Run off from Solvency II?

Another stage on the long road to Solvency II was passed on 8 April with the submission by CEIOPS of its final set of advice on Level 2 implementing measures. CEIOPS’ covering letter to the European Commission stressed the extent of its ‘discussions with stakeholders’ and joint work undertaken with the industry.

But, insurance lobbyists and buyers such as FERMA grow increasingly vocal about the additional burdens they fear Solvency II will impose on them. Last month the European insurance association Comité Europeén Des Assurances warned that excessively onerous capital requirements would be ‘bad for consumers, bad for Europe’s economy and bad for the insurance industry.’

One predicted side effect of Solvency II is that increased capital charges will prompt insurers to pull out of riskier and less profitable lines and put those portfolios into run-off.

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RUSH TO RUN-OFF

And there already are signs that re/insurance groups are examining their existing books of discontinued business with a view to accelerating their run-off, closing or disposing of them altogether. This is primarily because Solvency II will oblige insurers to allocate capital to discontinued business that they would rather deploy elsewhere.

In its fourth annual Survey of Discontinued Business in Europe, PricewaterhouseCoopers reports that ‘capital concerns remain a key driver of restructuring activity and these will increase the spotlight on discontinued operations.’

Over half of the insurers surveyed believe that Solvency II will impose a greater cost of capital, and 62% say Solvency II will lead to an increased focus on, and shedding of, underperforming lines of business.

Some 68% think it will make them focus more on their existing discontinued businesses and the exploration of exit options. Of those 90% that have a strategic plan for their run-off business, commutation is by far the most popular exit tool (78%), and more so in mainland Europe than the U.K.

“It is clear that European insurers are carefully considering their discontinued operations, and exit mechanisms which deliver value are becoming more of a focus throughout Europe,” said Dan Schwarzmann, Partner with PricewaterhouseCoopers.

“The impending arrival of Solvency II and the associated impact on capital will make dealing with run-off even more important and we are now seeing major groups taking positive steps to exit discontinued portfolios,” he continued.

“At the same time, with the recent ruling on Scottish Lion making it very clear that a solvent scheme of arrangement can be used to change contractual rights with a policyholder and exit a business, we predict that this tool will be used more by European businesses to deal with run-off portfolios,” added Mr. Schwarzmann.

A scheme is in effect a global mandatory commutation. The Scottish Lion appeal court decision rejected the proposition that there must be a ‘problem’ for a scheme to address. It said the key factor was the fairness of the deal, and it confirmed that a scheme could extinguish creditors’ rights and replace them with new rights.

The mood in the London run-off market, as was evident at the Association of Run Off Congress (ARC) this spring, is that Scottish Lion has confirmed the validity of schemes and constrained creditors’ grounds for objection. Schemes that were put on hold to await the appeal will now go forward, prompting an upsurge in pre-scheme commutation activity.

“A lot of creditors will seek to commute at their own terms before a scheme if they believe the success of the scheme to be almost inevitable (or at least out of their hands to influence),” said Jim Moran, Director, Liquidity Management, at R&Q, host of the annual commutations rendezvous at Norwich and Cologne.

“Thus this decision will have given a boost to commutation activity, both through creditors being prepared to commute and through scheme managers trying to commute reinsurance asset in advance of the scheme,” he added.

But, while Mr. Schwarzmann at PwC is an enthusiast for the option of, where possible, transferring portfolios from other European countries to the U.K. and then using a scheme to achieve finality, others in Europe are not so sure.

“In the future, solvent schemes need to be prepared and conducted more precisely, more thoroughly and more honestly,” said Dr. Hubertus Labes, Managing Director of Chiltington International consultancy in Hamburg. Scottish Lion, he thinks, made it clear that courts, cedants and policyholders will no longer accept an aggressive approach from scheme managers.

“Here in Germany and in some other European countries the reputation of scheme of arrangement procedures has suffered a lot,’ said Mr. Labes. “The reason is there was aggressive marketing by U.K. service providers in Europe, trying to tell European companies what they should do.”

This, he says, has not been well received. “Of course they are keen to hear about new developments and opportunities. But, there are also European ways to solve these problems, to achieve finality,” said Mr, Labes. Chief among these are the sale or transfer of a run-off portfolio, or the placement of discontinued lines into an Special Purpose Vehicle which is then sold.

DISPOSAL INCENTIVE

Mr. Labes believes that Solvency II will drive more commutations and portfolio transfers. He cites the example of an insurance company that wrote reinsurance for, say, two decades in the last century. Under the new regime, these books will need to be capitalised separately, which gives the company a fresh incentive to dispose of them.

“So that is a change in attitude that will drive commutations and portfolio transfers. Those companies will treat discontinued lines differently than before,” he said.

Mr. Moran at R&Q agrees: “The activity driven by Solvency II is driven by a fear of increased capital requirements; that comes from a mixture of credit risk and a change in the way capital will be made more specific to the type of risk it supports,” he said.

In terms of current commutations activity, Mr. Labes at Chiltington detects some difference by territory. “Our impression is that now it is easier to agree on commutations with U.S. cedants than it was three to five years ago,” he said.

His personal view is that, in the wake of the financial crisis, U.S. cedants are keen to generate cash and improve their balance sheets. In Europe, he says, it depends very much on the security of the reinsurer. “If the reinsurer is very solid and has a very good security it is still difficult to agree on a commutation with a good price,” he said.

Not everyone is convinced Solvency II is such a key driver.

Clive O’Connell, Partner with law firm Barlow Lyde & Gilbert, thinks it is still too early to assess its effect. “You might see some companies getting rid of legacy books—not necessarily trying to commute them but rather offloading them,” he said. “I don’t think we’ve seen Solvency II driving commutations yet, but, it might do in the future,” said Mr. O’Connell.

One stumbling block to commutation is when it looks far more attractive to one party than the other. “I think it’s always been the case that people have wanted to crystallise their inwards liabilities, but, when they have a reinsurance asset they have possibly been reluctant to crystallise that asset because they don’t know what might lie ahead in terms of their own liabilities. Therefore there is more reluctance from a reinsured to commute than a reinsurer,” said Mr. O’Connell.

“Look at the position taken by some of the large U.S. insureds on solvent schemes—their insurance if you value it tomorrow on an IBNR basis might be worthless. But, they are not willing to give it up because they never know where the next claim will come from,” he added.