Expert Commentary

Is a Perfect Storm Coming for Europe's Insurers?

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.

August 2011

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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