Solvency II Threatening to Squeeze Medium-Sized Companies

Medium-sized insurance and reinsurance companies will come under renewed pressure as a result of Solvency II, according to EMB, Europe’s largest non-life actuarial consultancy.

The firm, who are making a series of presentations at Monte Carlo, stress that consolidation is not an inevitable consequence of Solvency II. However, they say, outside the top tier of large international operations, too many companies are failing to take full advantage of the opportunities it provides. And they are in danger of losing competitive edge as a result.

EMB cite two specific aspects of Solvency II that can work against medium-sized companies unless action is taken: the technical resource required for implementation; and the emphasis on diversification. Both of these problems can be addressed, they say, but many companies are not doing so, which is partly a cultural issue.

The advantages of Solvency II
A key factor is that, unlike most medium-sized (re)insurers, their larger rivals see Solvency II as much more than just an exercise in keeping up with regulatory changes. Good risk management represents best practice; it enables firms to make better decisions and to improve return on capital. As a result, they have embraced the process enthusiastically and are becoming more competitive.

“Firms that truly understand their risk profiles are able to use their resources more effectively. They can expect to be more profitable, even during the inevitable difficult years that all risk carriers face,” according to EMB partner Raj Ahuja.

“These firms allocate their capital more accurately, know what markets they should be in and purchase reinsurance more efficiently. And these are just a few of the advantages of the disciplines demanded by Solvency II.

“Companies that fail to respond positively to Solvency II will be at an inevitable competitive disadvantage, regardless of their size.”


Financial modelling
Although Solvency II is a broad-based process, the use of stochastic models lies at its heart. These are models that simulate any number of possible real-life scenarios and which then forecast the impact that adverse circumstances would have on corporate finances. You can then identify the strategy that most suits your firm, taking into account its capital structure, market position and corporate objectives.

Although likely to become a regulatory requirement, this exercise is beneficial in its own right. It can help senior management to identify, for example, the most cost-effective reinsurance-buying, investment and underwriting strategies.

According to EMB many insurers are hesitant about using financial models, because of their cost and technical complexity. Much of this fear is, they say, misplaced.

“Financial modelling is like so many other things that initially seem to be cutting-edge, mind-blowing and resource-intensive. They eventually become part of every day life,” says Ahuja. “A key principle is to avoid doing too much. Firms that start with a simple template model and then tailor or build on it once they feel comfortable are more likely to succeed in their objectives.”

Diversification
Solvency II favours (re)insurers with diversified portfolios, putting medium-sized companies at a potential disadvantage. The greater the level of diversification, the lower the likely capital requirements in relation to the size of business.

EMB point out that this is thinking is similar to the ratings agencies, but with the added burden of being a regulatory requirement. Medium-sized companies, they say, could do much more to understand the levels of diversification within their portfolios and the degree to which they should be extended.

“Once firms understand what’s driving their risk, they can devise strategies to spread it without necessarily having to branch out into unknown territory,” says Ahuja.

Winners and losers
According to EMB, the effects of Solvency II on (re)insurers and their capital requirements will be broadly neutral overall, but there will be sizeable variations from company to company.

“There will be winners and losers, and the winners will undoubtedly be those firms that embrace the principles behind Solvency II with enthusiasm, rather than seeing them as a regulatory chore,” according to partner Andrzej Czernuszewicz.

“This is not about size, first and foremost, but about attitude and culture.

“In our experience there’s a massive difference in levels of implementation both within and between different countries.

“Whilst there will be a place for smaller, niche players for the foreseeable future, medium-sized insurers need to move more quickly on Solvency II or they will find themselves left behind by the tide.”

This article appeared in Reaction Monte Carlo Newsletter in September 2006