Scenarios and Strategies from an International Player Viewpoint. Gilles Benoist, CEO, CNP Assurances. Introduction

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1 Montepaschi Vita Forum - 14 October 2005 Coming Regulatory Developments and Future Shape of the Insurance Industry Scenarios and Strategies from an International Player Viewpoint Gilles Benoist, CEO, CNP Assurances Introduction The stock market crisis prompted radical changes It highlighted the vulnerability of life insurance companies invested heavily in equities Revealed the shortcomings of the prescribed method of calculating the solvency capital requirement Led to take measures to restore investor confidence New regulations applicable to life insurance industry To increase transparency To ensure greater protection for the insured 2

2 The insurance industry s regulatory environment is undergoing radical change. The stock market crisis at the beginning of the decade served : to highlight the vulnerability of some insurance companies, particularly life insurers that had invested heavily in equities. It also revealed the shortcomings of the prescribed method of calculating the solvency capital requirement, which is based on a quantitative approach that ignores the companies exposure to economic risks. On the whole, European insurers succeeded in withstanding the effects of the market break. However, some companies ran into problems, prompting regulators to take certain measures to restore investor confidence by increasing transparency and ensuring greater protection for the insured. New regulations applicable to life insurers Financial Security Act (1 August 2003) Imposes stricter requirements in financial disclosures, corporate governance and internal control International Financial Reporting Standards (from 2005) Standardizes accounting methods throughout Europe Ensures that solvency data are as transparent as possible Basel II applicable to banks ( ) Based on 3 pillars : minimum capital requirement, supervision, market discipline New methods of determining the capital requirement for insurance operations Solvency II directive (under discussion) Harmonizes regulations on solvency capital requirements in Europe Calculates solvency capital based on an economic analysis of the risks No plans to increase the overall capital requirement 3 In addition to the many European directives some of which are not yet applicable under French law four new regulations have or will have a significant impact on life insurers in France: The Financial Security Act ( LSF Act of 1 August 2003) is designed to restore investor confidence. It imposes stricter requirements in terms of financial disclosures, corporate governance and internal control. International Financial Reporting Standards (IFRS), which must be applied by all listed companies as from The aim is to standardize accounting methods throughout Europe and ensure that solvency data are as transparent as possible. In phase 2 of the IFRS transition process, insurance companies will be required to measure all balance sheet items at fair value, potentially leading to increased earnings volatility.

3 Under Basel II the Cooke capital adequacy ratio applicable to banks will be replaced by the McDonough ratio by the end of Basel II has three pillars: Pillar 1 establishes the minimum capital requirement for banks, taking into account operational risks. Pillar 2 concerns supervision; it encourages national supervisors to require institutions with a higher risk profile to hold a higher solvency capital than under Pillar 1. Pillar 3 concerns market discipline; it requires banks to publish large amounts of information to enable the financial community to assess the various risk profiles. Although Basel II concerns the banking sector, it may have an impact on insurance groups because it introduces new methods of determining the capital requirement for insurance operations. Furthermore, Basel II is a reference for the insurance sector. Lastly, the proposed Solvency II directive which is currently under discussion. The framework directive is expected to be issued next year and will be applicable as from The aims are to: Harmonize regulations and their application by supervisors in Europe, concerning the solvency capital requirement of insurance companies.europe-wide adoption of IFRS has been a critical factor in the drafting of Solvency II. Together, these two regulations will promote convergence of practices in Europe. Like its banking counterpart Basel II, to calculate solvency capital based on an economic analysis of the risks incurred by insurance companies and no longer solely according to a quantitative approach, as is the case today. But there are no plans to increase the overall capital requirement.

4 Effects on corporate strategies Two main effects 1) Insurers will have to become more competitive 2) Bankers may be encouraged to rethink the future of their insurance subsidiaries 4 The new regulations are designed to improve the quality and quantity of financial information, strengthen insurers balance sheets and impose stricter regulatory controls. Solvency II is likely to undergo many changes before it is adopted. However, from the direction the discussions are taking, we expect the new regulations to have two main effects on the strategies of insurance companies: 1) Insurance companies will need to becoming more competitive, by setting up more effective management and control systems, to have access to the capital resources needed to finance acquisitions and internal growth. This is true for all insurers, whatever their size, the types of business written and their distribution strategy. 2) The drive to become more competitive may encourage insurers to focus on their core businesses, a development that would create opportunities for pure players such as CNP Assurances.

5 Effects on corporate strategies 1) Becoming more competitive 1.1 By setting up tighter internal control The aim is to avoid any increase in their solvency capital requirement under Financial Security Act and Solvency II Two approaches to reduce the capital requirement and the cost of capital employed Develop an internal model to analyze the risks incurred and convince the regulator of the model s quality and viability Improve risk identification and its management 5 Insurers should become more competitive by tightening up internal control and allocating capital resources more efficiently. The aim is to avoid any increase in their solvency capital requirement as a result of the Financial Security Act and Solvency II. Two approaches can be followed to reduce an insurer s capital requirement and the cost of capital employed without lessening policyholder protection: Develop sophisticated and reliable internal model to analyse the actual risks incurred. Companies that develop a model and convince the regulator of its quality will be able to avoid applying standard benchmarks which risk increasing their capital requirement. According to Ernst & Young, major listed or international groups that are already developing internal models to measure economic capital are not expected to be penalised by the new directive. This is the solution we have adopted at CNP Assurances. Smaller companies and mutual insurers are unlikely to develop internal models, with the result that they will probably be faced with a higher capital requirement. Improved risk identification and management can also help to reduce a company s capital requirement. Effective control over risks reduces earnings volatility and leads to a lower capital requirement based on equivalent revenues

6 Effects on corporate strategies 1) Becoming more competitive (cont.) 1.2 By setting up high-performance financial management tools to make the capital work harder Several factors are taken into account to determine a life insurer s capital requirement : Quality of ALM Weighting of non-unit-linked and unit-linked contracts in the portfolio Risks associated with the various classes of assets (options and guaranties available to policyholders) Efficiently allocating capital resources is even more essential in the current economic environment 6 Another way of becoming more competitive and reducing the cost of capital is to set up highperformance financial management tools to make the company s capital work harder. Several factors are taken into account to determine a life insurer s capital requirement: The quality of the company s asset/liability management (ALM). The weighting of non-unit-linked and unit-linked contracts in the portfolio. Non-unit-linked contracts require more capital than unit-linked. In addition, the capital earmarked for these contracts must be topped up regularly because it must represent at all times at least 4% of mathematical reserves versus 1% for unit-linked. The risks associated with the various classes of assets: the higher the guaranteed yield and participation rate, the greater the capital requirement. A life insurer has to assess surrender risk and the risks associated with the other options and guarantees available to policyholders. In the current economic environment, efficiently allocating capital resources is even more essential to ensure that insurers are capable of fulfilling their commitments : Interest rates seem set to remain low, while of necessity the bulk of a life insurer s portfolio is invested in bonds. At the same time, market growth has slowed and margins are being eroded by stiffer competition across the market. As a result, life insurers are under pressure to maintain high standards of governance as they grow their business. The new regulations simply add to the pressure; they don t create it.

7 Effects on corporate strategies 2) Bankers may be encouraged to rethink the future of their insurance subsidiaries Insurance business Is viewed as a way of diversifying the banks offer, increasing customer loyalty and improving the profitability of their networks But is also a low-margin business and profits are being eroded Under IFRS and Basel II, companies are required to allocate greater amounts of capital to higher risk businesses But other factors could influence the banks choice of strategy Basel II Is unlikely to trigger a mass withdrawal from the insurance sector May encourage bankers to outsource their insurance operations to 7 major insurers that will assume the risk In the same way as Solvency II will encourage insurers to allocate capital resources more efficiently, so Basel II and IFRS are likely to encourage bancassurers to rethink the future of their insurance subsidiaries. 2.1 Insurance business Banks have viewed insurance as a way of diversifying their offer, increasing customer loyalty and improving the profitability of their branch networks. On the downside, insurance is a low-margin business and profits are being further eroded by fierce competition. 2.2 Under IFRS and Basel II Banks will be required to allocate greater amounts of capital to higher risk businesses. This may prompt the large banking groups to refocus on the businesses where they have the greatest competitive advantage, in which case they may well decide to withdraw from insurance. Basel I: capital assigned to insurance business deducted in full from total capital, Basel II: 50% deduction from Tier 1 and 50% from Tier 2. However, three factors could influence the banks choice of strategy: The impact on bancassurers will depend on how strictly Basel II is applied in the different countries. The inclusion of operational risks in the equation may result in a higher or a lower capital requirement, depending on the bank. The negative impact of insurance business on the banks capital and capital adequacy ratio may be offset by a favourable impact from other businesses, such as lending. As a result, IFRS& Basel II are expected to have little or no overall impact on the capital requirement of an average bank. The banks regulatory capital is generally already in excess of the minimum required under Basel II.

8 In all, Basel II is unlikely to trigger a mass withdrawal by the banks from the insurance sector. However, the new regulations combined with increasingly narrow margins may well encourage them to retain their insurance offer as non-core business. It would make sense for banks in this case to outsource their insurance operations to major insurers. Partnerships of this type would help to reduce the banks capital requirement and increase the amount of capital available for more profitable businesses. Effects on CNP Assurances 1) No adverse effects on CNP Assurances Strengthened internal control system (LSF and IFRS) Reliable model to analyse the actual risks incurred Internal Solvency II Committee Highly efficient and effective ALM system 2) Opportunities to pure players such as CNP Assurances Banks could join their force with large insurance companies To allocate their capital efficiently To benefit from insurer s expertise CNP s business model based on long-term agreements has demonstrated its quality 8 The new regulations should not have any adverse effect on our company; on the contrary, they support our business model and management methods and may offer new opportunities to pure players such as CNP. 1) No adverse effect on CNP Assurances, as it has already set up effective management and control systems and efficient asset allocation: As from 1999, CNP set up a dedicated risk management structure. In 2003, to comply with the provisions of LSF, CNP strengthened its internal control system. It launched a strategic LSF project to build an internal control database, model the group s business processes and establish a continuous assessment process covering the quality of supporting documentation and the effectiveness of internal controls. CNP selected as a basis the internationallyrecognised COSO standards. Lastly, CNP published an internal control charter. CNP Assurances is involved in Solvency II via the FFSA and CEA working sessions. It set up an internal Solvency II committee to examine the outcomes of the regulation under discussion. CNP Assurances is setting up a reliable model to analyse the risks incurred.

9 We developed a highly efficient and effective ALM system : investment policy tailored to the liability profile to fulfil our commitments to clients; asset allocation based on a battery of tests according to various interest rate and stock market scenarios; conservative profit-taking policy, to smooth the effect of fluctuating market yields and offer policyholders a stable return over the long term; cap on the amount and duration of guaranteed yields, to limit the Group s exposure to low interest rates); purchase of derivative instruments and floating rate or indexed bonds to protect the balance sheet against a sharp rise in interest rates. To gauge the system s quality, you need look no further than our share performance. Since the IPO in 1998, our profits and market capitalisation have more than doubled. We demonstrated a very high level of resilience during the stock market crisis. 2) The drive to become more competitive would create a competitive advantage for CNP Acquiring distribution networks or creating captive insurance companies are a source of synergy but eats up capital. While the need to allocate capital efficiently is an important consideration, banks are also looking to join forces with large insurance companies in order to benefit from their expertise in designing and managing insurance products. CNP stands apart in having chosen a model based on long-term agreements with distribution partners that are also shareholders. Whatever shape the market takes in the future, there will always be a place for a large insurance company such as CNP, which has amply demonstrated the quality of its business model.

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