PricewaterhouseCoopers (PwC)

Countdown to Solvency II: Making your capital work harder

Insurers seek to structure their operations so that they are capital and tax efficient - Solvency II has changed the playing field

The fifth quantitative impact study (QIS5) has demonstrated that capital management structures that are tailored to existing regulation are likely to be less efficient under Solvency II. What can you do to improve your capital position?

QIS5 has provided insurers with the best view to date of their future capital requirements under Solvency II, and why structures created for the current solvency regulations may no longer be optimal under the new regime. Although the recently published draft Omnibus II Directive includes some transitional measures, this might only delay the inevitable and the importance of reassessing the effectiveness of existing structures remains. As is often the case, early movers could gain a competitive advantage.

One of the clearest instances of where present arrangements may no longer be suitable is the penal capital loading for ceding risk to an unrated reinsurer (see Figure 1). In many cases, the unrated reinsurers are internal entities that have been set up to enhance capital under the current arrangements, but will have the opposite effect once Solvency II goes live at the end of 2012.

A range of other instances exist, many of which may be specific to your particular company. Rather than putting QIS5 to one side, it will therefore be important to look at what can be learned from the exercise. Some aspects of the new regime may have unfavourable capital impacts on particular products and will therefore demand further lobbying. Some aspects will require mitigation. The impact on capital of other areas of the new rules may appear satisfactory, but the position could be improved further. Assessing the results of QIS5 in this way will provide opportunities to extract value from your Solvency II programme.

Territorial scope creates uncertainty and opportunities

A further consideration for groups with operations outside the European Economic Area (EEA) is equivalence. Businesses based in equivalent jurisdictions will be exempt from group supervision at the EEA level and the additional costs and capital charges this may entail. This could generate structuring opportunities depending on the final capital requirements for countries with equivalent status; so itís worth monitoring the position as it emerges.

At the time of writing, only Switzerland, Bermuda and Japan (for reinsurance only) are being considered in the first wave in 2011, and even their approval is by no means certain. Other countries, including the US, will not qualify in time even if they do come forward. Itís therefore important to have strategies in place for operations in non-equivalent jurisdictions, along with contingency plans in case Switzerland, Japan or Bermuda arenít approved. Group risk may be deemed higher and intra-group transactions, including reinsurance to non-equivalent jurisdictions, may attract higher capital charges. You may also be required to hold funds at least equivalent to the group solvency capital requirement even if your headquarters is outside the EEA.

Tax liabilities in flux

A related question is the impact of Solvency II on your tax position. Itís likely that youíll amend your structures and internal operations in response to Solvency II. This is in turn likely to affect the tax efficiency of your group. There may also be other tax costs associated with Solvency II. In the UK, for example, the switch may generate a large one-off taxable profit or loss, and some product-related tax synergies, such as protection lines subsidising savings business, may be lost.

Easing the pain, maximising the gain

Using the QIS5 results as a starting point, itís possible to analyse the factors driving your capital requirements, determine whether your current arrangements are still appropriate and assess what can be done to improve capital and associated tax efficiency. This analysis should also focus on identifying the potential impact of areas of uncertainty on your capital requirements, and developing contingency plans to deal with the outcome. In our view, there are five main areas of opportunity:

Liability management

Additional diversification could offset some of your more capital-intensive exposures. As we examined in an earlier article in the Countdown series, Shaping up: Solvency II and M&A, more companies may look to mergers and acquisitions (M&A) to provide an immediate impact. In turn, acquisition opportunities are set to increase as companies seek to offload capital-intensive non-core business. Another option is to collapse multi-entity structures to consolidate a variety of risks in a single entity.

Reinsurance has long been used to manage risk, though programmes will have been designed with the current regulatory and tax regimes in mind. So it will be important to review reinsurance programmes to make sure theyíre still fit for purpose under Solvency II (see Figure 2). In addition to unrated reinsurers, other areas that may attract high loadings include large exposures to single counterparties.

Asset valuation

Solvency II is more demanding about the appropriate assets to back different classes of liabilities, with different capital requirements to those under the current solvency rules. Many companies are undertaking reviews of their asset liability matching strategies to optimise capital requirements. Non-life companies are starting to take more notice of this hitherto largely life-focused area, especially in terms of duration and currency matching. Solvency II is also likely to spur firms to investigate new hedging strategies or consider replacing certain assets within the investment portfolio. Investment banks are also likely to develop new synthetic products to fit in with Solvency II.

Legal structures

Rationalising complex group structures can help to reduce capital and compliance costs and make it easier to move funds around the group (Ďfungibilityí). It can also help to reduce the tax burden. Figure 3, Figure 4 and Figure 5 outline a range of different options.

The structure in Figure 3 seeks to minimise the costs of maintaining a large number of what may be superfluous entities under Solvency II. The structure may also be more efficient from a capital and operational perspective due to diversification benefits, along with cost savings from reduced governance and reporting demands.

Collapsing subsidiaries into the branch structure seen in Figure 4 would enable you to market your products locally, while concentrating capital in a single tax-efficient location. In the Type 1 European branch structure, the capital requirements are centred in a single European insurance company, but the separate branches are currently taxed under their local tax regimes. By moving to a Type 2 structure in which the services are passported into the various countries, the taxable presence is concentrated in the underwriting vehicle, in this case taxed under the Irish tax regime.

If youíre part of a global group, the structure in Figure 5 would split EEA operations from those in the rest of the world. This would overcome some of the problems associated with doing business in non-equivalent jurisdictions, in particular, keeping non-EEA entities outside the Solvency II regime. It may be possible to further enhance the position by reinsuring EU liabilities into a rated reinsurance company domiciled in an equivalent jurisdiction, such as Bermuda.

Product offerings

Higher capital charges will reduce the profitability of certain products. You may be able to offset some of the charges through diversification. Some products could also be redesigned in a way that reduces capital requirements or even takes them beyond an insurance designation. This may give rise to a competitive advantage, though this will take time to impact on capital requirements. Itís important to bear in mind the time needed to secure regulatory and policyholder approval for changes to existing products and redesign and launch new policies.

Funding

Solvency II values different forms of capital in different ways and the optimum amounts and types of capital will differ from the current requirements. In addition, new forms of capital (Ďancillary own fundsí), such as guarantees and letters of credit can count towards the capital requirements. Although to date letters of credit have not been widely used outside the Lloydís market, the latest guidance implies that in future up to 50% of the capital requirements could be met by such instruments in particular circumstances. Existing types of capital, such as contingent loans and financial reinsurance, may not be as efficient under the new regime. If your results suggest that you need to raise additional capital, it could be important to get moving as quickly as possible to avoid being caught up in a pre-deadline rush.

Capitalising on opportunities

Case one: Life insurance group

The group was at risk of being priced out of the market because of high capital charges for its large annuity book and reinsurance through an unrated captive. It had been operating through multiple entities, in part for tax reasons, though any advantages will be outweighed by the cumulative increase in capital and compliance costs. Through acquisition and new product ventures it has been able to spread its risk and reduce capital demands. Collapsing the entities into a single company has enhanced capital efficiency and cut compliance costs, with further savings coming from securing a rating for its captive.

Case two: Non-life insurance group

The groupís exposure to catastrophe risk could render it insolvent. Although its capital requirements would be much lower under its internal model, supervisory approval is uncertain.The group is therefore lobbying for a less capital-intensive catastrophe risk calibration and drawing up contingency plans in case it fails to secure model approval. Product and geographic diversification are being planned to reduce capital charges. Further plans include moving its underwriting platform to an equivalent jurisdiction outside the EEA, where capital and tax demands may be lower.

Emerging stronger

The results of QIS5 have brought the capital implications of Solvency II into sharp focus. Forward-looking companies are already assessing whether their current capital, reinsurance and tax arrangements will still be optimal under Solvency II and exploring options to manage these key aspects of their business more effectively. Theyíre also developing contingency plans to deal with uncertainties over internal model approval and the nature of the finalised rules.

If you make the necessary evaluations and decisions now you should have time to put them in place and reap the dividends once Solvency II goes live, bearing in mind that some strategies will take time to implement. If you delay, the challenges will become progressively harder, especially as market scrutiny of your capital position and proposed response will become more intense in the final months before the 2012 deadline.

Giving you the edge

PwC is helping a range of insurers get to grips with the practicalities of Solvency II implementation. If you would like to know more about how to make your capital work harder, please contact the authors.

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