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Solvency II: Cast away

Malta joined the European Union in May 2004 and is currently the smallest country in the EU with an estimated population of 415,000. In 2008 Malta adopted the Euro and in January 2013 the country will be implementing Solvency II, highlighting that numerous changes have occurred in Malta over the last few years. This article explores the potential impact that Solvency II may have on the Maltese insurance industry and how the industry could deal with these new requirements.

Malta insurance industry
The Maltese financial services industry is regulated by the Maltese Financial Services Authority (MFSA), which was established in June 2002. The Maltese insurance industry has grown considerably in recent years. In 2004 there were eight registered insurance companies, and by the end of 2009 there were 45 (Figure 1). Of the non-life and life insurance companies in 2009 there were three protected cell companies consisting of 12 cells and eight affiliated insurance companies (AIC).

Malta is fast becoming a viable insurance industry, offering the following:
>> As a member of the EU, Malta has implemented the Euro. Maltese legislation also permits EU passporting within the European Economic Area (EEA). Figure 2 shows the gross premium written (GPW) for risks being insured in and outside of Malta, highlighting the increasing usage of this benefit.

>> Competitive tax environment and full compliance with the requirements of the Organisation for Economic Co-operation and Development (OECD).
>> The Companies Act, which legislates for a Protected Cell Company (PCC), was introduced in 2004 by the MFSA. Malta is currently the only EU member country with PCC legislation.
>> International Financial Reporting Standards (IFRS) is the sole accounting requirement.
>> English-speaking, excellent infrastructure and a low-cost environment.

Quantitative impact study 4
The implementation of Solvency II is likely to prove challenging to most companies in Malta, as feedback from the QIS4 submission suggests that the quality of data and the amount of financial resource is limited. The participation rate in QIS4 for life insurers was high at 95% of aggregate market share. However, for non-life insurers this was less representative with only a 53% participation rate.

The main QIS4 results for Malta were as follows:
>> Solvency ratio under Solvency I was 291% for all insurers. In QIS4 the Solvency ratio was reduced to 187% (cf. CEIOPS QIS4 report, Annex, Table 29,A-34 and Table 35, A-40)
>> Five of the 16 companies saw a decrease of at least 50% in their available surplus (cf. CEIOPS QIS4 report, Annex, Table 14, A-19) Three of the 16 companies did not have sufficient ‘own funds’ to fund their solvency capital requirement (SCR) (cf. CEIOPS QIS4 report, Annex, Table 14, A-19).

These results are worrying from an individual company and Maltese industry perspective. Add to this the fact that QIS4 was based on data as at the end of 2007, before the economic crisis in 2008/9. A large portion of Maltese companies’ assets are invested in equities and it is likely that these have been written down and their solvency ratio reduced even further.

Any additional capital held will also be needed to support the growth trend in new business (Figure 2). The MFSA currently require an additional 50% capital to be held under Solvency I (ie. 150% of Solvency I). This buffer will, to some extent, help to smooth the transition into Solvency II.

Quantitative impact study 5
QIS5 was launched in August 2010 with many changes from QIS4. The two changes most likely to affect Malta are:
>> The correlation within some of the risk modules has been increased, with only a few reductions proposed (for example, there is now a dependency factor of 25% between the premium and reserve risk in the non-life underwriting module). The consensus among many commentators is that this is expected to increase capital requirements further.
>> Within the non-life underwriting risk module, there is now an increased allowance for the use of non-proportional reinsurance. An adjustment factor may be multiplied with the capital requirement for the premium risk. This adjustment factor will reflect the extent of coverage provided by the reinsurance arrangement more accurately than in QIS4.

Solvency ratio management
Maltese companies will need to be more proactive in managing their solvency ratios. The four main options are:
1. Restructuring
Mergers or acquisitions may increase in order to take account of diversification benefits. However, most companies are unlikely to consider this until Solvency II has been fully implemented. In Malta there are a limited number of insurers who could merge as they are expected to be dependent on the standard formula approach. This leaves them vulnerable to larger companies that are better able to take advantage of the more favourable (i.e. less capital) internal model approach.

Insurers may convert themselves into a protected cell company (PCC). This structure allows the company to be set up as a cell, with each cell required to hold capital needed to protect only their risks. This could be a more capital-efficient structure for smaller insurers like those in Malta, as the minimum own funds requirement applies to the PCC as a whole. The exact treatment under Solvency II is still being considered.

2. Raising additional capital
Additional equity may be raised in order to meet solvency requirements. This may be done through an equity issuance, which increases the amount of loss absorbing capital. However, currently only three Maltese insurers are able to raise finance via the Maltese stock exchange. Other insurers in Malta are able to raise finance by issuing subordinated bonds. These bonds will need to meet certain Solvency II criteria in order to be eligible to increase the solvency ratio. The expected return required from these options will make them expensive, as the capital markets are still in recovery.

3. Asset liability matching
Companies may move to de-risk their asset exposures, and better match their liability positions. This would help to reduce their market risk (particularly for life insurers) and their overall capital requirements.

4. Reinsurance
An attractive option could be to increase the use of customised reinsurance solutions in obtaining capital relief. Solvency I only allows a 50% recognition for reinsurance, while QIS4 and QIS5 allow full recognition. This is particularly relevant for Maltese insurers using the standard formula. Increased reinsurance would also allow the primary market to make use of the capital being held by reinsurers and reduce the underwriting capital component of their SCR.

Solvency II will be an improvement on Solvency I, increasing insurers knowledge regarding their risk drivers and capital requirements. However, the decision makers must ensure that adequate consideration is given to all participants involved in the Solvency II process. The Maltese insurance industry is represented by a small number of insurers, so any impact on these insurers will invariably have an impact on the Maltese insurance industry as a whole.

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Jean-Paul Shipley and Louis Heng are actuaries at Munich Re of Malta plc. The views expressed in this article are theirs alone and not necessarily those of Munich Re