With Solvency II model applications now in, attention is turning to the strategic implications of the new regime. Simon Woods explores the challenges and opportunities
As many overworked Solvency II project teams will attest, the focus of the past six-plus months has been getting over the line: whether it's IMAP, matching adjustment, Pillar 3 reporting or any other complications arising from detailed interpretation and application of Solvency II in practice.
However, management and investors are increasingly asking what Solvency II means strategically, and, to date, the answers have been less than compelling. Very few companies know where their base balance sheet will land, let alone how the balance sheet will evolve over time.
While we anticipate a continued period of uncertainty as Solvency II beds down, the direction of travel is clear. The winners from Solvency II will anticipate not just the balance sheet implications but also how best to communicate performance in a more volatile regulatory environment.
What are the key strategic effects of Solvency II?
While Solvency II will affect many areas of insurance businesses, including costs, governance and reporting, we highlight three key effects.
Changes to product return profiles
The implementation of risk-sensitive capital, whether regulator-led, such as individual capital assessments in the UK, or management-led economic capital models, has already resulted in a reappraisal of products in a number of jurisdictions.
This has led to a move from capital-heavy products, often with guarantees and high equity allocations, into capital-light products, such as unit-linked savings/corporate pensions. This trend has been exacerbated by the current low interest rate environment.
However, Solvency II is leading a further iteration, as the detail of the rules has material economic effects (at least before transitional measures are factored in).
In a UK context, annuities appear far less attractive given the operational restrictions regarding the matching adjustment and the calibration of fundamental spreads relative to the existing liquidity premium approach; this is exacerbated by the cost of the risk margin driven by low interest rates and prudent longevity stresses.
On the flip side, unit-linked and protection business look more attractive, given the allowance for negative reserves created by future expected profits.
Diversification and risk management are rewarded
As a risk-sensitive regime, Solvency II embeds a number of key assumptions as to how overall capital requirements are calculated (Chart 1):
? diversification is rewarded at every level, assuming capital is fungible;
? asset liability management, and matching in particular, has a marked impact on the solvency capital requirement and also on overall balance sheet volatility;
? consolidation versus legal entity drives the supervisory view, and reducing complexity has clear advantages.
We are starting to see these factors drive activity, including:
? emphasis on Pillar 2, and the use test;
? legal entity consolidation, especially within country;
? risk consolidation, often through intra-group reinsurance, where there are diverse international groups.
Internal models do provide an advantage, but not as anticipated
Ask an informed external observer about internal models and, more often than not, their assumption is that internal models will lead to lower overall capital requirements.
However, for many mainstream assets and liabilities, internal models are often giving rise to a higher capital requirement for specific risks than the standard formula does. On the other hand, there are many instances where the standard formula simply disallows material items, such as diversification between a matching adjustment portfolio and other business of an insurer.
Another area in which internal models have an advantage is in the flexibility they give companies to apply risk-appropriate capital charges for non-standard risks. This is most evident on the asset side, especially for long-dated liabilities such as annuities, where insurance companies have been moving into new, less liquid asset classes in search of yield and diversification. Standard formula charges, in particular for securitisations, or quasi-securitisations such as infrastructure debt, are often crude and overly conservative. These differences are best illustrated in Chart 2 below.
This disparity is particularly evident in the construction of matching adjustment portfolios. The clearest divide between internal model 'haves' and standard formula 'have nots' is the treatment of equity release mortgages. The Prudential Regulation Authority has said these need to be restructured via an internal special purpose vehicle to create the fixed cashflows required for matching adjustment eligibility, yet the restructuring is treated as a type 2 securitisation under the standard formula, often attracting a 100% spread charge in the spread stress owing to their duration.
Implications of the changes
The full strategic implications of Solvency II will likely become clear only in retrospect, not least owing to the feedback loop between industry action and regulatory reaction. That said, we can attempt to peer into our crystal ball and anticipate the following shifts over the next three to five years.
Accelerated shifts in new business, compressed margins
As a result of a number of factors including:
? scarce capital in the sector;
? altered product return profiles as a result of Solvency II;
? the low interest environment making traditional guaranteed products unattractive to consumer and to provider;
? changes to distribution (for example, the retail distribution review), tax and legislation (for example, the changes to the annuity market following last year's Budget).
We anticipate an accelerated shift in new products from capital-intensive business into capital-light business.
This is likely to lead to a repricing of the more attractive business, as insurers look to reposition their books, and as pricing moves to a marginal cost/return basis. Within this, the stronger players (whether from capital, cost or distribution) will look to capitalise on their strengths to capture market share.
Squeeze of the mid-market and monolines
Solvency II bestows three significant advantages on larger groups:
? scale to cover increased fixed costs of Solvency II compliance, including Pillar 2 infrastructure and Pillar 3 reporting requirements;
? the sustained ability to take credit for diversification benefits across multiple business lines and geographies, leading to a lower marginal cost of capital for incremental business;
? access to hybrid debt financing, lowering the overall cost of capital.
Weighing against this is the greater complexity and drag of legacy systems and products.
The mid-market and monoline specialists will increasingly be under pressure in mainstream markets, and will need to carve out successful niches defined by one or all of the following attributes: product design and pricing, customer service, differentiated distribution.
Capital and in-force management will become a core competency
The 'do-nothing' expected return on the back-book cannot be relied on as much in the Solvency II framework, as much of the expected return is already captured in the economic balance sheet. In this environment, the main drivers of performance will be new business contribution and value extraction from the back-book. The latter will predominate in a mature market such as the UK, and focus on operations and capital management will increase in importance as a driver of shareholder value.
Extraction of value from back-books will require significant changes in the sector in order to be executed effectively:
? an increased willingness to hedge or offload unwanted or peak risks, as well as an increased range of techniques and counterparties;
? better data and analytics to understand sources of earnings and returns, and quick identification of the likely impact of strategic options across the range of metrics;
? organisational changes to pull together the necessary strands from strategy, finance and risk, and to empower delivery of the strategic agenda.
While the scale of change implied by Solvency II may appear both overwhelming and inherently uncertain, doing nothing is unlikely to address the issues or satisfy investors that there is a clear value proposition on a forward-looking basis.
Laying the groundwork for a cogent analysis and the ability to deliver required changes are critical first steps, and these usually involve:
? a clear articulation of key metrics, key performance indicators and risk appetite to assess strategic options;
? forward-looking financial analysis for the key metrics, including the sources of Solvency II surplus generation, and of the drivers of the Solvency II balance sheet;
? the right operating model, which consolidates information from finance, actuarial and risk, and empowers capital-driven commercial and strategic decisions.
