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Solvency II and credit ratings

Working at a rating agency means anticipating the impact of big shake-ups in the insurance industry and credit ratings. The latest and arguably most significant storm to hit the insurance industry in years is the introduction of Solvency II, the new European insurance regulatory regime due to come into force in 2013.

Solvency II is expected to have far-reaching impacts, with both positive and negative credit rating implications (see Figure 1). Rating changes will be driven by the characteristics of each insurer and its management of the transition to Solvency II. The main rating drivers are likely to include exposure to risks that require significantly more capital under Solvency II such as equities, low-grade corporate bonds, products with high guarantees, as well as marine, aviation and transport insurance.

Solvency II could transform the insurance landscape with some fundamental shifts to a lower-risk product mix, more cautious investment strategy and, for certain products, higher premiums. Insurance companies hold large amounts of corporate and government bonds and equities. Changes in their investment strategies could significantly shift demand between these asset classes, with implications for asset prices and yields.

For product lines with increased capital requirements under Solvency II, insurers could pass the associated extra costs onto policyholders wherever possible. A key example is the UK annuity market, where annuity rates have already been seen to be cut in direct response to Solvency II. People retiring are facing lower annuity rates than five years ago; this has been due to increasing longevity and diminishing investment returns but now it is being exacerbated by Solvency II. Many insurers are preparing for the new regulations by moving to much more cautious asset strategies driven by the new rules. However, this means lower expected returns and therefore lower pensions for retirees.

Under quantitative impact study 5 (QIS5), the latest indication of how capital positions may look under the new regime, the strong capital position of the European insurance and reinsurance sector in aggregate reflects the recovery in financial markets and the balance sheet de-risking that many insurers have carried out both in response to the financial crisis and in anticipation of Solvency II, which is designed to discourage balance sheet risk.

However, several non-life insurers may fall short of Solvency II capital requirements as currently drafted. Unless the Solvency II risk charges for non-life business are recalibrated, some non-life insurers may have to recapitalise or reshape their business in order to survive. That said, the European Insurance and Occupational Pensions Authority is already performing additional work to improve the calibrations and it seems that Solvency II will ultimately be more favourable for non-life insurers than the draft rules as they stand.

Many smaller and niche insurers face a significant increase in capital requirements because they lack risk diversification, an important factor under Solvency II. This may lead to an increase in merger and acquisition activity, which could provide opportunities for larger insurers but could also bring integration risks to the insurance sector.

European insurers are lobbying hard for Solvency II to be recalibrated to avoid potentially negative impacts for the industry. In a recent letter to the European Commission, top professionals from the CRO Forum and other bodies representing the insurance industry’s views expressed their extreme concern, saying “Stakes are high and time is running out: a failure to properly implement this reform would have dire consequences for an industry that represents a significant component of the EU economy, capital markets, old age savings and jobs.”

There are a significant number of outstanding issues that could swing companies’ capital positions between comfortable solvency and significant deficit. These must be resolved before the true impact of Solvency II can be ascertained and investors can understand the impact on their holdings.

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Fitch’s report ‘Solvency II — Far-Reaching Implications of New Insurance Regulation’ is available at www.fitchratings.com on the Solvency II market focus page, along with reports on Omnibus II and the QIS5 results.

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David Prowse is a senior director at Fitch Ratings and leads Fitch’s UK life insurance ratings team. Clara Hughes is a director at Fitch Ratings and leads Fitch’s Solvency II analysis and European capital modelling