Solvency II a catalyst for change

A new report has been published by Oliver Wyman and Morgan Stanley looking at how Solvency II regulation and oversight will affect the insurance industry. Solvency II is something we’re following closely as it’s looking likely that it will spur on risk transfer and potentially insurance-linked securities.

The salient points for us in this report are:

• Insurers need to shift their product mix and achieve business diversification – this could lead to new entrants to the P&C world, or to insurers looking to diversify into capital markets linked products.
• There will be a stronger focus on asset liability management – effectively hedging liabilities will be a great way for insurers to achieve this and as we know the capital markets are a great way to do that through insurance-linked securities (and similar products).
• An increase in the use of reinsurance – again, this should have a knock on effect for the capital markets risk transfer market.
• Sophistication – the report suggests that insurers will have to be much more sophisticated in their risk transfer methods, this could lead to innovation and expand the sector we are most interested in.

It will be fascinating to see how Solvency II rolls out and how it affects the insurance market. Although it is an EU initiative it is going to impact globally and it could be that insurers in Europe come out of this more competitive, innovative and able to transfer risks to the capital markets.

The press release regarding the report is below.

Solvency II is a Catalyst for Change for Insurers, Finds Oliver Wyman/Morgan Stanley Report

– Solvency II will expose the industry’s economic risks
– Increase in M&A, focus on asset liability management and restructuring of traditional products are features of change

LONDON 23 September 2010 – Today Oliver Wyman and Morgan Stanley published a report, Insurance: Solvency II, Quantitative & Strategic Impact: The Tide is Going Out, which concludes that the impact of Solvency II will be greater  than reduction in Solvency ratios and will act as a catalyst for change for insurers. The report finds that Solvency II, the EU insurers’ regulation which aims to improve the link between capital and economic risk, will have a profound strategic impact on the insurance industry and will cause a reappraisal of traditional business models. It states that M&A opportunities will arise from the transparency of insurers’ balance sheets and the resulting identification of risky businesses from those with sustainable profit streams. Therefore, insurers’ need to shift their product mix and achieve business diversification and balance sheet scale will drive M&A deals.

Oliver Wyman and Morgan Stanley state that insurers’ management teams will focus on restructuring the life insurance portfolio from traditional towards unit-linked and variable annuity-type products. Additionally, there will be a stronger focus on asset liability management, e.g. hedging, risk management and reinsurance.

The report applies its own Solvency II model to assess the impact of the regulation on four fictitious Europe-based insurers: a global composite, a global life company, a reinsurer and a pure primary nonlife business. Overall, the results show that strongly capitalised reinsurers will benefit the most from Solvency II owing to demand from mutuals that lack alternative sources of capital and an  increase in the use of reinsurance as a risk mitigation tool. The model suggests that small, geographically narrow insurers – including many mutuals – will be most challenged by Solvency II since most of the buffer capital comes from the benefit of business and  product diversification.

“Solvency II will reveal the true economic volatility of many European insurers’ balance sheets – and while we are supportive of the framework – in the short-run we believe this could lead to a higher observed cost of capital,” said Jon Hocking, Head of the Insurance Research Team at Morgan Stanley in London. “We expect insurers to adopt far more sophisticated asset-liability management techniques in order to optimise returns on economic capital”.

“It’s clear from our analysis that certain business structures are inefficient from a capital perspective,” said Lukas Ziewer, Partner, Insurance Practice, Oliver Wyman. “Some groups still have several insurance carriers in single markets which support different brands, for example. Whilst consolidation of insurers across European markets is complicated, Solvency II means that it is very likely to happen. Overall, we expect a limited impact on group structures of mainstream companies in the short term, but a significant increase in intra-group capital optimization through reinsurance and leveraged capital structures.”

The report includes a summary on how insurers can adapt their corporate structures to benefit from Solvency Capital Requirements (SCR). There are three major levers to achieve this: the consolidation of subsidiaries into one legal entity; internal reinsurance; and, introduction of leverage into the Group’s capital structure.
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