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The Actuary The magazine of the Institute & Faculty of Actuaries

Capital concerns for European insurers pre-Solvency II

European insurers are struggling to prepare for the operational rigours of Solvency II and few are currently able to earn their cost of capital, according to a new study released today by consultants Bain & Company and Towers Watson.

The joint study covered the repercussions of Solvency II for major insurers in Germany, France, Italy and the UK operating in the life, health and property/casualty sectors. The report warns that many firms will still be ill-prepared for the new environment even if Solvency II is postponed until 2014, unless aggressive action is taken to manage scarce capital.

The study analysed firms’ solvency and risk-adjusted profitability ratios from publicly accessible data, and found that the underlying core problems for European insurers go beyond the results reported by the European Commission’s fifth Quantitative Impact Study published in April.

"Companies will have to carry out extensive groundwork to optimise their capital and risk before the new EU regulations are in play," said Dr. Gunther Schwarz, partner at Bain & Company and head of the insurance practice group.

"Insurers will also have to realign their corporate strategy, organisation and culture to these new conditions which is a Herculean task."

Dr. Schwarz also sees new doors opening particularly for companies strong on capital and profits: "The entire insurance market is in a process of transformation. This is an ideal opportunity for sector leaders to further expand their market positions."

According to Towers Watson director Naren Persad, insurers must tackle the new strategic challenges sooner rather than later. "Solvency II is not just about calculating new ratios," he said. "The new regulations call for companies to conduct a widespread business review and in some cases to implement completely new processes. The reporting process will have to be industrialised."

"Due to the complexity of the new process, even medium-sized companies will need a good two years to implement the changes. And realigning a business model within this period would still be an ambitious task even if the introduction were postponed to 2014."

Key findings by country

>> Twenty five percent of German and 21 percent of British companies have a solvency ratio based on QIS5 of less than 100 percent, largely due to the higher share of long-term annuity insurances in Germany and the UK. Today, every fourth German life insurance product is an annuity, and the trend is heading higher - the equivalent rate in France and Italy is less than 10 percent.

>> Compared with other European countries, a high discrepancy exists in Germany between the periods of the insurance treaties and the invested assets; in terms of the German HGB-based accounting system, a great many companies are still applying short duration strategies. In France, Italy and the UK, by contrast, the duration mismatch is generally not an issue because the liabilities have far shorter durations and longer life liabilities are covered by corresponding long maturity assets.

>> In the property and casualty market, German and British insurers measure up comparatively well. Eight percent of the simulated insurers in the UK and no simulated German insurers revealed QIS5 solvency ratios of less than 100 percent despite the fact that throughout Europe the capital requirements in this segment are due to rise by more than 200 percent compared to Solvency I.

>> Conversely, the analysis shows half of Italy’s non-life insurers to have solvency ratios of less than 100 percent due to an unfavourable product mix. In Italy the share of motor insurance in the property/casualty segment is considerably higher (some 50 percent) than in the other European markets. And the ratio of total costs to premiums in this fiercely competitive insurance segment in Italy is nearly 110 percent - burdening equity capital and, by extension, solvency.

Additional findings

>> Many insurers do not earn their cost of capital. The model reveals that considerable differences exist between traditional and unit-linked life insurance products. On average across Europe, the traditional products show a slightly negative risk-adjusted profitability of negative one percent, while the unit-linked lines can boast of, in some cases, double-digit returns. From a profitability viewpoint, term life insurance is even more attractive, with the simulation revealing returns here of an average 17 percent. If, however, life insurers are thinking of restricting themselves in future to these two product lines, they are clearly not thinking far enough ahead. Indeed, there is an opportunity for product innovation with new guarantee concepts which are capital-light while at the same time being clearly distinguishable from those of banks or investment companies.

>> The model confirms a widespread belief that property/casualty insurers see no money to be earned on third-party motor insurance. The European average of risk-adjusted profitability lies at negative three percent. With the exception of the UK, this ratio is also negative for property and building insurance. Lastly, attractive returns can be generated on other insurance lines, such as third party insurance in some European markets.