU 10.3% Others 1.9% GB 24.0% CH 3.6% ES 4.9% NL 5.3% FR 17.2% IT 11.0% DE 16.6% Total premium in 2004: 917,424 million Source: CEA The distribution of premia between life and non-life products varies across countries within Europe (see Figure 4). In general, the relatively large and/or mature markets have a relatively high share of life products, although this observation does not apply to Germany and Spain. The differences in the shares of life and non-life products across countries can be largely explained by differences economic development, saving capacity and social security systems (e.g. transferring the pillar two or/and pillar three pension savings to the insurance sector). Figure 4: Differences life and non-life segments across countries 100% Share of life and non-life direct premium in % 80% 70% Nonlife 60% 50% 40% 30% 20% Life 10 % 0% LU FI BE GB FR IE IT SE DK EU (25) Source: CEA CEA PT MT NL CY GR PL DE AT ES HU SK CZ SI EE LT RO BG LV The insurance sector has emerged as a significant actor in financial markets. In 2005, the total investment portfolio of the EU insurance sector was equivalent to almost 6 billion. 11 The bulk of this investment is in fixed-income securities markets (see Figure 5), although a substantial share is allocated to equities and other variable-yield products. This allocation between fixed and variable yield investments is a relatively recent phenomenon and the 11 CEA, Annual Report

9 combined effects of increased risk aversion after the global equity-market correction in 2000 and, more recently, the implications of adopting International Financial Reporting Standards (IFRS). Figure 5: Investment of insurance industry by category (CEA average) (a) Investments 2004 per category (e) 11.9 % (f) 3.1% (g) 5.0% (a) 4.3% (b) 4.4% (c) 28.2% Land and buildings and participating interests (b) Investments in affiliated undertakings and participating interests (c) Shares and other variable-yield securities and units in unit trusts (d) Debt securities and other fixedincome securities (e) Loans, including loans guaranteed by mortgages (f) Deposits with credit institutions (g) Other investments (d) 43.2% Share of debt securities and other fixed-income securities (% of total, CEA average) Source: CEA, European Insurance in Figures, June Share of shares and other variable-yield securities and units in unit trusts (% of total, CEA average) 37.0% 43.2% 37.1% 42.3% 41.7% 40.4% 32.3% 33.2% 38.7% 39.1% 38.9% 30.7% 36.6% 37.4% 37.2% 26.4% 25.4% 26.0% 26.7% 27.1% 27.9% 28.2% 35.5% 35.1% The importance of the insurance sector as an institutional investor is reflected in its share of total capitalisation of securities markets. For example, the EU insurance sector held 26% of the EU equity market capitalisation in 2004 (see Figure 6) As insurers typically hold shares in listed companies, this is a rather precise estimate of insurers' involvement in EU equity markets. 9

10 Figure 6: Importance of the sector as institutional investor 50% Investments / Market capitalisation % 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: CEA DK LU DE SE AT IE UK EU 25 FR NL EU 12 SI FI BE IT CY PT PL The degree of competition in the EU insurance sector varies across Member States, based on a C-5 indicator (see Figure 7). The link between concentration levels and the level of market development can assessed on the basis of correlations between C-5 indicators and the relative shares of life and non-life segments (which can be used as a proxy for level of market development). A negative correlation has been found between C-5 indicators and the relative share of the life segment in the total insurance market, implying that the larger and more mature markets tend to be less concentrated. On the other hand, the insurance sectors in Finland, Belgium, the Netherlands Italy and Sweden are characterized by high levels of concentration despite being relatively mature markets. In the recently acceded Members States, high concentration rates reflect the presence of former national monopolies. For Malta, Latvia, Lithuania and Cyprus, the difference in concentration between the life and non-life segments is rather striking (as is also the case for the Netherlands and Greece). 10

11 Figure 7: Concentration of the EU insurance markets Market share of the 5 largest insurers, % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% MT LV LT CY FI SI PT PL CZ SK HU NL BE SE CR5 Non life IE CR5 Life GR IT CEA EU (25) FR DK AT UK ES Source: CEA Legend: No 2004 figures for DE, EE, LI and LU. Non-life figure for NL is Key characteristics of the EU insurance sector The figures presented above indicate important differences in the economic and financial weight of the EU insurance sector when viewed on a disaggregated basis. These differences are also evident from a more detailed examination of the key characteristics of the sector, such as types of product sold and main distribution channels. Based on a topography prepared by the CEA 13, it is possible compare the key characteristics of the insurance sector in a selected number of EU Member States: France, Germany, the Netherlands, Sweden and UK. These Member States have been selected on the basis of their relative weight in the EU insurance sector and/or on the basis of specific features that distinguish them from the EU average. In comparing the insurance sectors in these Member States, it must be borne in mind that the definitions for insurance products are not harmonised across the EU. 13 CEA, Topography of EU25 Insurance Market,

12 Table 1: France Life products Non-life products Life insurance - euro based 77% Automobile 36% Life insurance - unit linked 16% Bodily injury 16% Bodily injury (accident, health) 4% Property personal 12% Capital redemption bonds 3% Property - commercial 12% Property agriculture 2% Miscellaneous 7% General liability (1) 6% Construction (2) 4% Natural disasters 3% MAT (3) 2% Total 100% Total 100% Main Distribution channels Life Business Non-life Business Multiple intermediaries (Brokers) 13% 18% Tied agents and employees 7% 35% Salaried sales associates 16% 2% Financial Institutions 62% 8% Direct writing company - 3% Others 2% 34% Total 100% 100% In France, more than 65% of total gross premia relate to life products (see Figure 4). Of these premia related to life products, 77% are traditional products (euro based) and only 16% are unit linked (although these products have become more popular in recent years). There is a wide range of non-life products available, with motor insurance constituting the main component of the market. The channels of distribution for both life and non-life products are diverse. Financial institutions (mainly banks) are the main distribution channel in the life segment, while tied agents are the most important distribution channel in the non-life segment. According to the CEA, intense competition among distributors is leading to a consolidation in the brokerage field, forcing insurance companies to restructure tied agency networks and spurring the development of alternative distribution channels. 12

13 Table 2: Germany Life products Non-life products Endowment 46% Motor insurance 41% Annuity 26% Property 26% Unit linked (capital and annuity) 14% General Liability 12% Group insurance 10% Accident 11% Term 4% Others (legal expenses, marine, credit) 10% Total 100% Total 100% Main Distribution channels Multiple intermediaries (Brokers) 20% Tied agents and employees 70% Direct Marketing 3% Others 7% Total 100% The German insurance market is relatively evenly distributed between life (45%) and non-life (55%) segments. Endowments (guaranteed products) represent the bulk of life products, with unit-linked products having a share similar to that in France. Similar to France also, motor insurance represents the biggest share of the non-life segment. It is notable that the distribution channels for insurance products in Germany are rather concentrated, with the bulk of products distributed by tied agents and employees. Table 3: The Netherlands Life products Non-life products Pensions 25% Accident and health 50% Deferred annuities 15% Motor vehicle 20% Direct 11% Fire 14% Mortgages 9% Transport 3% Others 40% Others 13% Total 100% Total 100% Main Distribution channels Life Business Non-life Business Multiple intermediaries (Brokers) 54% 50% Tied agents and employees 15% - Banks 21% 11% Direct Marketing 10% 32% Others - 7% Total 100% 100% 13

14 The Netherland insurance market is more or less equally split between the life and the non-life segments. In the life segment, there is no dominant product although pensions represent the largest share. In the non-life segment, health and accident insurance is the most popular product, followed by motor insurance. The distribution channels are dominated by three main actors: brokers (which are the most important), direct marketing (which is relatively developed in comparison with other EU countries) and banks. Table 4: Sweden Life products Non-life products Unit linked 44% Business & house owner 21% Occupational pension 37% Householder & homeowner 17% Others 19% Motor third party (TPL) 17% Other motor 18% Accident and health 23% Others 4% Total 100% Total 100% Main Distribution channels Life Business NA Non-life Business NA The share of life segment in the Swedish insurance market is almost 65%. Another prominent feature of the life-segment is the high share of unit-linked products. Property policies are the most popular non-life products (38%) followed by motor insurance (35%) and accident and health products (23%). 14

15 Table 5: United Kingdom Life products Non-life products Life insurance 36% Motor 31% Individual pensions 28% Property 29% Group pensions 34% Accident and health 1) 14% Income protection and critical illness 2% General liability 14% Pecuniary loss 12% Total 100% Total 100% Main Distribution channels 100% 90% 80% 70% 60% Personal lines 50% 40% 30% 20% 10% 0% Commercial lines 100% 100% 90% 90% 80% 80% 70% 70% 60% 60% 50% 40% 30% 20% 20% 10% 10% 0% 0% Other Affinity groups Direct Banks Company agents Other intermediaries and brokers National, chain and telebrokers The UK insurance market is also characterized by a very high share in the life segment (69%) of the total market. Pension products (for individuals and groups) represent over 60% of the life segment. The remainder of the life market is mainly allocated to life insurance products. The non-life segment is dominated by motor and property insurance. Brokers still play a dominant role within the commercial product lines (although there is evidence of change). In retail product lines, brokers have already lost significant market share to direct marketing channels, banks and affinity groups. 15

16 The investment behaviour of insurance companies in these Member States also differs considerably. In the Netherlands, 40% of the assets are invested in debt securities and other fixed-income securities and slightly less than 30% in equities and other variable-yield securities. The remainder (between 10 and 15%) is allocated mainly in loans (including loans guaranteed by mortgages). In Germany, 50% of investment is allocated to loans, while equities and variable-yield securities represent about 20%. In contrast with all other Member States, German insurers invest only marginally in fixed income securities (around 10%). Meanwhile, insurers in France invest the bulk of their assets in fixed-income securities (almost 70%) and the remaining 20% in equities, leaving portfolios among the least diversified in the EU. Insurer investment patterns are broadly similar in the United Kingdom and Sweden, with portfolios allocated more or less equally (about 40%) between fixedincome securities and equities. Figure 8: Categories of investments for selected countries Investments by categories, % 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% DE FR UK NL SE CEA (a) (b) (c) (d) (e) (f) (g) (a) Land and buildings and participating interests (b) Investments in affiliated undertakings and participating interests (c) Shares and other variable-yield securities and units in unit trusts (d) Debt securities and other fixed-income securities (e) Loans, including loans guaranteed by mortgages (f) Deposits with credit institutions (g) Other investments Source: CEA 16

17 3 Impact of Solvency II on the EU insurance sector Section 2 illustrates the extent of diversity in national insurance sectors across the EU and highlights the various "starting points" in different Member States in the context of the regulatory reforms implied by Solvency II. Allowing for this difference in starting points, this section examines the possible effects of Solvency II on the EU insurance sector 14. This is the first stage in the schematic framework of analysis (see yellow column in Annex 1 of this document) and is based on a Level 1 Directive (i.e. principle-based legislative proposal). As many of the detailed elements of the Directive are not yet available, the analysis is substantially inspired by the experience of the Swiss Solvency Test 15 which has many parallels with the Solvency II project. 3.1 Impact on capital requirements and excess capital The first direct effects of a new regulatory capital regime implied by Solvency II would relate to the assessment of technical provisions and capital requirements, and particularly excess capital. The impact of Solvency II on overall capital requirements will depend on the starting point (e.g. legal environment, supervisory culture etc.) in the Member State and the risk profile of both individual insurers and insurance sectors. Accordingly, the initial effect on capital requirements is likely to vary significantly across Member States but will derive from the balance sheet structure proposed under Solvency II, which is presented schematically in Figure 9. Figure 9: Balance sheet structure under Solvency II Excess Capital Market consistent Value of Assets Solvency Capital Requirement Market consistent Value of Insurance and Other Liabilities Assets Liabilities 14 It is not the purpose of this note to present a comprehensive overview of the Solvency II regulation. The focus rather lies on the expected impact of such a regulation. For a more extensive presentation of the regulation please refer to "Solvency II - proposal for a framework directive". 15 This section is also inspired by a study published by Swiss Re: "Solvency II: an integrated risk approach for European insurers", Sigma N 4, 2006, Swiss Re. 17

18 The main principles with respect to balance sheet structure and capital requirements under Solvency II are: Insurance and reinsurance companies are required to maintain technical provisions 16, according to the value of their insurance liabilities. These provisions will be calculated according to methods and parameters, which will be modernized and harmonized throughout the EU. Insurers and reinsurers will be required to hold at all times enough capital (i.e. essentially an excess of assets over liabilities) to meet the Solvency Capital Requirement 17 (SCR) and to serve as a buffer against unexpected losses. The amount of required capital will be calculated, either in accordance with a standard formula, or using an internal model possibly reflecting better the individual characteristics of the company and its risk profile. Solvency II builds on a "total balance-sheet" approach in which technical provisions and SCR add up to total capital needs of the insurance company. In meeting such needs, the insurance company is required to hold at least an equivalent amount of assets of sufficient quality 18. The amount of asset holdings over and above these capital needs is termed excess capital. Accordingly, the net impact of Solvency II on the financial position of the EU insurance industry - the excess capital in particular - will stem from changes in the assessment of all three components of the balance sheet - technical provisions, SCR and assets Balance sheet structure and the level of capital requirements Assessment of the likely impact of Solvency II on balance sheet structure is based on the results of the QIS 1 and 2 exercises 19. However, the objective of these exercises was to test the structural design of Solvency II so their implications for balance-sheet structure must be treated with some caution. 20 Under Solvency II, the calculation of technical provisions should be based on available market information for the valuation of insurance liabilities. An important change introduced by Solvency II would be use of the risk-free interest rate term structure for discounting technical provisions, which in not the case under Solvency I in several Member States (e.g. France, Italy, Germany). Discounting technical provisions using a market interest rate instead of a maximum guaranteed rate would imply a significant decline in valuation. The Solvency Capital Requirement (SCR) under Solvency II is expected to better reflect the true risk profile of the insurance company than the current regime by capturing more risks, such as, mortality-longevity risk, catastrophe risk, credit risk, market risk, operational risk. This could lead to additional capital requirements, although the use of risk mitigation tools such as diversification and reinsurance could allow insurers to lower their overall risk profile. 16 Technical provisions = the regulatory valuation of insurance liabilities. In Figure 9 they are included in "other liabilities". 17 Note that the regulation will also foresee a Minimum Capital Requirement (MCR). The MCR reflects a level of capital below which the operations of an undertaking represent an unacceptable risk to policyholders. If basic own funds fall below the MCR, ultimate supervisory action is triggered. In other words, as part of the SCR, the MCR is the lower bound that, once breached, triggers the intervention of supervisors. 18 I.e. invested in accordance with the prudent person principle, relying on good asset management practices, rather than in accordance with general quantitative prescriptions and they should be selected on the basis of their economic ability to absorb risk. 19 QIS 1was an exercise for the valuation of technical provisions; QIS2 was testing different options for the SCR and MCR. 20 When considering QIS 2 results, some caveats listed in the QIS 2 report should be borne in mind. 18

19 QIS 2 results indicate a different balance-sheet impact for the life and the non-life segments. The SCR for the non-life segment is likely to be significantly higher than the current level (2 to 4 times the current minimum) because Solvency II would demand higher capital charges for "low-frequency, high-severity" risks. The SCR for the life segment should be closer to the current level (0.5 to 3 times the current minimum). On balance, the QIS 2 results indicate that the EU insurance sector holds enough capital to withstand these balance-sheet adjustments. The situation varies across Member States, with some having already developed their own risk-based capital requirements (such as the UK and Netherlands) and moved in the same direction as Solvency II. For individual insurers, the change in capital requirements linked to Solvency II will very much depend on the starting point, i.e. the prudential supervisory environment and the insurer's specific risk profile. As the existing regulation does not really discriminate between risk profiles, Solvency II will probably lead to increase capital requirements for some companies and a decline for others. Insurers exposed to investment risk, insufficient portfolio diversification, disability and surrender risks, may be confronted with higher capital requirements, while insurers with a conservative investment strategy, resorting to reinsurance and writing retail insurance policies may need less capital. Accordingly, large insurance firms or groups, with well diversified insurance portfolios (e.g. geographical diversification) will face relatively lower capital requirements than small mono-line companies, exposed to one type of risk concentrated in one region (although they will try to manage their risk actively). Therefore, a decline in capital requirements would be expected in relatively large companies, while the effect on capital requirements for small and medium-sized firms is more difficult to predict. The choice of risk evaluation model will have important implications for the capital requirements of individual insurers. Insurers will be generally free to choose between a standard formula and an internal model. Specialised firms, for which the standard formula would be likely to underestimate their risk profile, could be required to build an internal model. As internal models are expected to result in lower SCR than the standard formula, there will be strong incentives to use internal models 21. For insurers using an internal model, the supervisory review process will need to take account of control and model risks and will need to demonstrate the extent to which the internal model(s) appropriately reflects the actual amount of required capital. Where incentives to implement an internal model are not strong enough, insurers will opt to calculate their SCR using the standard formula. Firms using the standard formula will need to assess the extent to which it adequately captures their particular risk exposures, while setting-up internal control, risk management and governance systems (Pillar Two measures) and decide if internal model would not be more appropriate. The design of the standard formula would be crucial as the extent of risks and their interdependencies should be appropriately assessed. It cannot be excluded that a poorly designed formula would create some financial stability risk, by increasing the risk of default of an insurer and the risk of contagion to other insurers (see Section 4.4.2). 21 See also, CEA, "Results and discussions on the impact assessment of future Solvency II framework on insurance products and markets", February This study shows that only 5% of large insurers and 52% of smaller insurers intend to use the standard approach. 19

20 3.1.2 Volatility of capital requirements The new rules for calculation of capital requirements under Solvency II could induce more volatility in capital requirements. Under existing rules, the required solvency margin is essentially calculated on the basis of collected premia, claims and technical provisions. As a result, changes in the capital requirements mainly reflect changes in the volume of business written by the company. Under Solvency II, the calculation of capital requirements will be based on the assessment of the insurance company risk profile using updated market information. Therefore, the amount of capital required may change substantially from year to year, depending on changes in the risk profile of the insurer and financial-market developments. This phenomenon is expected to be more marked for companies using an internal model, since internal modelling should reflect the risk profile of an insurer even more accurately than the standard formula. A particular source of volatility in capital requirements would be changes investment-risk exposure (e.g. equity vs. bond allocation), in operationalrisk exposure (e.g. fraud, mis-selling, IT issues) or in underwriting-risk exposure (e.g. changes in the business mix), which will be assessed at least once per year. The overall risk profile will take into account the correlation between these different types of risks, which may also change in the medium to long term. It is worthwhile highlighting some cases where capital requirements may become particularly volatile under Solvency II. The introduction of risk-related capital charges for both underwriting and investment risks could result in more stringent capital requirements for products with a high claims volatility (e.g. certain property covers), long-term products and products with guarantee and option features. One-off transfers of required capital to lines of business showing a higher risk exposure could take place. In other words, a reallocation of capital compared to the current situation could be observed (although the overall amount of capital required in the sector would not necessarily change). The direction of the shifts in capital allocations would be from "high-frequency, low-severity" to "low-frequency, highseverity" lines of business. Those reallocations could occur either within the company or from one company to another and would depend on the company's business model. (see Section 3.4) As a general conclusion, it is likely that insurers will choose to hold additional capital as a buffer in response to increased volatility in capital requirements under Solvency II. 3.2 Valuation of assets and liabilities and portfolio reallocation In the risk-based economic approach implied by Solvency II, assets and liabilities would be valued as closely as possible to their true economic value, i.e. marked to market. Indeed, Solvency II is expected to emphasise the importance of realistic balance-sheet valuation as the foundation for the development of a risk-based capital regulatory regime. To this end, Solvency II should as far as possible provide prudential valuation standards for assets and liabilities for insurance undertakings. These standards should be compatible with the accounting rules elaborated by the International Accounting Standards Board (IASB). The IASB is currently working on an "Insurance Contracts" project (which concerns measurement of insurance liabilities for accounting purposes) and the final standards will not be known for some time yet. For the purpose of this analysis, we assume market-consistent valuation of 20

21 assets and financial liabilities, based on the information provided in "Amended Framework for Consultation on Solvency II" 22. The value of assets held by insurers will be affected by a move to a mark-to-market valuation in several ways. First, the average value of the total balance sheet may change in comparison with amortised historical cost accounting. For example, the current low level of interest rates would imply an upward revision in the value of fixed income assets bought with higher yields, while the valuation of intangible assets could decline in value. However, QIS 2 suggests that the new prudential valuation standards should have a positive overall impact on the amount of available solvency capital, as it is likely to reduce technical provisions and increase asset valuations. 23 Second, the implementation of market consistent/fair value accounting 24 of financial assets may give incentives to investment managers, particularly in the case of lifeinsurance policies, to focus excessively on short-term investment results. The market value of assets, at any given time, may not provide the best estimate of their intrinsic value and so result in a distorted view of the long-term financial health of an insurer. This is especially true for long-dated assets where the value may be particularly sensitive to short-term market developments (and which are likely to constitute a major part of the investment portfolio of an insurer for reasons of assets-liability management). Third, capital charges for investment risk may encourage insurers to shift to safe investment especially when the expected financial returns of risky assets do not offset the additional capital requirement. 25 In this context, insurers could reduce the share of equity and real estate in their portfolio and switch to high-rated bonds, in order to reduce their SCR. Again, the direction and amount of portfolio reallocation will depend on the initial structure of the insurer's investment and insurance portfolios. However, as insurers are aware of changing regulation and have been rebalancing their portfolios accordingly, there should not be any significant sudden portfolio reallocations in the transition period. (See: Potential Impact of Solvency II on Financial Stability, ECB 2007) Another possibility to reduce investment risk would be hedging, either by natural means or by using derivatives. Insurance companies could hedge their exposure to investment risk e.g. by buying put options for equities or buying swaptions to reduce interest-rate risk. Alternatively, insurers with a high share of long-term, guaranteed products could improve their asset-liabilities matching, which is a cheaper means to reduce interest-rate risk than buying swaptions (See Section 4.3). The cost 26 of identifying and developing hedging strategy may be prohibitively high for smaller insurers. 27 The impact of assets revaluation and portfolio reallocation will vary from Member State to Member State, depending on the overall investment pattern of their national insurance sectors 22 MARKT/2515/06, 23 The extent of those variations should be seen against the background of interest rate conditions. 24 When market valuation is not possible, assets should be valued following the fair value accounting principles. 25 In the context of the whole portfolio, i.e. including the possible diversification benefits. 26 Mainly personal and software. 27 However, smaller companies with the need for lower amounts of long-term fixed income assets for ALM would be able to meet those needs more easily than larger insurers. 21

22 i.e. the distribution of variable-yield versus fixed-income holdings (See Section 2). Moreover, portfolio reallocation may vary across Member States because the exact criteria for assetsliabilities matching are laid down in domestic legislation even though current EU legislation determines which categories of assets are eligible to cover technical provisions. Rebalancing of the investment portfolio will also depend on the stage of development and integration of financial markets. In countries where more sophisticated products are not yet available, the possibility of hedging will be limited, unless they are well integrated with other more developed markets. Life insurers offering long-term guaranteed products in countries where the supply of long-dated (e.g. more than 10YTM) is scarce would have to provide higher solvency capital because of an unavoidable maturity mismatch in their assets and liabilities. In terms of currency risk, the euro-area and non-euro area Member States must be distinguished. Insurers from the euro area enjoy access to a large, liquid and developed financial market, where they can more easily access securities matching their liabilities without taking into account currency exposure. Insurers outside the euro area (particularly in Member States with small financial markets) do not enjoy the opportunities and will face either additional capital charges for currency risk or will be required to hedge that currency risk at additional cost. 3.3 Greater transparency and market discipline Solvency II should achieve greater supervisory convergence across the EU insurance sector. This will help to ensure that there is a level playing field for all insurers and should provide a common standard for protection to all EU consumers regardless of the insurers legal form, size or location. Convergence in supervisory practices should imply enhanced transparency and disclosure among insurers across the EU. Solvency II is expected to require that insurance and reinsurance companies provide the supervisory authorities with information on internal governance provisions, risk models, scenario testing, and other internal procedures as well as financial and investment information (so-called Pillar Two measures). Consequently, supervisors will be provided with a more complete picture of the solvency situation of the insurer and therefore should be able to react to any deterioration in the solvency position and take corrective actions. This additional information could improve the timing of intervention by supervisors, particularly in relation to an insurer experiencing a deteriorating solvency position. Solvency II is also expected to require supervisors to work much more on risk assessment of individual insurers and on decisions regarding ultimate supervisory action. 28 Under Solvency II, there will be specific measures requiring public reporting and disclosure as a means to enhance market discipline (Pillar Three measures). Regulated insurers will be required to make key information available to financial markets. Greater transparency should help shareholders and potential shareholders to understand risk exposures and accurately value the company by reducing information asymmetry. To the extent that potential investors are more confident in the state of their financial health, insurers should find it easier to raise capital. Nevertheless, there may be additional costs in complying with Pillar Three provisions. The current very different levels of transparency required in the Member States implies that compliance costs will vary among insurers but, for cross-border providers, there will be offsetting savings from more convergent transparency requirements across the EU. 28 These features should positively contribute to enhancing financial stability (see Section 4.4). This would also require additional resources for the supervisors (see Report on the Impact of Solvency II on Supervisory Authorities, CEIOPS 2007). 22

23 3.4 Industry structure and business model The greater emphasis on the risk measurement and management implied by Solvency II can be expected to impact on the structure of the EU insurance sector and on business models pursued by insurers. By linking the amount of required capital with the level of risk, Solvency II should eventually result in a more efficient allocation of capital across lines of business and enhanced competition in the provision of insurance products. To this end, insurers will have a stronger incentive to seek the best premium/risk profile combination and optimal scale of operation, which is likely to induce structural changes in the sector. Insurance companies will also need to critically analyse individual products (risks covered, guarantees, pricing, options etc.) and the impact of product features on their SCR. A comprehensive revision of some business models (product design, marketing and sales, asset-liability management) could be expected. While these changes will impose adjustment costs, it should be remembered that the financial sector is in a process of continuous change and changes in the insurance sector must be seen in this context. Indeed, regulatory reform is not the only driver of upgraded risk management in the insurance sector, where shareholder activism, pressure from ratings agencies and intensified competition are also relevant Organisational structure and processes In order to minimise operational risk under Solvency II, insurers would need to adapt their activities to eliminate potential "weak links" in their organisation. Since capital requirements should be determined on a group basis, minimising operational risk may mean that branches become more specialised in their activities or develop entirely new business lines (e.g. create specialised distribution companies that sell brand and white-labelled 29 products). Insurers will also need to decide whether to be a product provider or to focus on distribution and tailoring existing products for customers. In such a context, insurers could opt to focus more on core competencies and no longer pursue an integrated business model 30. Insurers may also have incentives to consolidate further, as the implementation of Solvency II could require substantial investment in data collection, IT and risk management systems and expertise. Similarly, strengthening risk management will give rise to fixed compliance costs which are likely to fall more heavily on small firms. While this effect should be smoothed by applying the proportionality principle (limited reporting requirements for small firms), the higher weight of compliance costs for small firms could be a further driver of consolidation. Moreover, the use of relatively sophisticated internal models for risk management could ensure lower regulatory capital requirements - and a consequent pricing advantage for bigger insurers. 29 White-labelling occurs when a supplier packages an existing product or produces new products for another company with that company's own label. For white-labelled services, a provider re-brands processes with the name of the user firm. Customers of the user firm believe that it is the user firm that is providing the service and not a third party. 30 This scenario is not very likely in the short term but could materialize in the longer term. 23

24 3.4.2 Insurance product design and prices 31 A revision of product design in some insurance segments is a likely outcome of Solvency II, implying a change in the range and/or prices of products offered. 32 In this process, insurers might review profit sharing arrangements and the need for options and long-term guarantees. They might introduce terms and conditions, which allow for adjustment (like indexation of premiums to inflation or regular review of the annuity conversion rate), guarantees to consumers may be reduced and surrender value terms changed. Other possible approaches to risk mitigation via product design would include offering combined risk products, extending the risk base to benefit from better diversification, hedging risks, passing them on to the reinsurers, or securitisation. The type and scope of modifications to product design would be likely to vary from insurer to insurer. Life insurers, focusing on traditional guaranteed products, could be more affected than those who offer mainly unit-linked products (See Section 2) and could face a trade-off between modifying their product design and accepting an additional capital charge. In the case of life product modifications, it should be noted that modifications could mean the transfer of investment and longevity risk to households (see Section 4.4.1). In the non-life sector, similar changes in product design could be observed, especially for "high severity, low frequency" lines of business (e.g. professional third-party liability insurance and natural catastrophes insurance). Again, insurers could decide to transfer more risk to policyholders, for instance by reducing the scope or extent of the coverage they provide (see Section 4.1). Since the sunk costs of product design are independent of an insurer's size, smaller companies are likely to bear relatively higher costs in this process. The need for modifications in product design due to Solvency II would vary across Member States, depending on the stage of development of the market and its characteristics. In Member States with relatively undeveloped markets (where the non-life segment dominates and the bulk of non-life business is motor insurance, i.e. "high-frequency, low-severity") the need for product re-design could be relatively less pronounced, as such products require less capital backing. In Member States where the markets are relatively developed and mature (with high insurance penetration ratio, a large life-segment and a wide range of products) the need for product redesign could be greater (see Section 2). Solvency II could also impact on the price of insurance products. Under the existing regulatory rules, insurers tend to price their products on two levels. First, they price products according to economic value, with the use of actuarial techniques. Second, they price products according to their position on the market compared with the competitors' prices. Solvency II would mean a shift to more "risk-based" pricing. While insurers might try to limit the impact on prices by redesigning products, price increases (potentially significant) could be unavoidable, especially for "low-frequency, high-severity" risks. In extreme cases (especially for non-life insurance), some products might disappear from the market because consumers would be unwilling to pay the required price. The opposite could be the case for products covering "high-frequency, low-severity" risk, where the reduced capital requirement and competitive pressure could lead to lower prices. More accurate product pricing could also 31 See also, CEA, Results and discussion on the impact assessment of the future Solvency II framework on insurance products and markets, February From an insurer's point of view, these two elements are interrelated as changes in product's features involve changes in prices. However, for presentational purposes (and sequential relation to Section 4) the product design and the prices variations are discussed as two separate issues. 24