Time ripe to batten down hatches against the ‘perfect storm’ of insurance risk

Date: 04/11/04

IT HAS been a torrid decade for Europe's insurance industry. Life insurers in particular have been suffering, hit by what Anthony Stevens, a managing director of consultants Mercer Oliver Wyman, describes as "a perfect storm" of accumulating risk.

Even Allianz Group, Europe's leading insurance company, had to turn to the market for new capital in 2003, raising €4.4 billion to strengthen its equity base and secure its high credit rating.

Insurance is a business which matters in the European Union. Earlier this year a group of independent insurance industry experts - appointed by the European Commission's internal market department to assess the Financial Services Action Plan - estimated that, in 2001, the Union's insurance and pensions industry's premium income amounted to €822bn.

This was almost one-third of worldwide industry premiums. Their report also stated that the European industry employs almost 1.4 million people.

No wonder then that insurance industry regulators have been turning their minds to the question of how to strengthen the financial underpinnings of an industry which plays so vital a role in the eurozone's financial markets and which should be a growth sector for the EU in the global economy.

Steps to reinforce minimum solvency requirements for the industry were taken in 2002 when the fallout from the bursting of the dot.com bubble and the slump in global equity markets was beginning to threaten the financial stability of weaker firms.

In February 2002, Internal Market Commissioner Frits Bolkestein greeted the new solvency margin directives he had sponsored (Solvency I) with the dubious claim that they would "significantly increase security for policyholders".

Even before the Solvency I Directives were approved, however, he had announced in 2001 that the Commission was "going ahead with a complete review of the overall financial position of insurance undertakings", a project that has come to be known as Solvency II.

The decision to launch a wider review was a tacit admission that, compared with the risks threatening to swamp the industry, the new directives were simply a finger in the dyke.

Confirmation of this came last year.

Several EU insurers found themselves forced to protect their financial position by selling equities into a falling market. This development, had it continued, could have turned their worst fears into self-fulfilling prophecies, by driving markets lower still.

It is not just the collapse of share prices after the dot.com bubble burst - and the protracted weakness of markets since - that triggered Anthony Stevens' "perfect storm".

For more than 20 years, many life assurance companies have been increasingly mismatching their risks and liabilities, either by investing in shares rather than bonds, or by purchasing bonds of shorter maturity to take advantage of rising interest rates in the "great inflation" era in 1970-90.

Government requirements or competitive pressures, which led life companies to attach generous but inadequately risk-assessed guarantees to their products, were also storing up trouble for the future, as the financial difficulty of the UK's Equitable Life has demonstrated.

Even before the stock market collapses at the dawn of the new millennium, falling inflation and the associated rapid decline in interest rates were beginning to send icy blasts through the boardrooms of frailer firms in the market.

The breakdown of cosy, age-old, protectionist relationships between companies and their governments, induced by the single currency, was also creating new financial pressures.

These included driving insurers to look for other ways to improve the rate of return on their investments, a search which has led them to raise their risk profiles further by increasingly becoming repositories for assets which capital economizing banks no longer want to keep on their books.

So where are we now? The short answer, so far as industry regulators and the Commission are concerned, is 'still researching'.

"The first phase of the project which determined the basic structure of Solvency II has been completed," says Julia Staunig, of Brussels consultants GPlus Europe.

This is pointing in the direction of a new, three pillar structure, modelled, but in truth only loosely modelled, on the Basle II capital adequacy regime for banks, an EU version of which is supposed to be heading for the statute book for implementation next year.

Solvency II will aim to establish a more sophisticated solvency regime for insurance companies to replace the simplistic, ratio-based structures now widely used across the EU.

The exception is in the UK, where the Financial Services Authority is moving ahead with the implementation of its own new risk-based capital regime for insurers.

The 'three pillars' approach, which is unlikely to start coming into effect before 2007 (given its complexity, even this is a highly optimistic launch date), would try to ensure that the actual risks an insurance company is running are more precisely assessed and closely monitored by supervisors and management.

It could also, like Basle II, give companies the opportunity to tailor their own in-house risk assessment systems (although a standardized approach would probably be necessary for smaller firms) and it would put increased disclosure requirements on the companies.

Under the so-called Lamfalussy procedures, the Commission is working on a framework directive, which would be published next year.

It also works with CEIOPS, the Committee of European Insurance and Occupational Pensions Supervisors, to prepare implementing measures which would follow approval of the framework directive.

But don't hold your breath. The global accountancy and consulting firm KPMG warned in 2002 that insurance is a more complex and diverse business than banking.

And Mercer Oliver Wyman estimated that, based on end of 2002 figures, Solvency II could create a capital shortfall of €100bn, a figure which will have since declined as markets have recovered and remedial steps have been taken.

Some of the weaker companies are still exposed and capital shortfalls exist among firms in Germany, the UK and Sweden.

Major restructuring of the life insurance sector is going to be needed, including consolidation and cross-border mergers.

The fact that countries will experience different impacts will complicate both the politics and the details of any new directives.

If the European Union is determined to face the challenge of its ageing populations and the importance of developing robust euro capital markets, reform will, eventually, have to come.

• Stewart Fleming is a Brussels-based freelance journalist.

Analytical feature on the European insurance industry and the European Commission plans for the Solvency II regulations, which aim to establish a more sophisticated solvency regime for insurance companies to replace the simplistic, ratio-based structures now widely used across the EU.