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Insurers
and society
How regulation affects the insurance
industry’s ability to fulfil its role
A report from the Economist Intelligence Unit

Sponsored by:

© The Economist Intelligence Unit Limited 2012
xx

INSURERS AND SOCIET Y: HOW REGULATION AFFECTS THE INSURANCE INDUSTRY’S ABILIT Y TO FULFIL ITS ROLE

contents

Executive summary 2

Preface 4

About this report 4

Introduction 5

1 Striking the right balance 6

2 Who will pay the price? 9

3 Shifting down the risk spectrum 14

4 Implications for companies seeking financing 17

5 Predicting the unintended consequences 19

Conclusion 21

Appendix 22

1 © The Economist Intelligence Unit Limited 2012

executive
summary

As discussion of the details of the Solvency II regime rolls on, insurers are
thinking long and hard about how they will manage and monitor their risk
strategies and capital bases. But the implications of their decisions will reach
far beyond the boardroom, affecting both their relationships with corporate
and individual policyholders, and also their role as major investors in the debt
and equity capital markets.

The new regulations were designed to ensure better protection for policyholders,
but raise important questions about the extent to which consumers and
corporates will ultimately foot the bill for Solvency II, either directly through
higher costs or indirectly via less comprehensive products.

Meanwhile, the demands of the new regime threaten to disrupt the key role
played by insurers as investors in the capital markets, by pushing them towards
‘safer’ assets with lower capital charges, and away from the equities and non-
investment grade debt on which much private industry depends for financing.
This could be a particularly troubling outcome for businesses seeking to raise
capital, given that banks remain reluctant to lend because of their own balance
sheet constraints.

The Economist Intelligence Unit, on behalf of BNY Mellon, conducted a survey
of 254 EU-based companies, including insurers, other financial institutions
(FIs, excluding insurers) and corporates (non-financial institutions, or non-FIs).
The findings shed light, from a broad range of perspectives, on the potential
impact of Solvency II on the retail consumer, the insurance industry itself and
industry more broadly, including how insurers are likely to behave as debt and
equity investors.

Key findings include:
S
olvency II goes too far in its requirements
Survey respondents believe that Solvency II oversteps the mark, with only
16% agreeing that it strikes the right balance in ensuring insurers have
sufficient capital to meet their guarantees. Insurers and FIs (excluding
insurers) are more critical of Solvency II, with 55% believing the directive
goes too far compared with 39% of corporates (non-FIs). Less than one
in five insurance respondents believe that most insurers are insufficiently
capitalised under the present regime.

2


P
olicyholders will ultimately issuers more significant, as insurers,
bear the costs driven by capital charge considerations,
Almost three-quarters (73%) of are increasingly pushed towards
survey respondents agree that the investment-grade debt. However,
costs to insurers of compliance with corporates (non-FIs) seem less aware
the new regulations will be passed of this shift, with just 48% agreeing
on to policyholders, and there is compared with 62% of insurers and 79%
concern that both corporates and of FIs (excluding insurers). The reality
individuals may choose to be under- is that companies are likely to have to
insured as a consequence. However, either adjust their capital structure to
insurers are markedly less convinced achieve investment-grade status or
(57%) than FIs (excluding insurers) offer higher yields in compensation for
(82%) and corporates (non-FIs) the capital cost to insurers.
(69%) that policyholders will pick up
the tab, raising the question of how R
egulators should revisit
they see the costs of regime change their capital charge levels
being met. Also, over one-half (51%) Given the economic risks attached to
of respondents believe the shift to many EU countries at present, there
unit-linked policies, which put the is strong support, particularly among
investment risk on the policyholder, insurers (50%), for regulators to
will have a negative long-term affect reassess the zero capital charge for
on pension and long-term savings sovereign bonds—despite the fact that
provision, with life insurance and a readjustment would mean they would
annuities considered the products be required to hold further capital. A
most likely to be affected. further 41% of insurers would like to
see the capital charges for all assets
I
nsurers expect to further de-risk reconsidered. Overall, less than one-
their asset allocations quarter (22%) of respondents believe
A clear shift down the risk spectrum that regulators should maintain the
is anticipated by respondents. Assets current capital charges.
expected to attract more interest
include investment-grade corporate I
s Solvency II creating a ‘squeezed
bonds, cash and short-dated debt, middle’ among insurers?
at the expense of non-investment- While large insurers are able to
grade bonds, equities and long-dated absorb the costs of preparation for
debt. Almost three in five (58%) Solvency II and enjoy the benefits of
respondents overall believe that shift economies of scale, and the small,
will happen gradually, giving time local or specialist providers prevalent
for market adjustment. But nearly in continental Europe may either
one-third of corporates (non-FIs) fall outside the scope of Solvency II
(32%) do not believe the changes altogether or have a sufficiently strong
will have an adverse impact on any niche market to survive and thrive, the
asset class, suggesting they may not mid-sized mutual insurers could be at a
fully understand the wider financial disadvantage. Only 16% of respondents
implications of the new regime. expect no material impact from
Solvency II on the structure of smaller
C
orporates seem less aware of friendlies and mutuals, and more than
the impact Solvency II will have on one-half (54%) believe the pressures of
debt issuance the new regime will result in a spate of
Among insurers and FIs (excluding consolidations to achieve scale, while
insurers) there is a strong consensus 36% of insurers believe these players
that Solvency II will make the tenor will outsource more in order to access
and rating of bonds from corporate scale.


preface

Insurers and Society is an Economist Intelligence Unit report, sponsored
by BNY Mellon. The findings and views expressed in the report do not
necessarily reflect the views of the sponsor. The author was Faith Glasgow
and the editor was Monica Woodley.

about
this report

In January 2012, the Economist Intelligence Unit, on behalf of BNY Mellon,
surveyed 254 respondents from companies in Europe to get their views on
how regulation is changing insurers’ role in society.

The survey reached insurers, financial institutions (FIs, excluding insurers)
as well as corporates (non-financial institutions, or non-FIs).

Respondents are very senior, with over one-half (133) coming from the C-suite
or board level. They were drawn from Europe, with the UK, Spain, Germany, the
Netherlands, Denmark and Sweden each having over 20 respondents.

In addition, in-depth interviews were conducted with six experts. Our thanks are
due to the following for their time and insight (listed alphabetically):
J
enny Carter-Vaughan, managing director of the Expert Insurance Group
J
ames Hughes, chief investment officer at HSBC Insurance
J
ulian James, UK CEO of broker Lockton International and president of the
Chartered Insurance Institute (CII)
R
avi Rastogi, senior investment consultant at Towers Watson
J
ay Shah, head of business origination at the Pension Insurance Corporation
R
andle Williams, group investment actuary at Legal General

4


introduction

Insurance companies have But these changes are set to upset
traditionally been viewed by wider the status quo, not just for insurers
society as the bearers and managers but for policyholders and also
of formalised risk, freeing individual for companies looking to attract
policyholders from financial worries investors through the capital
in the event that things go wrong, markets. Policyholders are likely, for
and providing institutions with example, to see the cost of premiums
an efficient mechanism by which rise—potentially pushing some to
to transfer risk. They have also opt to reduce or ditch their cover
historically played a central role rather than pay more. Companies
as institutional investors, seeking investors, meanwhile, may
channelling funds into the capital find it harder to raise funds in the
markets and providing industry capital markets—at the very time
with crucial flows of both equity when banks, for their own reasons,
and debt capital. are reluctant to lend. Insurers
themselves are likely to have to
Are those longstanding roles adjust their investment timescales
under threat with the impending and strategies of asset allocation,
introduction of Solvency II in the potentially finding themselves under
European Union? Solvency II aims, conflicting strains as they try to
among other things, to provide find the best balance between risk,
policyholders with more robust return and capital efficiency.
protection by requiring insurers
to hold capital according to all In this report, we explore the danger
their business risks—including that regulation may, ironically, force
the differing risks attached to the insurers to reduce the amount of risk
various asset classes in which they they take—and instead offload that
invest clients’ cash. risk on to their stakeholders.


1 Striking the right balance

As insurers play a central economic and measuring risk on consistent principles and linking
social role in modern Western societies, it has capital requirements directly to those principles.
been accepted since the 1970s that some form They will apply throughout the EU, harmonising
of prudential supervision by the authorities standards and providing a level playing field for
is necessary. insurers across the euro zone.

Until now, the focus has tended to be on measures But our survey findings indicate that although
to guarantee the solvency of insurers or minimise there is a perception that something needs to
the disruption caused by their insolvency. be done to improve the current situation and
Solvency II raises the stakes across the board harmonisation should bring its own benefits,
by introducing a risk-based capital approach, the proposed regime could be overly cautious.

Chart 1: Do you agree or disagree with the following statement?
Most insurers already have sufficient capital to meet their guarantees.

All respondents

36% 39% 25%
agree neutral disagree

Corporates (non-FIs)

33% 36% 31%
Insurers

44% 38% 18%
FIs (excluding insurers)

36% 40% 24%

6


On the one hand, just over one-third (36%) of
Chart 2: Do you agree or disagree with the following statement? respondents believe that most insurers already
Solvency II goes too far in ensuring insurers have sufficient have enough capital to meet their guarantees,
capital to meet their guarantees. and even among insurers themselves that
confidence only rises to 44%. So there is a
Corporates (non-FIs) Insurers FIs (excluding insurers) broad acknowledgement that measures to
improve the capital cover of insurance companies
are in order.

On the other hand, just 16% of all respondents
13% 39%
% agree that Solvency II will strike the right balance
15
in ensuring that insurers are properly capitalised in
1% line with their guarantees, and over one-half (51%)

16%
2

say that it goes too far. As Jenny Carter-Vaughan,
managing director of the Expert Insurance Group,
disagree observes: “No one has gone down in the insurance
industry for a very long time; I’d say the current
33%

solvency regime is very robust.”
55%
all 51% Randle Williams, group investment actuary at Legal
respondents agree General, points out that it is unsurprising that
the industry feels that the authorities are setting
34% the capital charges too high. “It’s important to
neutral remember that some EU countries don’t have any
31

compensation net comparable to the UK’s Financial
%

Services Compensation Scheme in place to protect
consumers. But the tendency of regulators is to go
too far—they always want more capital,” he says.
%
40
% 55 However, Julian James, UK CEO of Lockton
International, a broker, and president of the
Chartered Insurance Institute (CII), observes that
harmonisation across the EU means that there
will be both winners and losers, so it is difficult to

Most insurers already have sufficient capital to meet their guarantees.

Life

32% 47% 21%
General

50% 27% 23%
Composite

50% 43% 7%
disagree
agree neutral


generalise. “Some insurers will see their capital sovereign debt should be reconsidered—a sensible
requirements increase, but others will see a suggestion in the light of the self-evident mismatch
decrease,” he says. “For consumers, though, between these supposedly ‘risk-free’ government-
the important thing is the knowledge that the issue assets and continuing deep uncertainty over
insurer will have the same level of capital cover the extremely fragile economic situation in some
if they buy in France or Germany as if they were EU states.
buying in the UK.”
Insurers are less likely than other survey
Insurers and FIs (excluding insurers) are markedly respondents to support the proposed capital
more critical of the looming regime than corporates charges of Solvency II—just 9% compared with
(non-FIs), with 55% believing it will go too far and 22% of FIs (excluding insurers) and 26% of
insurers will be over-capitalised for the level of corporates (non-FIs). But what is surprising is
guarantees they have to meet, compared with 39% that one-half of insurers favour just reassessing
of corporates (non-FIs). This raises the question the capital charge for euro zone debt, compared
of whether corporates, while attracted by the idea with 41% who would like to see charges for all asset
of greater security, fully understand the potential classes reconsidered.
implications of an over-capitalised insurance
industry for their future activities in the financial The dramatic events in Europe over the past
markets. months, reflected in a series of bond market
crises, have made it clear that it is not realistic,
Looking specifically at the capital charges that nor sensible, to talk about a zero risk rate at the
Solvency II will institute for different asset present time. However, any alteration to the
classes, survey respondents are in favour of a capital charge of this debt will have to be upward—
reassessment—just 22% say the current charges which will certainly not be in insurers’ interests.
should be maintained. Most are in favour of an “I can’t see why any insurer would want to see a
across the board reassessment (43%), but 35% reassessment,” says Ms Carter-Vaughan of Expert
say that only the zero capital charge for euro zone Insurance Group.

Solvency II sets capital charges for different assets according to their risk level,
with EEA sovereign bonds given a zero-credit risk charge. In light of the eurozone debt
crisis, what do you think should happen to the capital charges of Solvency II?

All respondents FIs (excluding insurers) Insurers Corporates (non-FIs)

Regulators should maintain the current capital charges

22% 22% 9% 26%

Regulators should reconsider the capital charges for all asset classes

43% 42% 41% 48%

Regulators should reconsider the capital charge for sovereign bonds
35% 36% 50% 26%

8


2 Who will pay the price?
There is a clear feeling that the bill for Solvency although one-half feel that price increases
II—both the costs of testing and implementation are an acceptable trade-off for the additional
and the ongoing costs of holding a greater amount security provided by enhanced capital
of capital—will have to be absorbed by insurance guarantees.
companies’ customers. Almost three-quarters
(73%) of survey respondents see it as inevitable “It’s inevitable that the new regulations will be
that Solvency II will ultimately be paid for paid for by policyholders. Greater security is a
by policyholders through higher costs, quid pro quo [for the higher cost], but people

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

7%
17% 69
% %
16
% 11%
12

disagree
26%

16%
neutral
all
57%

73%
15%

respondents
agree

82%

Corporates (non-FIs) Insurers FIs (excluding insurers)


Chart 6: Do you agree
or disagree with the 15%
following statement? %
27 46
Solvency II will lead

%
to higher costs for 20%

%
21
policyholders but this disagree
is acceptable in view
of the additional
security provided by all
50%

41%
the capital guarantees. respondents
agree

4 4%
30%
neutral

29
%

Insurers %
34
% 57

probably won’t feel they get value from it—I think which means premiums have to go up anyway,
it will depend on how much more they have to regardless of the regulatory changes. Solvency
pay,” comments Mr Williams of Legal General. II will exacerbate that trend because it’s likely to
He points out that long-term products with result in fewer small and medium firms, so there’ll
greater requirements for extra capital charges be less supply to meet demand.”
will be particularly hard-hit. “Annuity prices, for
example, could well rise and they’ll feed through Rising premiums are likely to bring their own
to consumers.” ramifications. The survey shows there is some
concern that policyholders faced with price rises
Ms Carter-Vaughan agrees. “A few years ago, they consider unacceptable may simply review
insurers could make a loss on their underwriting their insurance needs and cut corners: 41% of
book because they could rely on investment profits respondents expect companies to choose to be
to offset it—but low interest rates and a poor under-insured in the wake of Solvency II, with
investment climate have put an end to that. So now a similar percentage (39%) anticipating that
they have to make a profit on the underwriting, individual policyholders will take such action.

Chart 7: Do you agree or disagree with the following statements?

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

39% agree 41% agree

30% neutral 28% neutral
31% disagree 31% disagree

10


But Mr James of Lockton gives that idea short
shrift. “I think under-insurance is highly unlikely,” Chart 8: Do you agree or disagree
he responds. “There is a highly competitive with the following statement?
insurance market across the EU, and consumers Solvency II will ultimately be
will be able to shop around. The harmonisation paid for by policyholders through
of EU capital standards is a worthy goal, in that it inferior products.
makes that option possible.”
28% 36%

The survey suggests that it is less likely that
insurers will respond to higher costs by reducing

19
%

%
44
the quality of their products—for instance, by
incorporating less-extensive guarantees—with 32% 29%
disagree agree
only 29% overall expecting the emergence of
all

31%
inferior products.
respondents

23%
The interviewees are divided in their views on this
hypothesis. Mr James’s view is that “there will be
a rebalancing of product ranges” in response to
39%

%
43
the new parameters of Solvency II, but there is % neutral 4

3
no reason to assume those products should be of
poorer quality. 37%

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

Chart 9: Do you agree or disagree with the following statements?
INSURERS

Solvency II will lead to higher costs to Solvency II will ultimately be paid for by
corporate policyholders, which will lead to policyholders through inferior products.
more companies choosing to be under-insured.

37% 44%
27% 35% 38% neutral disagree
19%
agree

Solvency II will ultimately be paid for by Solvency II will lead to higher costs to
policyholders through higher costs. individual policyholders, which will lead to
more people choosing to be under-insured.

57% 26% 22% 35% 43%
agree neutral agree neutral disagree

17%
disagree


happen because we will lose medium and smaller
insurers, and that is where more innovative, flexible Chart 10: Which products do you think will be most negatively
underwriting goes on, in contrast to the very by-the- affected by Solvency II? Select up to two.
book approach of the big insurers,” she explains.

Interestingly, insurers responding to the survey
Other, please
specify 1%
are markedly more optimistic across the board that
Personal lines
the financial fallout from Solvency II will not have
an adverse impact on policyholders. Given that of insurance 15%
insurers are likely to have thought more about the
cost implications of the new regime than any other Commercial
insurance 25%
group, are these surprising findings? Are the FIs
(excluding insurers) and corporates (non-FIs) being
overly cynical in their assessment of the obvious
Catastrophe
insurance 26%
outcome? Are the insurers being naïve or do they
have a solution up their sleeves?
Annuities 43%
Our interviewees are convinced that there is only
one, inevitable outcome. “Policyholders will Life
insurance 67%
undoubtedly end up shouldering the costs—the
bottom line is that there’s nothing free on any
balance sheet,” says Mr James.

Concerns over how increased costs will affect
different types of insurance products show Chart 11:
that the longer-duration products are expected Do you agree or disagree with the following statements?
to be hit hardest. As seen in the chart below,
shorter-duration products such as personal lines, With-profits policies With-profits policies, The shift to unit-linked
commercial and catastrophe are predicted to be less have been largely driven which smooth the policies, which put the
out of existence because volatility of returns, investment risk on the
negatively affected than longer-term products such
of capital charges and would be valued by policyholder, will have a
as life insurance and annuities. accounting rules. retail customers in negative long-term affect
today’s turbulent on pension and long-
Looking at the effect of regulation on insurers’ market conditions. term savings provision.
savings products and a broader shift to unit-
linked policies, which put the investment risk on
the policyholder, over one-half (51%) of survey 39% 45% 51%
agree agree agree
respondents believe that a shift (to unit-linked
products) will have a negative long-term effect on
pension and savings provision. The survey also finds
some regrets at the demise of with-profits products
in favour of unit-linked policies, with 45% saying

38%
with-profits policies would be valued by retail
customers, given the turbulence of current market
neutral 39%
31%
conditions. But 39% concur with the idea that they
have been driven out of existence by excessive neutral
capital charges and accounting rules. neutral

“When unit-linked policies came onto the market,
they were seen as cheaper and more transparent,
23%
and customers preferred them,” comments
disagree 16% 18%
Mr Williams. “With-profits are still very popular in
disagree disagree
other EU countries such as Germany, because of the
guaranteed returns always offered there, but LG
won’t be offering new with-profits products.”

12


Will pension The European Commission is keen to introduce
a Solvency II-style regime for defined benefit
schemes also (DB) occupational pensions as well, forcing
pension schemes to account for their liabilities
be subjected to by using a ‘risk-free’ rate of return. At present,

Solvency II-style the proposals are still being considered, but
it is clear that pension funds in general are
regulation? against such a proposal. Two-thirds of pension
funds responding to the survey agree with
the idea that pensions should be separately
regulated from insurers.

As Jay Shah, head of business origination at
the Pension Insurance Corporation, observes:
“This is set to be hugely controversial over the
next two years. Pension schemes are concerned
because their funding position is likely to
look worse as a consequence of Solvency II.
Of course, unlike insurers who have to be
fully funded, pension schemes can rely on a
corporate sponsor, and they would have to
work out what the value of that sponsorship
amounted to.”

“But the liability side doesn’t differ between
the two,” he adds. “Insurance companies and
defined benefit schemes are promising the same
thing to the individual member, so why should
there be a need for different regulation?”

He expects that although the Solvency II rules
will not be applied precisely to DB pension
schemes, the principles will, so that in an
adverse scenario the scheme could meet
100% of its liabilities to members.


3 Shifting down the
risk spectrum
The survey also examined the impact of Solvency The assets most widely expected to lose
II on insurers’ role as investors in capital markets. favour are equities, non-investment-grade
Respondents were asked to indicate, from a lengthy corporate bonds, hedge funds and long-
list, those assets they expected to become less dated debt. The top beneficiaries include
popular with insurers in the light of the new regime, investment-grade corporate bonds, cash
and those they thought would grow in popularity. and short-dated debt.

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

reduced increased
Non-investment-grade
corporate bonds 55% 8%
Investment-grade
corporate bonds 17% 43%
Equities
56% 9%
Long-dated debt
44% 24%
Short-dated debt
17% 39%
Emerging market
sovereign debt 30% 16%
Developed but non-
eurozone sovereign debt 21% 16%
Eurozone sovereign debt
26% 21%
Hedge funds
45% 8%
Infrastructure
investment 26% 15%
Property
25% 29%
Private equity
37% 14%
Cash
16% 40%
Other, please specify
1% 1%

14


Specifically in the case of insurers’ responses,
that reduced appetite for equities and lower-grade Chart 13: Because of Solvency II,
corporate debt is even more pronounced. Insurers insurers will have a reduced/increased
are also markedly more negative on infrastructure appetite or which of the following
and property investment than respondents overall, assets? Select all that apply.
with 44% anticipating a downturn in demand for insurers
both those asset classes. That said, they are more
comfortable with euro zone sovereign debt and
reduced increased
somewhat more enthusiastic about investment- Non-investment-grade corporate bonds
grade bonds.
67% 6%
So there are indications of a clear shift down the Investment-grade corporate bonds
risk spectrum by insurers. Is there a concern that
such a shift could leave insurers looking at their 24% 49%
market capital requirements in isolation, rather Equities
than in the wider context of return on capital? Ravi
Rastogi, senior investment consultant at Towers 64% 11%
Watson, believes that in practice insurers will not
Long-dated debt
be able to afford to ignore investment return.
“They will have to make trade-offs between return 42% 16%
on capital and capital charges,” he comments.
Short-dated debt

One possible outcome, indicated by respondents’
views on likely shifts in asset allocation, is that
26% 35%
they may move away from investing right through Emerging market sovereign debt
the cycle on a buy and hold basis, and towards a
more active approach to asset allocation, moving 42% 16%
into capital-intensive assets only when the Developed but non-eurozone sovereign debt
outlook is particularly positive. The question is
then, is Solvency II a force for good in that it forces 35% 9%
insurers to become sufficiently sophisticated to Eurozone sovereign debt
look at risk-return against capital charge, with
an eye to where a given asset class is in its cycle, 24% 40%
or will it promote a less positive but more easily
Hedge funds
implemented short-termist agenda?
47% 6%
Mr Rastogi believes that, in some respects,
Infrastructure investment
changing regulations may actually work to
insurers’ benefit as investors provide a broader
potential investment choice for them. “Solvency
44% 7%
I favours yield-producing assets so insurers Property
have a bias towards them even if non-yielding
assets make macro-economic sense; there is also 44% 18%
an inbuilt bias towards sticking with the home Private equity
currency,” he explains.
29% 24%
“Solvency II has no such constraints—there Cash
is no bias towards yield, and the risk capital
requirements will not vary according to territory 27% 36%
(although there will of course be differences
between the credit-worthiness of different
countries). That means insurers should 0% 2%
have better opportunities for economically


driven diversification, and also for more allowing clients to show more detailed analysis on
globalised investment.” their entire portfolio.”

Nonetheless, although insurers are allowed Mr Shah makes the additional point that there is a
in principle to hold a range of risk assets, in danger that the new regime will not be sufficiently
practice their decisions under Solvency II will flexible to allow the fine-tuned treatment of
be constrained by the need to match assets different asset classes. “Solvency II needs to be
and liabilities and to optimise returns within a written to allow the emergence of new assets such
limited capital charge budget—and that will have as infrastructure. These investments tend to be
implications for the make-up of their portfolios. secure, very long-term ones; they pay a high yield
because the money is tied up during that time, not
“There is a risk that the Solvency II regulations just because there is an element of capital risk.
might push many insurers towards a narrow Solvency II could prejudice such investments if it
range of investment options, which could lead to penalises them with excessive capital charges.”
increased volatility in those areas. But nimbler
insurers could exploit that herd mentality The fact is that the rules are not yet set in stone,
by making use of less popular asset classes,” and until they are it is not clear how asset
comments Jay Shah, head of business origination allocation will be affected. The survey gives some
at the Pension Insurance Corporation (PIC). hope that the transition may not be too painful.
A majority (58%) of respondents are confident
For James Hughes, chief investment officer that changes to asset allocation will be phased
at HSBC Insurance, the issue is not just about in gradually by insurers, which should give the
regulation forcing insurers in and out of different corporates hoping to attract their capital time
asset classes, but also how to make assets more to adjust to the new funding paradigm. But there
capital-efficient. “Solvency II is making everyone is less reassurance from the finding that almost
think very hard about every strategy—it is not just one-third (32%) of corporates (non-FIs) are
about risk and return but now has a greater focus confident that the changes will have no adverse
on capital implications,” he says. “I’ve seen fund of effect on demand for any asset class—again raising
hedge funds marketing themselves as potentially the question of whether they have fully grasped
more capital-efficient because they are offering the wider implications of the new regime for
greater transparency through risk analytics, financial markets.

Chart 14: How do you think insurers will implement All respondents
any changes to asset allocation?
In different ways, so no asset class is adversely impacted. Insurers

23% 16% 25% 32% Corporates (non-FIs)

On a phased basis over a long period of time, with no shock effect to markets.

58% 65% 57% 45%

All at once, directly impacting asset markets over a short period of time.
19% 19% 19% 23%
26%

16


4 Implications for companies
seeking financing
There is a strong consensus among FIs (excluding
insurers) and insurers that the new regulations Chart 15: Do you agree or disagree with
will make the tenor and rating of corporate the following statement about corporate
bonds more significant, as insurers, driven by debt issuance? Solvency II makes
capital charge considerations, are increasingly the tenor and rating of bonds from
pushed towards investment-grade debt at the corporate debt issuers more significant.
expense of lower-grade debt. Insurers obviously
48% 62% 79%


Insurers

understand their own capital considerations and
agree agree agree
FIs (excluding insurers), looking at their own
funding requirements under Basel III, will be very
aware of the importance of tenor. Basel III aims to
improve banks’ stability by requiring them to hold
more long-term debt funding than in the past. But
that requirement is at odds with Solvency II, which
makes holding long-dated debt less attractive to
insurers. In other words, there is the risk that banks
and insurers are set to find themselves pulling in
opposite directions.

However, corporates (non-FIs) do not seem to see
at this stage the connection between regulatory
requirements and their own funding preferences: 31%
only 48% concur, and 21% disagree outright. neutral
Over time, however, it is likely that debt-issuing
companies will adjust their behaviour to try to align
with insurers’ requirements. They may have to issue 31%
shorter-dated debt on a more frequent basis. They neutral
may also adjust their capital structure to achieve
investment-grade status, or offer higher yields in
compensation for the capital costs to insurers.
21% 17%
disagree neutral
Most notably, a clear majority (60%) of survey
respondents agree that unrated companies may
have to pay higher yields to attract insurers in the
aftermath of Solvency II. But insurers as a group 7%
are markedly less convinced. Only 39% agree, disagree 3% disagree

compared with 73% of FIs (excluding insurers) and
53% of corporates (non-FIs) This suggests that,


Chart 16: Do you agree or disagree with the following statement about corporate debt issuance?
Unrated corporates will be forced into paying higher yields as that will make their debt more
attractive to insurers post-Solvency II.

60% 53% 39% 73%

All respondents

Insurers

agree agree agree agree

37%
neutral
31%
25% neutral
neutral
16%
15% 16%
24% neutral
disagree 11% disagree
disagree disagree

unlike other groups with less knowledge of the An examination of the implications of Solvency
implications of the new regulations, they know II for companies trying to raise debt throws up
they may be unable to afford the capital charges another concern—that the regulators may have
associated with such companies’ debt, no matter failed to consider the big picture, and that there
how generous the yield. is a mismatch between the aims of this piece of
regulation and those of Basel III.
“Of course, insurers will have to assess the risk
versus reward profile for any corporate debt they When asked whether the two directives represent a
consider buying, but they will only have a finite conflict of interests for banks and insurers, and if
amount of capital available as cover,” comments so what the consequences might be, the majority
Mr Rastogi of Towers Watson. “It will be a question of survey participants who offered an opinion were
of finding the optimal mix of assets within their in agreement, although they gave a wide range of
specific risk budget.” possible outcomes.

Mr Williams of Legal General speculates that “I think these regulations might create conflict;
insurers may be allowed to appeal to the authorities they may increase demand for sovereign debt
on the grounds that they have built up a strong from both banks and insurers,” commented one
portfolio of BBB-rated debt and therefore have the UK-based bank respondent. Others suggested that
expertise to make distinctions on the grounds of a the main consequence could be a more volatile
company’s security and quality. He believes that the market. “The potential conflict between these two
shift away from non-investment-grade debt could directives could put EU banks and their funding at
cause significant difficulties for many companies. risk,” added a composite insurance respondent
“EIOPA wants to see a lower chance of default on from the UK.
insurers’ investments, through the use of higher-
grade debt. But many smaller, well-established A number were more cautious, admitting
industrial firms across the EU are graded BBB. Of that until Solvency II comes into force, it
course they are not as secure as blue-chips, and will be very difficult to predict how the clash
they pay higher yields to compensate, but they are of interests will affect those involved. “I think
not inherently risky propositions. Importantly, it’s that these regulations are going to create
these companies that tend to lead their countries conflicting goals, but the consequences are
out of recession, and if the banks are not lending still unknown. We will have to wait until their
and the insurers are penalised for buying their debt, implementation,” said a bank respondent based
they will face a big problem.” 3in Denmark.

18


5 Predicting the unintended
consequences
There are fears that the regulatory regime of
Solvency II will introduce a host of unforeseen Chart 17: Do you agree or disagree with
problems. The survey findings indicate that there the following statement on regulation?
is little sense of any profound need for additional The current level of regulation is
regulation in terms of insurers meeting their sufficient to ensure that the insurance
obligations to policyholders. Most respondents— industry is able to fulfil its obligations
particularly insurers (62%) and pension funds to policyholders.
(64%), unsurprisingly—consider the current level All respondents
of regulation sufficient.
56% 18% 26%
Moreover, there are serious concerns among
respondents that regulators have not thought
through the broader impact of the new legislation
on capital markets. Answers to an open question Corporates (non-FIs)
in the survey highlight the sheer range of
potential problems.
48% 21% 31%

A number of respondents are worried about the
idea of introducing a complex and potentially
restrictive regime at a time when both EU Insurers
economies and markets are so fragile. As one bank
62% 17% 21%
respondent from Denmark puts it: “Capital markets agree neutral disagree
are in a bad shape right now and are not ready for
a major change.” Several voice concerns about the
negative impact on wider economic growth, and
one, another bank respondent from Denmark, FIs (excluding insurers)
adds that it is not only macroeconomic factors 58% 16% 26%
that are at risk, “but also the pressure put on the agree neutral disagree
financial sector due to the timing of Basel III and
Solvency II.”

Others highlight the impact on particular asset
classes. “My main concern is that insurers are


Chart 18:
How will Solvency II impact the structure of smaller friendly societies and mutuals?

20%
54% 11% 16%

They will They will They will There will be
outsource more consolidate to close to new no material
to access scale achieve scale business impact

being dissuaded from buying long-term bonds Ms Carter-Vaughan of Expert Insurance Company
under the EU Solvency II rules,” says a life agrees that the insurance giants are in a stronger
insurance respondent from the UK. But others position because of their resource base. Medium-
are worried about the impact on equity markets, sized firms, especially broker-only businesses
growth in demand for derivatives, the trend without their own direct distribution arm, are in a
towards a more concentrated range of asset particularly difficult position, exacerbated by the
classes and the risk of a further credit crunch as a economic climate.
consequence of over-regulation.
“These businesses may be well-capitalised, with
A further area of uncertainty focuses on the impact generous solvency margins—but if they’re invested
of the new regime on smaller friendly societies, in government bonds and banks, and the ratings
mutuals and monoline insurers. Mr Williams of agencies take a view on that investment base and
Legal General makes the point that large insurers downgrade their ratings, as has happened already to
with a range of products have the resources to some firms, the insurance brokers will have to drop
absorb additional overhead costs, and that at away,” she explains. “Solvency II will make this much
the other end of the spectrum the industry in worse—it couldn’t be happening at a worse time.”
Europe is much more skewed towards small mutual
specialists serving a local community, who have However, Mr Shah of PIC disagrees that it is all a
their own well-established niches and may be matter of scale, observing that large multi-national
below the minimum size to qualify for Solvency II insurers with subsidiaries in different EU countries
regulation anyway. “It’s the monoline providers in are likely to face their own problems. “Before
the middle who are likely to be more disadvantaged Solvency II, local regimes often understated the
than either of these groups,” he says. amount of capital needed by insurers, on the
grounds that the multi-national parent was holding
More than one-half (53%) of all respondents a sensible amount at group level, albeit in other
expect to see a spate of consolidation as smaller jurisdictions. Solvency II will push the obligation
insurers try to achieve economies of scale; a to hold the right amount down to subsidiary level,
further 20% anticipate that they will move towards and limit companies’ ability to move capital around
outsourcing more functions. between countries as needed.”

20


conclusion

It is clear that while some boost to the current corporate debt and towards ‘safer’ assets such
regulatory situation may be necessary, both the as cash and investment-grade debt. But that
potential consequences and the timing of Solvency may leave a tranche of smaller companies—
II are a source of considerable concern. Indeed, companies that could be leading European
it seems that while the new regime would be economies back towards growth—with serious
bound to have ramifications regardless of when funding problems because they do not have a
it is introduced, the euro zone’s current difficult high enough debt rating.
political and economic climate and wider tough
investment conditions are all set to make things So what is the prognosis for the future, and for
worse for insurers and their stakeholders alike. Solvency II’s progress onto the statute books?
Mr James of Lockton emphasises that what
There are various implications for policyholders, the insurance market really wants is “absolute
but the bottom line is that premiums are clarity as to how the rules will be applied”.
likely to increase in price—as a result of the Implementation is still two years away, in 2014,
implementation and overhead costs of Solvency and clearly there will be many discussions before
II, the further reliance on underwriting profit everything is clarified, particularly given the
rather than investment return and because the highly uncertain political and economic backdrop
range of providers may shrink as firms are pushed against which decisions must be made.
into consolidation. Some policyholders may be
forced to reduce their levels of cover or drop some One area where regulators must consider the
insurances altogether because of price increases. implications of Solvency II is the impact on
There is also a risk that they will find it harder to the cost of guarantees. EU regulators seem to
source more unusual types of cover because of the want safety at all costs and appear to be more
contraction in the number of middle-sized firms, comfortable with people being under-insured
which have traditionally played an innovative role rather than properly insured but somewhat at
in the insurance marketplace. risk of the guarantee not being met by the insurer.

Savings and investment products are also likely Mr Shah of PIC believes that the European
to be affected. As the costs of guarantees become authorities are likely to have to agree on
clearer, they will inevitably increase. Investors substantial compromises to make it more workable
generally see guarantees as attractive but do not and acceptable to national regulators and the
place the same value on them as the cost to hedge industry, if it is to be in place roughly on time.
those guarantees—the challenge to the industry
will be to find the right balance. There is also pressure to get things right as
Solvency II’s reach has potential to go beyond the
The possible consequences are arguably also EU. “Many foreign regulators, particularly those in
serious for companies seeking to raise money in developing markets, look to the EU and the US for
the capital markets, where insurance companies guidance on key principles as they don’t want to be
are major institutional investors. Insurers are out of sync with these major markets,” comments
likely to shift their portfolios down the risk Mr Hughes of HSBC Insurance. “This could make
spectrum, away from equities and lower-quality Solvency II even more far-reaching in the future.”


appendix:
survey
results

In which country are you personally located?
(% respondents)

Spain
18
United Kingdom
16
Denmark
13
Germany
12
Netherlands
11
Sweden
10
Finland
6
France
6
Luxembourg
5
Belgium
1
Ireland
1

Note: numbers do not add to 100% due to rounding
0

0

0
What is your primary job function?
(% respondents)
0

Finance
72
Risk
24
IT
2
General management
12
Operations and production
1

0

0

0

22


Which of the following best describes your job title?
(% respondents)

CFO/Treasurer/Comptroller
30
Head of department
28
SVP/VP/Director
15
Other C-level executive
9
CEO/President/Managing director
8
Board member
6
Head of business unit
4
CIO/Technology director
1
Other
1

Note: numbers do not add to 100% due to rounding
0

0

0
What is your primary industry?
0
(% respondents)

Automotive
0
1
Chemicals
0
1
Construction and real estate
1
Consumer goods
2
Financial services
71
Government/Public sector
2
Healthcare, pharmaceuticals and biotechnology
2
IT and technology
2
Manufacturing
10
Power utilities
2
Professional services
2
Retailing
1
Telecommunications
1
Transportation, travel and tourism
2


What is your main business?
(% respondents)

Pension fund
25
Bank
25
Non-financial corporates
25
General
9
Life
8 25
Composite - both life and general
6
Asset manager
1
1 25

0

0

What are your company's annual global revenues?
0
(% respondents)

0 €500m or less
21
0 €500m to €1bn
44
0 €1bn to €5bn
15
0 €5bn to €10bn
9

0 €10bn or more
5 11
10 15 20 25
0
What are your organisation’s assets under management (AUM)?
0
(% respondents)

0
€100m or less
2
0
€100m to €500m
14
0
€500m to €1bn
11
0
€1bn to €10bn
30
0
€10bn to €25bn
6
0
€25bn to €50bn
3
0
€50bn or more
34
0
0

0

0

0

0

0

0
24
0

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