Insurers should avoid Solvency II myopia, argues Paul Fulcher, and be aware of wider regulatory developments that could have a greater effect and present significant opportunities
Insurers have in recent years focused their attention, and lobbying, on Solvency II. But Solvency II myopia may lead insurers to overlook a raft of other major reforms that could have an even greater effect.
Examples include the Dodd-Frank reforms in the US, Basel III rules for banks, and new European Market Infrastructure Regulation. In contrast to Solvency II, which was designed for a pre-global financial crisis world of much more stable markets, these arise directly from the response of regulators and politicians to the crisis. But that's another story!
In some cases, insurers will be affected directly. Large insurers, in particular, are fighting to avoid being designated as 'systemically important financial institutions' - likely to transmit or amplify shocks around the financial system - which would subject them to many of the same restrictions as banks.
One example is the move to central clearing of over-the-counter derivatives, discussed in the May 2012 edition of The Actuary.
Another is the UK government's proposals following Sir John Vickers' Independent Commission on Banking. These centre on a requirement for banks to ring-fence their retail operations, prohibiting them from engaging in many investment banking activities. A ring-fenced bank is also required to limit exposure to all insurance companies, other than the smallest friendly societies. If investment banking is seen as a casino, it seems that the government sees insurers as professional gamblers.
Even where insurers are not directly affected, the wider macro-economic impact of banking reform will have a significant effect on the economy and on asset markets.
One key area of opportunity for insurers arises from 'deleveraging' in the European banking sector - reducing the relative size of their assets and lending versus their capital base. Table 1 summarises the pressures on banks' balance sheets, and their responses.
We expect these pressures to lead to a substantial reduction in leverage ratios, as measured by the total assets owned by banks relative to their Tier 1 capital. Figure 1 shows the International Monetary Fund's estimate of the amount and source of the reduction in this ratio across the largest 58 EU banks over the period from 2011 to end-2013.
The largest contribution comes from retaining earnings, rather than distributing them to shareholders and staff. This will enable banks to build up their capital buffers over the next few years, and avoid fire-sales of assets. However, they will continue to face pressures on funding these legacy portfolios.
Asset sales also play a major part, and the IMF estimates that these EU banks will reduce their balance sheets by a total of 2trn (£1.6trn) by the end of 2013. Only a quarter of this reduction is expected to come from reduced lending, with most from outright sales.
By the nature of their liabilities, insurers typically have a lower and more stable cost of funding than banks, and less need for immediate liquidity. They are therefore natural seekers of long-dated secure assets and, in a world where core sovereign bonds have negative real or even negative nominal yields, face a dearth of other opportunities.
Banks are likely to dispose of a range of assets, including: consumer loans; asset financing - infrastructure and project finance, and shipping and aviation loans; commercial real estate loans; residential mortgages; corporate loans; and asset-backed securities and structured credit.
Figure 2 shows analysis by Deloitte of 50 portfolio transactions that came to market in 2011. Each of these asset classes has distinct characteristics that insurers will need to understand and map to their needs, but in many cases they are secured on long-dated underlying assets, and fit more naturally in insurers' rather than banks' balance sheets.
However, insurers still face impediments.
- Banks are able to carry many legacy assets at book-value and may be unwilling or unable to recognise market-value losses on a sale.
- Other market participants may be more natural buyers - for example, local retail deposit banks in the US and Asia as EU banks exit these markets, and pension funds less affected by the regulatory issues discussed below.
- Insurers will need to acquire the expertise to manage these different assets.
- Insurers face an increased risk of being deemed systemically important if they are seen to engage in 'shadow-banking'.
Insurance regulation also provides an unexpected barrier. Solvency II, at least in its purest form, does not recognise the ability of insurers to buy and hold investments, and is instead based on the assumption that assets are liquidated at distressed prices after an extreme 1-in-200-year event. Basel III banking capital charges are typically lower than Solvency II, other than for isolated cases such as low loan-to-value residential mortgages or short-term credit card loans.
Legacy asset classes of banks are typically not in a suitable format for insurers, often being short-dated or pre-payable by the borrower at short notice and with limited penalties, and floating not fixed interest rates. In particular, they are often not eligible for the Solvency II matching adjustment.
Therefore, insurance company activity has primarily been focused in two areas.
- Liquidity swaps - providing near-term funding to banks secured on their legacy run-off assets, rather than buying assets outright.
- Originating new lending - often with a bank, in a more insurer-friendly format.
Regulatory reforms from the global financial crisis represent both a threat and an opportunity for insurers, and actuaries should ensure they keep on top of developments. a
Learn more about bank deleveraging and central clearing at session A7, 'There's more to life than Solvency II', at the Life Conference and Exhibition, Brussels, on 4-6 November. Book online at www.eventsforce.net/tap/320/register