Prospects and pitfalls in a changing global insurance world

No European city has recently changed as much as Berlin (with the possible exception of Dublin). Since the fall of the wall in 1989, its 3.4 million residents have experienced an unprecedented building boom, as the German government and city officials worked overtime to restore Germany’s historic capital to its former glory. The city offered a perfect venue to the International Insurance Society’s 43rd Annual Conference this past summer, as changes are indeed the order of the day.

The Seminar Program, “Redefining the Industry: Regulation, Risk & Global Strategy,” summarized the transformations in those areas that have begun to sweep across the insurance industry. As AIG Executive Vice President Nick Walsh noted, “global expansion is an ever larger factor, as Brazil, Russia, India and last but not least China — the ‘BRIC’ countries — assert themselves on the global stage.” Compared to the saturated and highly competitive markets in Europe, the United States, Japan and Australia, the rest of the world offers new opportunities for growth, but not without risk.

Some of them are specific to the industry, but many are not.

Marvin Zonis, professor emeritus of the Graduate School of Business at the University of Chicago, described just how scary some parts of the world have become. Even as total gross domestic product rose to nearly $54 trillion in 2006 (the United States and the European Union account for almost half of that figure), 20 percent of the countries in the world (which Zonis numbers at around 160) were going backward. He described more than 20 countries with a total population of 1.221 billion people as “failing states,” including Iraq and Iran. The current waves of war, terrorism and violence have their origins almost exclusively in those states. The violence, as the United States, the United Kingdom and other western countries have learned, frequently strikes them directly.

Europe’s insurance community, however, is more focused on the often delayed Solvency II (SII) regulations — now set back to 2012 (from 2010) — which will alter the way European insurance companies are regulated. Upon implementation the current “rules-based” system will be replaced by a “principles-based” format — the “Three Pillars” approach. The first pillar — “Solvency Capital Requirements” — will continue to assess capital adequacy, but measured by the level of risk as well as assets. The second requires greatly increased risk management, and the third requires transparency or full disclosure of the company’s risk-based financial position. Companies that fall below these standards will become subject to increasing levels of regulatory supervision.

Both on their own behalf and to prepare for SII, Europe’s insurers and reinsurers are placing new and significant, emphasis on enterprise risk management (ERM). They are adopting a holistic view of what their product offerings, distribution channels, reserves and investments should be, including an increased emphasis on securitizations and the capital markets. Decisions based on those parameters will determine the types of products they sell, where they sell them and their premium levels. Some things don’t change, however, as “taming the cycle” and sticking to “underwriting discipline” remain primary concerns for industry leaders.

Global trends

“While globalization [of the financial markets] offers more equality at the international level, there are also negative consequences,” said Dr. Thomas Miro, former German State Finance Secretary in his keynote speech. Those negatives include the type of unregulated transactions that produced the Asian financial crisis of 1997, which started in Thailand and spread as far as Russia. “The risks are amplified, they become larger and more complex, and there’s an increasing lack of transparency,” Miro explained. The resulting “imbalances” have to “be addressed through sound regulation,” but this will only be possible if the participants — the countries, the banks, insurers, hedge and private equity funds — engage in a meaningful dialogue to create appropriate regulations, which are ultimately in their own interest.

Dr. Miro’s insights and warnings have not been swept under the carpet by the industry, as might have been the case in past years. His remarks were followed by a “blue ribbon” panel discussion, moderated by Karl Wittmann, the outgoing I.I.S. chairman and former Munich Re board member. In a forceful presentation Swiss Re’s CEO Jacques Aigrain stressed that the “changing risk landscape” requires new responses and methods from the industry.

The increase in hurricane frequency and strength, floods, terrorism and similar events capture the headlines. Natural catastrophes are increasingly linked to climate change/global warming, and, as the phenomenon continues, things may get worse. “The demand for cat cover has been growing by almost 10 percent annually, more than most other lines of business,” Aigrain pointed out. The industry needs to find solutions. He called for the establishment of an “adequate regulatory framework, with financial strength based on both economic and risk-based models.” He also advocated a new “holistic risk and capital assessment framework,” which encompasses risk mitigation techniques and includes “capital market solutions.”

Aigrain has built on his predecessor, John Coomber’s, achievements in utilizing risk transfers. Swiss Re has placed around $32 billion into various capital market vehicles, about evenly split between P/C (mostly nat cat coverage) and life. He sees the use of these vehicles as “enlarging the size of the pie,” i.e., by transferring certain specified risks to the capital markets, they free up more capital to meet demand. He also urged his colleagues to “sell, swap, trade and retrade risks,” as being an effective way of “escaping the market cycle.”

AIG’s Walsh echoed Aigrain’s conclusions, noting the need for more information, especially from governments, to help the industry create adequate models to assess both catastrophic and economic risks. He also called for more coherent regulations, and urged developing countries, especially the BRIC, to “open their financial systems.”

On the same panel Don Stewart, CEO of Canada’s Sun Life, spoke for his industry. He described the problems it faces from aging populations and the growing role the private sector will be called on to play, as governments reduce their role in funding pensions and other forms of old age security.

ACE’s former Chairman and CEO Brian Duperreault, who will succeed Wittmann as I.I.S. chairman, joined the panel at the last moment, following the death of RK Joshi, chairman and managing director of the General Insurance Corp. of India. Duperreault said that while he agreed that the capital markets could help moderate the cycle, “it cannot be avoided.” Ideally there is a “technical price,” which is more or less the ideal rate for balancing premiums against risk; trying to achieve the “technical price promotes discipline,” he continued, “but it can’t always be done. However [by staying as close to the technical price as possible], you lose less money in bad times and make more money in good times.”

At a press conference following the discussion Duperreault backtracked a bit, admitting that, despite attempts to do so, underwriting discipline is rarely observed “during bad times.”

Partner Re’s CEO Patrick Thiele also noted that the ongoing presence of the cycle reflected a fundamental of economics, i.e., “when there’s an increased supply of capital, there’s less demand, which in turn creates pricing pressures.” As a result “containing losses becomes more difficult.”

Rules and regulations

Regulation of the insurance industry is a fact of life, but, like death and taxes, it hasn’t been a particularly welcomed one.

Hannover Re’s CEO Wilhelm Zeller, citing a study by PricewaterhouseCoopers, noted that “too much regulation,” was No. 1 in the list of the highest risks, or “top insurance banana skins of 2007.” Increasing globalization heightens the problem. It’s not just the United States with its 50 different jurisdictions; it’s all the regulation in all the countries the world’s big players now do business in. Zeller said the United Kingdom’s Financial Services Authority tops his Company’s list of the most difficult, as it’s “even worse than the U.S.”

When Karl van Hulle, who heads the European Commission unit that’s been drafting the proposals, told a skeptical audience that they are designed to replace the 13 existing European Union directives on insurance, harmonize rules and may result in a diminution of capital requirements, he captured their immediate attention.

Van Hulle described SII’s four “Principal Objectives” as being to: “Deepen the single market; enhance policy holder protection; Improve (international) competitiveness of European Union insurers; and further better regulation.” The key to achieving that goal is better risk management, which is an area that most of the larger insurers are already enthusiastically embracing. “Risk management has become more sophisticated,” said Allianz CFO Helmut Perlet, “there are less insolvencies now than in the past.”

Perlet and his peers aren’t really worried about insolvencies; they are working on integrating ERM into all phases of their operations. Multiple and often conflicting regulations make achieving that goal more difficult. In fact companies like Allianz, Hannover Re, Swiss, Re and others are adopting the types of risk management models and tools that form the basis for SII’s radical departure from the traditional “rules-based” regulations.

Revolution and rancor

As both the companies and the regulators are more or less on the same track, SII may be less radical than it appears. But Yann Le Pallec, who heads Standard & Poor’s European Insurance Practice, nonetheless describes it as “a revolution.” However, he stressed that implementation is still another five years away, and that the 1,000 or more pages of proposals have to be pored over, analyzed and formalized. Then the European Commission and the 27 individual E.U. member countries have to vote to approve them, and the member states have to pass enabling legislation. Le Pallec expressed S&P’s concerns that the ultimate form SII takes may not be sufficiently effective in calculating solvency, may not mandate the needed improvements in transparency, and that the inevitable politicization of the ratification process may weaken or dilute standards.

He also predicted increased consolidation in the industry, as larger, more affluent companies acquire less well off mid-sized and smaller firms. However, Le Pallec acknowledged that SII’s regulatory approach “converges with Standard & Poor’s ratings approach,” and that it “will have a global impact, as risk-based analysis is used more and more.” The United States’ approach with its emphasis on rules dictating rate and form and relatively rigid capital requirements, is becoming an exception. “It will take years to sort out this problem,” he said, adding that an optional federal charter might be a good place to start.

That assumes that SII works. If it does, “it could become a blueprint for regulatory regimes around the globe,” said Jochen Sanio, president of the German Federal Financial Supervisory Authority (FFSA). He described the positive aspects of using “more sophisticated internal models that will give a much better analysis of risk.” Under SII companies will be required to provide that type of analysis in order to achieve the “deeper insight into their risks” that forms the basis of the new approach. For the most part the big players are already doing exactly that for their own benefit. Being prepared for fully integrating SII into systems they’ve already established is an added bonus.

Jerry de St. Paer, senior vice president for finance at AIG, spoke, on behalf of the Group of North American Insurance Enterprises (GNAIE), which represents a number of major U.S., Bermudan and Canadian companies in matters concerning standards and regulations. “We support level regulatory playing fields,” he said. But, he complained that SII is designed to give E.U. insurers an advantage, particularly as it provides for “Group Supervision,” one regulatory team for an insurance group that covers all of its business activities, wherever located. The United States doesn’t have such supervision. He noted that this provision of SII could give E.U. players “a greater advantage in diversifying their activities in third countries.”

De St. Paer stated: “Identical insurers, writing exactly the same business, assuming same quality of management, should be treated identically from a solvency viewpoint, regardless of domicile,” something the E.U.’s insurers, especially Lloyd’s, have been saying for years.

Rating agencies

Although the rating agencies might not acknowledge — in Wilhelm Zeller’s candid terms — “S&P and A.M. Best are the de facto regulators,” and they nonetheless wield enormous power.

This explains why the attendance for Rodney Clark’s presentation of S&P’s ratings criteria might well have been the most attended session of the conference. He opened his remarks with a reminder that “we [S&P] focus on global consistency,” i.e., the same criteria are used to rate companies wherever they are located.

Clark described S&P’s approach as “non-quantitative, as well as an analysis of [relative] strength.” It strongly emphasizes ERM, and the degree of sophistication and implementation a particular company has achieved in integrating those practices into its everyday business culture. “Is it regular and effective? Does it link the top to the bottom line? Does it create the right incentives?” Clark asked rhetorically.

“Those who understand the risks are in the best position to know what business their company should be in, or not; where to best allocate assets,” he continued. “As recently as 2001 there was virtually no holistic analysis of risk. Today more highly structured ERM is bringing it together.”

However, they’re not there yet, Clark noted, adding that in the context of adopting ERM of the 207 companies S&P rates only 3 percent are currently “excellent,” while 12 percent are “strong;” 5 percent are considered “weak” and the rest — 80 percent — are “adequate.” Of those about a third are dedicated to making improvements; about a third don’t need to as they deal with less complex risks, and one-third are “companies with complex risks, but who haven’t sufficiently invested in ERM.”