Is a Perfect Storm Coming for Europe's Insurers?
August 2011
There are two virtual category
5 hurricanes bearing down on Europe's insurance industry. One is
the proverbial "immovable object," and the other is, yes, you
guessed it, the proverbial "unstoppable force." If the Euro zone
insurers were only faced with one of these pending maelstroms,
they'd probably be fine, but their convergence could make for
some interesting times indeed.
by
Donald J. Riggin
Spring Consulting
Group, LLC
The immovable object is the Solvency II Directive. Solvency
II is the European Union's massive new set of regulations
designed to ensure that EU insurers and reinsurers hold capital
and surplus commensurate with their risks. The Directive
introduces a new financial model for determining surplus
adequacy. This is known as the Solvency Capital Requirement
(SCR). The SCR is defined as the amount of capital that would be
consumed by unexpected large loss events whose probability of
occurrence within a 1-year time frame is 0.5 percent. Put
another way, their surplus must be sufficient to contain 99.5
percent of their risks.
The definition of "loss events" includes underwriting as well
as financial risks such as market risk and credit risk. In early
July, the European Insurance and Occupational Pensions Authority
(EIOPA) stress tested the capital adequacy, as would be required
under Solvency II, of about 60 percent of the European market.
The test used three scenarios: baseline, adverse scenario, and
runaway inflation. It revealed that about 10 percent of Europe's
insurers would fail to satisfy the SCR's capital requirements.
Of the sample, the failure rate represents 13 insurance groups
failing the adverse scenario, causing a €4.4 billion industry
shortfall as measured against Solvency II's minimum
requirements.
You may think that since 90 percent of the sample is already
meeting the Solvency II minimums, the sector is in pretty good
shape—until you understand the magnitude of the unstoppable
force making its inexorable way toward Europe's insurance
markets—the continent's debt crisis.
According to the Wall Street
Journal (WSJ), many European insurers hold large
portfolios of bonds issued by financially shaky banks and
governments. In the run-up to Europe's financial crisis, many of
Europe's largest insurance groups bought billions of euros worth
of bonds issued by seemingly stable Euro zone banks and
governments. As the market for insurance was, and remains, very
soft (lots of competition producing very low premiums), these
insurers saw these low-risk high-return bonds as a way to offset
underwriting losses precipitated by the soft market.
Of course, we now know that Greece has just barely avoided
default, thanks to the International Monetary Fund bailout, and
that Ireland, Portugal, Spain, and Italy are potential default
candidates, to one degree or another. One telling statistic
provides a glimpse into the magnitude of the problem—according
to Barclays Capital, Euro zone insurance companies were holding
€24.1 billion of Greek government securities as of last fall.
When the WSJ interviewed
EIOPA Chairman Gabriel Bernardino, he said that he thinks the
exposures to the shaky securities are manageable "right now."
Reading between the lines, we might interpret Mr.
Bernardino's "right now" qualifier to suggest that at some
future time, perhaps when Solvency II kicks in (on either
January 1, 2013, or a year later), things might not be so
manageable. If Euro zone insurers are marking these bonds to
market (posting their value at market rather than book),
assuming they haven't defaulted by then, while at the same time
being required to meet the SCR minimum capital and surplus
requirements under Solvency II, well, as they say in the movies,
something's gotta give.
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