Timetable: although RBS is selling its insurance businesses it must still meet the Solvency II directive
Banks that own insurers are preparing for the Solvency II insurance directive, which in its current form could require huge amounts of extra capital to be set aside. Meanwhile, investment banks are busy advising their insurance clients on how their risk management and capital structures will have to change as a result. Writer Michael Imeson
The EU's Solvency II directive, agreed earlier this year and due to come into effect in October 2012, will comprehensively reform the prudential regulation and supervision of insurance. It is the biggest regulatory challenge that European insurers have faced for decades.
The directive's main objective is to force insurance companies to improve their risk management and set aside enough capital to cover all the risks they take. The intention is that better risk and capital management will reduce the likelihood of insurers failing, which in turn will improve protection for policy-holders and reduce the likelihood of market disruption.
But what are the implications for banks? The biggest implication is for those that own insurance businesses, either wholly or in a joint venture with an insurer, and which manufacture insurance products. This is bancassurance in its purest form, so their insurance arms fall fully within the scope of Solvency II and they will have to comply in the same way as pure-play insurers.
The definition of bancassurance also includes banks that distribute insurance products manufactured by insurers they do not own, either through tied-agency agreements or as brokers. These banks are outside the scope of the directive, but will be impacted indirectly. Many of the insurance products they distribute will change in availability, form and price because of the changes in the risk and capital management requirements that underlie them.
The third implication is for banks as purchasers of insurance, as policy-holders. They may also notice a change in choice, form and price of what is available to them because Solvency II's risk and capital requirements will fundamentally change the market.
The fourth impact is on investment banks as advisers to insurance companies. Insurance specialists in the financial institutions groups and capital markets divisions of investment banks are making the most of the opportunities to advise their clients on how to change their risk management frameworks, asset and liability management and capital structures.
Expert analysis
Bart Patrick, head of insurance at business analytics company SAS, says the directive affects bancassurers in the same way as pure insurers. "If they carry insurance liabilities, they will have to comply with Solvency II and hold separate capital for their insurance and banking operations," he says.
"The more diversified bancassurers will be able to take advantage of the diversification benefits of the directive," he adds. "If they have diversified businesses and operate in different countries, there is natural hedging because their overall risks are reduced."
In his discussions with insurers, whether owned by banks or not, Mr Patrick has found common concerns about Solvency II. One is 'the use test' - how are insurers going to embed risk into the business, as the regulators require? "Availability of data is another issue," he says. "Where will they get the good quality data necessary to carry out sound underwriting and premium calculations?
"Another issue is getting regulatory approval for the internal models that many will use to calculate their Solvency Capital Requirement (SCR). The UK's Financial Services Authority (FSA) has received applications from 99 firms that want to use internal models. It will be a stretch for the FSA to get them processed in time."
Finding all the extra risk managers needed will create headaches. "Solvency II requires insurers to expand their risk management departments and take on more risk professionals, which will create more demand in the market and therefore a shortage," says Mr Patrick. "Insurers are poaching risk people from banks. Regulators are taking on more risk people too. There is a lot of 'CRO [chief risk officer] musical chairs' at the moment."
Banks distributing but not underwriting insurance do not carry insurance liabilities and are therefore not within the scope of the directive. "However, they may notice in time, along with all insurance brokers and agents, that certain products carrying higher risks and which therefore require more capital may be withdrawn or made less easily available, and premiums may rise," suggests Mr Patrick.
Leigh Bartlett, RBS Insurance's chief financial officer
RBS: from basel to solvency
Royal Bank of Scotland (RBS) is a major bancassurer, owning several insurance businesses including Direct Line and Churchill, which are run through RBS Insurance. Although the group announced recently that it will sell its insurance interests to meet European Commission (EC) competition rules, it will be an orderly disposal taking place over several years, so Solvency II compliance is a major priority.
"The bank has been through the Basel II framework and it's now time for the insurance arm to go through something of a similar nature," says Leigh Bartlett, RBS Insurance's chief financial officer. "There is a greater focus on our risk-based capital requirements, on the modelling and techniques we will need to employ, and on reporting. This will lead to a strengthened risk management approach for insurance.
"It will move risk capital management within the insurance division further up the boardroom agenda. We are going to have improved risk management, greater linkage to our long-term plans and strategic decisions, and also a recognition of some of the risk diversification or mitigation benefits that will be available to us."
It is all systems go on the preparation front, with formalised plans in place and staff and systems being sourced. "We are going down the internal model for SCR," says Mr Bartlett. "We are using third parties to ensure our plans are appropriate and are resourced appropriately. We are reading all the consultation papers and responding as and when appropriate. We also took part in the QIS (Quantitative Impact Study) 3 and 4 for certain entities and are working closely with external bodies such as the FSA."
Business as usual: until its insurance operations are sold, ING must also work to meet Solvency II
ING's approach
ING, the Dutch financial services conglomerate, is also selling its insurance and asset management businesses, partly due to its 'back to basics' strategy, but also because of coercion from the EC competition authorities. Until the insurance operations are sold, it is business as usual for its Solvency II teams.
"Solvency II applies at the 'sector' level, so the rules for us are the same as for any other insurer," explains Jeroen Potjes, director of corporate insurance risk management at ING.
"The legislation is designed to provide as level a playing field as possible, so it is not expected to provide significant advantages or disadvantages to bancassurers."
He says that Solvency II promotes "sound corporate governance and risk management principles" and uses an economic capital-based measure of solvency. "This is aligned with the way we currently operate our business internally, so ING is supportive of Solvency II," he says. "We believe it will benefit consumers through the promotion of products that balance economic risk and reward, and provide consumers with greater confidence and protection in terms of the financial strength of our company."
He sounds a note of caution about the technical measures being drawn up by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). "It is important that the regulations reflect sound economic principles and realities. We are working with the industry - most notably through the CRO forum and CFO [chief financial officer] forum - to engage with all stakeholders, including CEIOPS and the EC, to reach a practical and economically sound agreement."
Investment banker advice
Theo Lentzos, a director in the insurance debt capital markets division of JPMorgan Cazenove, says that in his conversations with insurers he has detected a number of concerns about the technical measures that CEIOPS has drafted in its consultation papers, including:
- The proposal that liabilities cannot be discounted using a rate that includes a liquidity premium, and managing longevity risk generally.
- The proposals on how own funds should be calculated.
- The capital requirements for investment portfolios - for example the fact that holding equity investments is regarded as more risky.
- The capital requirements for the duration gap between assets and liabilities and how this should be managed when interest rates are falling.
- The proposals on stress-testing solvency to see how insurers would cope should there be renewed capital market turmoil, a more severe recession or a rapid increase in inflation and interest rates.
"The liquidity premium has been the hottest topic in the industry in the past few weeks, especially in the UK which seems to be the most impacted," says Mr Lentzos. A liquidity premium is important when valuing illiquid liabilities, such as annuities, especially in distressed markets.
"CEIOPS' proposals on own funds would make hybrid Tier 1 instruments more equity-like and therefore less appealing to fixed-income investors," says Mr Lentzos. There is also a fear that the rules would be retrospective and apply to existing instruments, since the consultation paper contains no grandfathering (exemption) clauses.
"Solvency II is more punitive on holding equity outright," adds Mr Lentzos. "We are therefore spending time developing products which allow insurers to take equity exposure without actually being an outright equity owner. Furthermore, we are working with insurers on how to structure annuity products which mitigate the investment risk for insurers and therefore the capital requirements."
Finally, his team is advising insurers on how they should manage the duration gap between assets and liabilities as it increases or decreases, with the addition or subtraction of capital.
Strategic implications
Jeff Sayers, head of European insurance, global capital markets, at Morgan Stanley, advises clients on optimising their risk and capital management, and Solvency II is one of the biggest issues. He does not advise them on detailed compliance issues, but focuses on the more strategic implications. "UK insurers have had to fit into the FSA's Individual Capital Assessment framework for some years, which has many things in common with Solvency II, so they should be better prepared than other insurers, although this is not always the case," says Mr Sayers.
He is reluctant to go into any detail about how he is advising his clients for fear of giving away competitive information, but he agrees that the debate about the liquidity premium, and its implications for capital management, is a pressing concern for insurers and will have to be resolved. Another over-riding question is how the directive will affect each company's capital structure. "What should be the mix between debt and equity, what form of debt and to what extent does debt count as equity?" he asks. Words from the supervisors
Gabriel Bernardino, one of the leading Solvency II officials in CEIOPS, and a director in the Portuguese Insurance and Pension Funds Supervisory Authority, says that large groups, whether they are pure insurance undertakings or bancassurers, may have a more challenging time than smaller organisations in meeting the directive's governance, reporting and disclosing requirements.
He adds that Solvency II has parallels with the Capital Requirements Directive (CRD) for banks, in that it allows insurers to use internal models to calculate their regulatory capital requirements, but Solvency II allows more freedom in modelling than the CRD. "The scope of the partial internal models is larger, with the possibility of having partial internal models by risk, including sub-risks, or by line of business," he says.
"As the use test is one of the tests internal models have to pass to be approved, this will require bancassurers to fully integrate those models in the management of their insurance business. Also, although the internal models will be necessarily different since insurance business is different from banking, consistency in the hypothesis underlying the insurance and bank internal models will be expected by supervisors."
Mr Bernardino believes that Solvency II will lead to more collaboration between banking and insurance supervisors. "To fully understand an insurer belonging to a banking group, the insurance supervisor will need to interact with the banking group supervisor."
Ben Carr, a Solvency II executive in the FSA's prudential risk division, believes that, for bancassurers, Solvency II should result in greater alignment between the Pillar 2 requirements applied to their insurance activities and their banking activities. This is because the Own Risk and Solvency Assessment (ORSA) in Pillar 2 of Solvency II shares many of the features of the Individual Capital Adequacy Assessment Process (ICAAP) in Pillar 2 of the CRD for banks.
Although the directive similarly applies to bancassurers and pure-play insurers, Mr Carr says the directive should result in some existing differences between banking and insurance rules being reduced, which in turn will reduce opportunities for regulatory arbitrage, such as in the treatment of repackaged loans and structured bonds. "Similarly, regulators are seeking to align the definition of capital - 'own funds' - across both sectors," adds Mr Carr.
The tone at the top
The directive is in some respects a double-edged sword for bancassurers, says Rick Lester, Solvency II lead partner at Deloitte. "On the one hand they have the benefit of having been through Basel II," he says. "They are familiar, for example, with the use test, embedding these practices within their business and the waiver application process for adopting internal models. These are all positive features that would place a bancassurer in a more advantageous position.
"Having said that, one of the challenges they may face is a mistaken perception that Solvency II will be the same as Basel II. If you look at the bancassurance groups, they are predominantly banking-led, and therefore the boards and the executive may not be as conversant with the insurance dimension of Solvency II.
"The senior management team needs to understand the differences between Solvency II as it impacts their insurance business, and what they went through on Basel II."
As is so often the case, how well a bank responds to new regulation is dependent on the preparedness of the people at the top.
Solvency II - a summary
The aim of the directive is to oblige insurance companies to improve their risk management and set aside appropriate capital to cover those risks. It emanates from the Internal Market and Services Directorate General of the European Commission (EC). It is the insurance sector equivalent of Basel II and the Capital Requirements Directive, so like Basel II it has three pillars.
Pillar 1 requires firms to show they have enough capital to remain solvent, according to two measures: the Solvency Capital Requirement (SCR), which is the ideal level; and the Minimum Capital Requirement (MCR), which is the lowest level below which a firm must not fall.
A firm can chose to calculate its SCR and MCR using its own internal model (which must be approved by the regulator) or the European Standard Formula.
Pillar 2 is the Supervisory Review Process. This requires firms to demonstrate that their risk management systems and capital allocation processes are effective, which they do through an Own Risk and Solvency Assessment (ORSA). Supervisors then review the ORSAs and take action if necessary.
Pillar 3 requires firms to publicly disclose certain information about their risk and capital management, the idea being that disclosure will impose a degree of market discipline on their approach.
The directive does a number of other things: it will harmonise insurance standards across the EU; force insurers to give a more accurate picture of their financial situation through a shift to market consistent valuation of assets and liabilities; and improve the supervision of insurance groups instead of concentrating on individual subsidiaries.
The technical measures are currently being drafted by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) and are out for industry consultation before being agreed by the EC. Many of the measures have been strongly criticised by the industry, especially because in their current form they would require a massive increase in capital. Much more negotiating and arguing - in public and in private - will take place before the final measures can be agreed.
