New regulations could mean big is best for European insurers

LONDON – The European Union’s planned overhaul of insurance regulation will intensify consolidation pressure in the sector, with changes expected to benefit the region’s diversified giants, while smaller players may struggle. The new rules – known as Solvency II – will update European Union guidelines regulating how insurers calculate the amount of money they hold on their books to back policies. The rules will bring regulation for the world’s largest insurance market into line with the industry’s increasingly sophisticated modeling processes and make capital requirements more sensitive to risk. One key element in a draft due next year is expected to be the so-called diversification benefit – recognizing that insurers spread across several continents and business lines may carry less risk of failure from a single catastrophic event. Such groups may be allowed to hold less capital to back policies than peers focused on one country or product line. This means larger firms like Axa, ING or Aviva could free cash previously tied up in regulatory solvency, but also price policies more competitively, as they would need less cash to back each piece of new business. «It would be an incentive for larger companies to purchase smaller companies operating in different areas, because they have potentially greater surplus capital to take them over and, potentially, because taking over a company in a different market would allow them to claim greater diversity credit,» said Mark Nicholson, director at credit rating agency Fitch. «Equally, developing models that are required internally to calculate Solvency II capital requirements would be a regulatory burden on smaller players.» Big is beautiful? Investment bank Fox-Pitt, Kelton estimates the potential economic capital benefit of diversification for the 10 largest insurers and reinsurers in Europe from Solvency II could be up to 17 percent of their total market value, or up to $87 billion. «The big diversified players will be the winners – in the UK, it’s Aviva, Prudential, Old Mutual. Beyond that, Friends Provident will have some diversification benefit,» analyst Mikir Shah at Fox-Pitt, Kelton said. «Monolines will be the biggest losers, because they will gain the least from diversification benefit – Legal & General, Standard Life, which have just a small proportion of business outside the UK.» Major insurance acquisitions so far this year have already showed large firms’ awareness of a need to diversify earnings – either with new product lines or by expanding geographically. Old Mutual’s purchase of Sweden’s Skandia in January diversified its business away from South Africa, boosting its UK and European presence, while Aviva’s purchase of life insurer AmerUs in July helped increase its undersized US business. But it’s not all over yet for smaller, specialist players. Niche players with expertise in higher-risk specialist insurance, for instance, may adjust their prices to take account of the potentially higher capital demands under Solvency II. But shareholders expecting a release of excess capital under the new rules, either through a special dividend or big acquisition, may be disappointed. Pressure on large players to keep their credit ratings unchanged may act as a brake. «I don’t think there will be a great change in our criteria, which is why I suspect there wouldn’t be a great reduction in capital that companies hold,» Fitch’s Nicholson said. «If there was, I would be concerned.» Even the capital benefit that companies do take is likely to come under scrutiny, with analysts and investors anxious they won’t use the cash to slash prices to unprofitable levels to win market share, or plough it into ill-advised deals. «Some managements will take the capital benefit in a shareholder friendly way. Others may chose to use it to make acquisitions… which… without the benefits of Solvency II may not be of particular value,» Fox-Pitt, Kelton’s Shah said. «It’s a risk that exists now, but after Solvency II they’ll be able to use other metrics to try to justify these deals.»