Fundamental changes to the insurance industry’s solvency regime to establish a pan-European capital adequacy framework are currently being formulated. Joanna Gant looks at the implications of ‘Solvency II’ on the insurance industry’s private equity exposure.
The European Union’s (EU) regulatory agenda, inspired by the European Commission’s Financial Services Action Plan, plus the adoption of International Financial Reporting Standards (IFRS), present major challenges for Europe’s insurance industry. The most dramatic changes, however, are likely to come from the revision of the solvency regime for insurance companies. Dubbed ‘Solvency II’, it aims to achieve for insurance what Basel II has for banking by linking regulatory capital requirements to risk.
Insurance companies are the third biggest source of capital for the European private equity (PE) industry, after banks and pension funds. According to the European Venture Capital Association (EVCA), between 1999 and 2003, €157bn was invested in European PE funds, of which insurance companies committed some €20bn – almost 13% of the total. The possible impact of Solvency II on the insurance sector’s appetite for PE fund investment and its ability to invest in the asset class, is therefore critically important.
The current solvency regime in the EU was created in the 1970s. It was amended through a package of directives, known as ‘Solvency I’, in 2002. This was designed to increase the protection of insurance policy holders by improving the rules regarding the solvency margin of both life and non-life insurance undertakings. Now the European Commission is in the midst of formulating ‘Solvency II’, a more wide-ranging and radical review of the current solvency framework in its totality. Solvency II is currently going through the various EU consultative processes. This should result in a draft framework directive in mid-2006. However, the new regime is unlikely to be implemented before 2008 and could be as far off as 2010.
Solvency II aims to establish risk-responsive, Europe-wide principles for the capital requirements of EU insurance companies that address both asset and liability risk and set the right incentives for good risk management. The project addresses issues such as implementing a more risk-based approach to solvency, the harmonisation of the establishment of technical provisions, new risk transfer techniques and recent developments in IFRS.
While EVCA has stated it is hopeful Solvency II will not ‘unduly prevent insurance companies from investing in the PE asset class’, some observers believe the reforms could actually give PE funding a boost. “Although a whole range of different factors are at play, long-term the outlook for PE under Solvency II is ultimately likely to be positive,” says Anthony Stevens, a director of Mercer Oliver Wyman.
In contrast to the new Basel II rules on bank capital adequacy ratios, which could raise PE’s risk weighting from about 100% to 150% and thus make PE a less attractive asset class for banks, this may not be true of the changing regulations for insurers. As Mark Chaplin, a partner in the insurance and financial services practice at Watson Wyatt, explains: “Although there is a desire to maintain consistency with Basel II/CAD III where possible, Solvency II may well actually encourage more PE investment by insurance companies.”
Chaplin believes that under the Solvency II regulations, insurers are likely to have more freedom in the way that they operate, provided they are adequately capitalised to cover their risks. In keeping with this, the new framework looks likely to replace some of the existing Solvency I restrictions. “The current solvency rules are very prescriptive about types of asset and levels of exposure permissible. While there will be some rules in this regard, Solvency II is likely to be more flexible and less stringent,” says Chaplin. For example, the 10% limit on unlisted securities may be relaxed, provided that any liquidity risk is properly monitored. “Basically, we are moving towards a system of more realistic, risk-based capital assessment. This will discourage concentrations of risk and PE may be a useful source of diversification from more conventional asset holdings. Under Solvency II insurers will be given the opportunity to use internal models to determine their capital requirements. This is a particular reason why a diverse portfolio is going to be a benefit,” Chaplin says.
Peter Vipond, director of financial regulation and tax at the Association of British Insurers, agrees that Solvency II has the potential to allow life companies to commit more capital to PE investment and take a charge on their balance sheets. “PE is deemed a relatively risky investment but as long as the calibration of capital is appropriate to the risk then Solvency II will give them the flexibility to do so. And given the lack of return in key traditional markets, PE may well come to occupy a bit more of the space previously allocated to listed equities,” he says.
However, the sting in the tail is that currently under the new IFRS, notably IAS 27 that requires a ‘true and fair view’ of an asset’s value, it is more difficult to deal with PE on the balance sheet. “Clearly, with unquoted assets, you cannot ‘mark to market’ to establish an objective valuation. In addition, the big insurance companies are encountering real problems in the way the IFRS rules require main balance sheet consolidation with regard to PE,” Vipond says.
Ian Poynton, an insurance partner at Freshfields, believes that because PE currently occupies such a small part of most insurers’ portfolios, then the impact of Solvency II will only be at the margin. “The real problem for most insurers regarding PE lies with the admissibility of assets, the liquidity risk and valuing unquoted investments,” he says.
Mark Chaplin points out that, hitherto, the prudential supervision of insurance companies has been fragmented geographically. “With considerable discretion left to national regulators regarding how the insurance directives are implemented there are many insurance regimes within the EU which currently impose tougher rules. There are therefore some insurance markets in Europe with little exposure to PE,” he says.
Solvency I has been implemented by regulators in different European jurisdictions under a ‘super-equivalency’ approach, ie they can take the European directives as a minimum standard and add further constraints. The proposal under Solvency II is currently for ‘maximum harmonisation.’ “This will make jurisdictional differences in terms of the treatment of PE less likely and may help avoid any regional prejudices against PE or any other asset class. However, regulators may be given flexibility in the parameterisation of standard capital models, which would typically apply to less sophisticated insurers,” says Chaplin.
“Although its precise form has yet to become clear, Solvency II will remove many of the inconsistencies across countries in statutory balance sheets, and will link current regulatory solvency capital and risk. It will bring significantly improved transparency to the capital position of both the sector as a whole and individual life companies; better alignment between regulatory capital requirements and true economic capital requirements; and significant improvements in risk and capital management capabilities,” says Anthony Stevens of MercerOliverWyman.
“These changes will possibly lead to more turbulence and uncertainty in the near term but, in the medium term, successful life insurers will stand out more clearly as transparency increases and capital is allocated in a more economically rational manner,” Stevens adds.
Stevens believes the current framework does not adequately differentiate between insurers with dramatically different investment mixes or asset/liability profiles. “For insurers that are well-capitalised, even after the advent of Solvency II and the adoption of economic capital techniques, the problem is less one of finding ways of raising capital or drastically reducing capital consumption, than one of raising capital productivity,” he says.
Many of Europe’s larger insurance companies, in anticipation of Solvency II requirements, have already taken steps to improve their capital position and risk management capabilities. These measures are being encouraged by local regulations in some EU states. To this end, a number of European regulators have already initiated their own changes to solvency regulation, partly in response to the perceived weakness of existing regulatory approaches in handling the difficult market conditions of the past few years.
The insurance companies most likely to be affected will be those focused in the EU states that have continued to rely on the Solvency I framework eg France and Germany. But elsewhere in Europe several countries have already developed their own risk-based capital requirements and are thus are already moving in the anticipated direction of Solvency II. Regulators in the Netherlands, Switzerland and Sweden are expected to introduce new risk-based rules in 2006 while Denmark and the UK already have new solvency systems up and running.
Prompted by the situation at Equitable Life as well as the dips in equity markets in 2001/02 and general concerns about solvency levels at UK insurers, the UK’s Financial Services Authority (FSA) introduced a risk-based solvency regulation regime for insurers, part of a broader programme of ‘integrated prudential supervision’ for all financial institutions, in January this year. “Solvency II is broadly in line with the FSA’s approach, which has been very sensible. And in this respect UK insurers are ahead of the regulatory game,” says Stevens. “The FSA has already advanced ahead of Solvency II with its own regulations,” agrees Ian Poynton.
“Given the long lead in to Solvency II, the FSA felt there was a need to put in place interim measures which would reflect, more accurately, the current state of the insurance market and its risks,” notes Mark Chaplin. Even so, a more sophisticated approach to risk management, financial reporting and corporate governance will be necessary for insurance companies to meet the proposed Solvency II requirements. Current processes and systems will need to be enhanced and greater reliance will be placed on internal models to determine capital requirements.
According to a recent report by Mercer Oliver Wyman, over the last 15 years the European insurance sector has systematically delivered lower returns on equity than the European banking sector. The firm finds that returns to risk intermediation have been depressed due to the historical ‘barbell’ investment strategy of focusing investments primarily in equities and government bonds, with a relatively low proportion of assets (compared to US life companies) invested in less liquid alternative investments such as PE, corporate bonds, private placements and even hedge funds.
“There is considerable scope for improved returns to risk intermediation through improved asset allocation, with increased focus on making full use of the illiquid nature of insurance liabilities to take more liquidity risk on the asset side of the balance sheet. The illiquid liabilities of life insurers make them the natural holders of illiquid risks and our view is that, in Europe, life insurers’ asset allocations are still much more liquid than they need to be. This suggests that asset returns can be increased without running into either liquidity or financial risk constraints,” says Anthony Stevens.
Stevens asserts that, on balance, the post-Solvency II regime will probably see significant increases in PE allocation and alternative investments. But this could simply be due to overall market conditions. “It can be hard to disentangle structural and regulatory changes from general market sentiment and outlook. But certainly, in terms of liquidity, big insurers can afford to have more exposure to less liquid forms of investment,” he says.
There are still a number of technical issues to be addressed before Solvency II hits the home straight and adoption of the new measures remains a good few years away. However, the consensus at this early stage appears to be that the moves towards risk-based regulation will result in fewer artificial barriers to non-conventional asset classes. This has the potential to open PE up to a wider European audience of insurance company investors and encourage larger capital commitments. So far then, so good.