The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2013

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With the implementation of Solvency II posing a significant challenge over the coming years there are a number of potential ramifications for insurance companies, most of which suggest consolidation will become more likely in the industry.

Against this backdrop, outsourcing investment portfolios to specialist asset managers would appear to be a particularly attractive proposition for insurers looking to hold an optimal investment portfolio that takes into account both market conditions and regulatory requirements.

Increased capital charges
With Solvency II imposing a more onerous capital treatment for several types of investment, insurance companies are now increasingly incentivised to develop sophisticated models to assess the risk characteristics and appropriate capital treatment of their investments.

The standard formula capital treatment under Solvency II is often more conservative than the current treatment being used for an insurer's individual capital assessment (ICA). It typically requires higher capital charges for riskier investments such as equities and commodities.

As a result, the standard formula approach is more prudent and so favours investments in traditional instruments like government bonds.

The rationale for insurers to undertake their own capital assessment is that there is the potential for capital treatment that reflects actual economic risks rather than prudent standard formula assumptions.

This is, of course, subject to insurers' own in-house models and capital assessment being approved by the regulators. However, the potential for advantageous capital treatment via in-house modelling significantly favours larger companies, which typically have greater resources and can therefore absorb the initial development and ongoing maintenance costs necessary to implement such tools.

The result is likely to be an increasingly challenging competitive environment for smaller companies in the insurance industry.

Solvency II comes at a cost
Further to the competitive disadvantage that smaller insurance companies are likely to face from the Solvency II capital requirements, there are also significant direct costs that all insurance companies will incur to keep in line with the changing regulatory environment.

These include personnel costs, with an increased burden on actuarial, finance and risk resources to implement Solvency II. In many cases, consultants with specialist expertise in Solvency II will also need to be employed.

In addition, company procedures will have to be updated to reflect the changes, as will investment processes.

The result of these higher costs is two-fold. First, while the costs affect all insurance companies, the smaller industry players are most likely to suffer the highest costs as a percentage of their revenues. As a consequence of this, smaller players and closed books of business will see profit margins constrained and may be forced to review their business models.

Second, those insurers that continue to write new business will ultimately need to pass on the additional costs to the end consumer, which could result in higher insurance premiums, less competitive investment products or reduced levels of cover over time.

Inflation-beating investments
Today's market environment is characterised by relatively high inflation levels combined with historically low yields on fixed income investments, particularly at the short end of the yield curve. The result of this is negative real yields on lower-risk investments, which creates an extremely challenging environment for insurers, particularly those that are investing to match short-dated liabilities.

Smaller insurers in particular are likely to struggle, as they are saddled with investments unlikely to generate positive long-term returns after inflation. This position is compounded by the realisation that they may not have the resource base to support the capital assessment and charges that Solvency II requires for more complex investments.

In a relative sense, the larger, better capitalised insurers are therefore likely to be the long-term winners in this environment, as they have more scope to reflect their market views and are not just limited to short-dated bonds offering negative real yields.

For example, they may have greater scope to use derivatives to manage duration, and therefore minimise capital charges arising from interest rate exposure. They can also justify the due diligence and selection costs associated with longer-term and/or less liquid real assets such as infrastructure, property, absolute return and farmland - which the current market environment potentially makes attractive options.

Indeed, for the larger insurers with plenty of capital, the higher charges and increased reporting requirements for more adventurous investments are a small price to pay for the potential to generate higher longer-term returns and outperform those companies without the capital or resource base to do the same.

Likely consolidation
The costs of accommodating changes from Solvency II and the higher capital charges on investments offering potential for real long-term returns means that smaller insurers face an uphill battle to compete with the larger, better capitalised insurers on a number of levels.

In the long run, this would appear to make increased consolidation in the insurance industry likely, whether through mergers and acquisitions or through a number of smaller insurers going out of business.

In addition, larger insurers are often actively incentivised to acquire smaller insurance firms in a bid to improve diversification within their business, with each part of a larger business bringing a variety of different risks and exposures that have the potential to offset each other.

Those companies that combine life assurance and annuity provision, for example, have the potential to benefit from diversification, as there is a natural offset between the two, with longer life spans benefiting life insurers.

There is significant precedent in history for such an outcome, as after regulation was introduced in the life insurance industry there were numerous instances of small profitable firms being taken over by larger entities already operating in the insurance market. These include the takeover by Phoenix Group of Resolution, which was already a consolidation of several insurers in itself.

Outsourcing
While the impact of Solvency II will clearly be extremely significant for the insurance industry, and for smaller market participants in particular, outsourcing expertise to specialist investment managers would appear to be one of the most attractive ways for insurers to adapt to the changing regulatory environment.

Small mutual and friendly societies potentially stand to gain the most from outsourcing, as it enables them to benefit from a broader array of specialist experience, which includes access to range of investment solutions supported by actuarial expertise, specialist risk controls, full look-through reporting capabilities and detailed knowledge of how best to manage portfolios in light of Solvency II and today's challenging investment markets.

Charles Pears is head of insurance at Insight Investment