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Richard Shackleton looks at the steps being taken to reform the way insurers assess risk across Europe.

In the past insurance used to be such an easy business. Policyholders handed over premiums to the insurance companies, who invested it until they needed to pay out claims. In the meantime soaring stockmarkets boosted this pool of capital thereby inflating the insurers’ assets, profits and dividends to shareholders.

The present looks far less rosy. Because they invest heavily in shares, gains on the swings can be lost on the roundabouts as insurers are particularly vulnerable to falls in equity markets. Even though they have cut back on their equity holdings, European insurers still hold around 30% of their assets in equities, compared with only 4% for American insurers, according to investment bankers Morgan Stanley. (The European average falls by 8% if British companies are excluded.)

Insurers used to tolerate losses on their underwriting business because healthy investment returns more than made up for them. The average combined ratio (i.e. claims plus expenses divided by premiums) is 105% for European non-life insurers, and just over 100% for life insurers. Therefore investment returns matter.

Increasing Losses
Catastrophe losses and rising long-term liabilities have added to insurers’ problems. Last year was the worst ever for property-and-casualty insurance with widespread flooding throughout the continent as well as several forest fires. That is before taking into account rising claims from long-standing issues such as the terrorist attacks on the World Trade Centre or asbestos-related illnesses.

A number of European insurers are so short of capital that they cannot underwrite new business. A few are almost broke, unable to meet immediate liabilities without a cash injection or a rights issue.

Life insurers are more fragile than non-life insurers; they have tended to invest more heavily in equities. They also tend to lock their policyholders into long-term contracts and so cannot increase prices each year. Unfortunately for them, their new business suffers when stockmarkets are tumbling.

Companies in Trouble
Equitable Life in Britain and Swiss Life, Switzerland’s biggest life insurer, are among the companies in a critical condition. Equitable Life has closed for new business; it has imposed hefty penalties on policyholders who try to cash out early; and it has sold over £2bn ($3bn) of equities since June, to meet solvency requirements. Swiss Life sacked its chief executive, made a cash call for SFr1.2bn ($730m), cut 1,500 jobs and announced the sale of non-core businesses.

Share Values Crash
The scale of the rout in insurance company share prices is truly alarming. In the past three years UK life and general insurers have seen their stockmarket values halve. Though only a handful of insurers are heading for insolvency, the European insurance landscape will look very different in a few years’ time.

Insurance is much more fragmented than, say, banking. Germany, for example, has more than 150 insurance companies, but that number may shrink sharply, as the stronger insurers take over the weak. It’s not just national regulators who are beginning to take an interest in this unfolding drama.

Creating a Single Market for Financial Services
The European Union’s Financial Services Action Plan is a complex series of individual measures designed to create a single market for financial services by 2005. It has three objectives; namely ensuring a single market for wholesale financial services, open and secure retail markets and an increasingly important but state-of-the-art regime of rules and supervision.

However, the current high degree of subjectivity in the measurement of assets and liabilities means that it is almost impossible to compare companies. At times, it can be difficult even to begin to compare, as disclosure rules differ markedly from country to country.

The Commission was already working on radical financial reform before the financial upheavals following the 11 September attacks. In 1999, it published a plan under which the whole spectrum of financial services, from the publication of initial public offering prospectuses through to reinsurance, would be overhauled to allow the creation of an integrated financial market across Europe. It was always a key part of this plan that insurers would be required to measure and manage risk in a much more sophisticated way.

Tightening Solvency Requirements
Last year, the Commission tightened solvency requirements. These say how much capital an insurer must set aside to cover certain types of risk; regulators set them so that insurance companies will be able to meet the claims which they have underwritten. Under the Directive (Solvency 1), minimum solvency margins were increased, particularly for volatile lines of business, where losses can be less predictable.

As “work in progress” most insurance company chiefs are reluctant to comment on the process until a final conclusion is reached, probably in 2006/7. However, CGNU’s Chairman and Chief Executive Pehr Gyllenhammar speaks for many major European insurers through the European Round Table of Financial Services (EFR).

“We are all convinced of the importance of supporting the completion of the single market in financial services which will bring substantial benefits for consumers by promoting competition and consumer choice. We are looking forward to working constructively with the European Commission, the European Parliament and national governments to support initiatives which will bring practical benefits.”

This year, the Commission will put forward proposals (Solvency 2) that will require insurers to put aside capital in a way that better reflects risk.

The scale of the harmonisation required is breathtaking. KPMG’s Global Chairman of Financial Services, Brendan Nelson, says the way the EU deals with existing national requirements will be crucial.

“The industry’s regulation remains very jurisdiction-bound, and while regulators are engaged in an active dialogue on more consistent standards for insurance, the first real attempt to recast insurance regulation on a regional basis will be previewed in the European Commission’s Solvency 2 project.”

The Commission is also looking at changing the way in which the regulatory solvency requirement is worked out. In Europe, the requirement is measured as a simple fixed ratio comparing premiums to claims. Therefore, it takes into account only underwriting risk (the risk of a claim). It does not take into account the risk to the value of the assets out of which such claims have to be paid (insurers’ own investments in shares, bonds and so on). Nor does it take account of the risk that reinsurers, who are supposed to pay out if losses exceed a certain level, fail to do so.

Impact on the Industry
Mr Nelson says the outcome of Solvency 2 for the larger insurance industry will be significant.

“For the first time it will reflect the more sophisticated understanding of risk exposures garnered in the course of the last decade, as the financial services industry overall has tackled a growing array of risk challenges. The active dialogue between the industry and its regulators will have repercussions at a global level, because the European insurance industry remains a pre-eminent force in global insurance.”

Solvency harmonisation will mirror similar advances elsewhere in the continent-wide regulation of the industry. Already, insurers have an EU-wide “passport” to sell policies in any member country, this should have given the industry the excuse it needed to boost both the scale and efficiency of their sales operations.

However, with negligible returns from flatlining stockmarkets European insurers need to make profits from underwriting, to invest less riskily (meaning less in equities), and to bring down the costs of selling policies before investors regain faith in their business model.

Richard Shackleton is a freelance business journalist

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