Who's Who Legal has brought together four of the leading practitioners in the world to discuss issues affecting insurance and reinsurance lawyers today.
Who’s Who Legal: In light of the financial crisis, what new challenges face the insurance industry? How have clients responded?
James Grennan: There are very few new challenges for the insurance industry.The most obvious effect of the financial crisis on insurers is the effect it has had on asset values and, in some cases, the need to shore up reserves. This isn’t new and happened after 9/11, the dot.com crash and other crises.In an environment where investment funds are unavailable or expensive, the obvious response to reducing asset values would be to increase rates. However, this financial crisis is interesting in that it coincides with a prolonged soft market.There appears to be significant capacity in the reinsurance markets (thanks, in no small part, to relatively benign catastrophe results over the last few years). As a result, competitive pressures make it difficult for insurers to increase their premiums. However, managing risk is the core skill of the insurance industry and, so far, the industry seems to be weathering the storm pretty well. Recent increases in stock market indices have also provided relief.
Martin Lister: My experience in Hong Kong reflects the comments of James Grennan. The material crash in asset values has put great capital strain on insurers, at a time when shareholders have not merely been reluctant to inject additional funds but have actually wanted (and in some cases needed) to extract surplus capital from the insurers. In consequence, insurers have looked closely at containing their costs of capital and there has been a move away from the use of letters of credit, which are relatively expensive, to cheaper and more flexible cash/bank deposits and alternative trust structures. In addition, direct insurers have entered discussions with their reinsurers to find ways to release capital from their reinsurance programmes through use of financial reinsurance and pre-payment of reinsurance credit. As asset values have increased significantly in recent months, it would seem that insurers have managed to weather the challenges of the financial crisis and are in reasonable shape.
On the business front and given Hong Kong’s role in the export of China’s manufactured goods, there has been an inevitable increase in the level of claims in respect of trade credit defaults over the last year. It has been difficult in the immediate term given the soft market for relevant insurers to raise their premium rates despite this adverse claims experience.
Natalie Vloemans: The financial crisis has had an impact on the image of financial institutions, including the insurance industry. As a reaction, insurers are working on adjustments with a focus on solvability and corporate governance. As mentioned by James Grennan, the crisis has also had an effect on asset values and in certain cases there is a need to strengthen the equity capital.
Furthermore, the public opinion on life insurance is subject to change – people now tend to prefer ‘classic’ products like bank saving and avoid investment products. The insurance industry here faces the challenge of regaining the public’s trust.
In another field, the industry is posed for a challenge that in fact is a challenge for everyone: climate change. In the EU, the CEA (the European insurers and reinsurers federation) plays an active role in climate-related debates in order to help safeguard the insurability of related risks.
Peter Mann: In Australia, the global financial crisis has been accompanied by a rise in claims under directors’ and officers’ liability policies and professional indemnity policies, particularly from the financial services and financial planning sectors and especially involving third-party claims against financial planners. A challenge for the insurance industry going forward is determining appropriate pricing for these insurance products given the deterioration in claims experience in these lines since the crisis.
Volatility in the share market has also provided challenges for companies generally. Because of Australia’s class action laws, its continual market disclosure regime for publicly listed companies and the increase in actions brought with the assistance of litigation funding, there has been a rise in claims made under Side C (securities cover) of D&O liability policies. One insurer has met some of the challenges by insuring securities cover on a stand-alone basis.It remains to be seen whether other D&O liability insurers will follow this lead.
Who’s Who Legal: How have the regulatory authorities responded to the financial crisis? What, if any, changes will the industry face?
Peter Mann: Australia was arguably in a unique position going into the global financial crisis because a strengthening of the country’s prudential regime had been taking place since the collapse of HIH Insurance in 2001.
At the time of its collapse HIH was Australia’s second largest general insurer and had a number of operations internationally. Given the large number of policyholders affected, the Australian government established a Royal Commission to inquire into the circumstances surrounding the collapse. The product of the Royal Commission was a report in 2003 containing a number of recommendations for the reform of Australia’s prudential regulatory regime.
Since that time Australia’s prudential regulator, the Australian Prudential Regulation Authority (APRA), has undertaken a wide-ranging programme of ongoing reform that has concentrated on ensuring that insurers meet minimum capital adequacy requirements, have appropriate governance structures and implement risk management programmes. As a consequence, Australia’s regulatory regime and insurance industry were already in a robust position to meet the challenges of the GFC going into the crisis.
APRA’s programme of regulatory reform has continued through the global financial crisis and has responded to many of the issues arising out of it. This focus has included increasing supervision of conglomerate groups containing prudentially regulated entities who have exposures to group risks, consulting on the remuneration practices of prudentially regulated entities and establishing a financial claims scheme to allow financially distressed general insurers to be externally administered for the benefit of policyholders and the wider stability of the financial system. More recently, APRA has told insurers in Australia that they are likely to be subject to the same new tough global regulation as banks.This may result in some insurers increasing the level of capital reserves in their balance sheets even further and placing an even greater emphasis on higher-quality forms of capital.
Natalie Vloemans: The regulatory authorities are working on adjustments of financial supervision. There are concrete plans in the area of corporate governance, leading to more strict rules on the renumeration of board members of financial institutions.
Another plan, not concrete yet, but part of the debate on regulatory supervision relates to providing the supervisory authorities with new and more effective powers. It has been suggested that the authority might be empowered to intervene in the corporate structure of financial institutions. We are not there yet and such a change would require – at least in the Netherlands – a law change, but it is being considered.
James Grennan: In the EU, the regulatory response to the financial crisis has been pretty muted in relation to the insurance industry.The De La Rosiere report produced for the EU Commission didn’t put the blame for the crisis on insurers and its principal recommendation for insurance regulation was to fast track Solvency II. This has been done. However, it’s fair to assume that the detailed rules under Solvency II will be influenced by what is happening in relation to other industries, notably banking.Therefore, for example, CEIOPS (the body that advises on detailed rule making) has said that it is refining its Solvency II calibrations in light of the crisis and that risk management, governance and internal controls in the insurance sector need to be strengthened.A greater emphasis will also be placed on consolidated group supervision. CEIOPS will also be focusing on exposure to SPVs, off-balance sheet value-in-force securitisations and the like. For credit insurers, CEIOPS is considering “through the cycle” reserving and will be influenced by developments in banking and other regulatory areas.
Possibly the most significant EU response to the crisis in the longer term is the intention to establish a new European Insurance Authority (essentially giving some muscle to CEIOPS).You don’t have to read too far between the lines of the De La Rosiere report and the Commission’s response to it to realise that, over time, the intention is to move rulemaking to Brussels with local regulators having the job of implementing those rules. I can anticipate significant resistance to this from some regulators and it may be some years before this actually happens. However, the push for tightly harmonised standards across the EU is strong and almost inevitably points to a single rulemaking body. This may be some time off but don’t say I haven’t warned you!
Martin Lister: The response by the Hong Kong insurance regulator to the financial crisis has been to enter into even more regular and frequent dialogue with authorised insurers and to watch their capital adequacy carefully; to ensure that surplus funds (if any) are retained within the insurers and that additional funds if needed are provided to the insurers. At the same time, insurers and the regulator have looked at applying the new European Solvency II regime in Hong Kong as a way of both modernising Hong Kong insurance industry regulation and harmonising it with European regulation.
The Hong Kong government is also looking at the independence of the insurance industry regulator (which at present is a branch of government). Though this review predated the financial crisis and was effectively put on hold for the last 18 months, it is seen as one way to modernise and improve insurance industry regulation which would assist in the event of future financial crises.
James Grennan: Interesting comment on the HK insurance regulator, Martin. It’s a typical knee-jerk political reaction for governments to look at the structure of the regulator following a crisis. The current Irish regulator, the Irish Financial Services Regulatory Authority was fast-tracked into being following a rogue trader incident and, interestingly, the Irish government has just published legislation to change the structure of the regulator, again, in light of the banking and financial crisis. This is echoed elsewhere. For example, the Conservative Party in the UK has announced its intention to replace the FSA with the Bank of England. At the end of the day, of course, what matters is the quality and substance of regulation.
Your comment does make an important point. To function fully effectively, the regulator should be independent. That said, the regulator can’t function in an ivory tower and must have the ability to balance prudent regulation with pragmatism so as not to make regulated insurers uncompetitive. This can sometimes be a difficult balancing act and the key to getting it right is to have an open and responsible ongoing dialogue with the industry.
One also has to ask where the experienced regulators will come from under any new structure. The vast majority will have to come from the old regulator. Therefore, there is always the danger that creating a new structure is simply delivering old wine in new bottles. In Ireland, the regulator has recruited external experts to fill senior regulatory positions in an attempt to avoid this problem. Expectations of the new regulatory team are very high. Time will tell whether the 2010 crop will produce a vintage regulator.
Martin Lister: To be fair to the Hong Kong government, the review of the independence of the insurance industry regulator commenced long before the current economic crisis.
One of the main reasons to make the regulator independent would be to enable it to move away from the government employment structure, restrictions and pay scales and recruit a number of industry-experienced and professionally qualified experts in the market (as has been done in Ireland). However, that begs the question: who would pay for those experienced and qualified experts (assuming they could be found)? Independence means the regulator would be self-financed and there is in addition no question that such an expanded regulator would cost more than the current regulator. The industry is very concerned that the cost would be borne by insurers (with a consequent impact on premiums), while the public and government appetite for a policy duty or premium tax or similar is very small – Hong Kong prides itself on having very few taxes at very low rates.
If the regulator was able to recruit a number of industry-experienced and professionally qualified experts, this would in itself enhance its independence from government and the influence of any one particular insurer, whilst also enabling the regulator to balance prudent regulation with pragmatism. A failure in this regard would not only render Hong Kong insurers uncompetitive but would also damage Hong Kong’s reputation for business efficiency. It is essential that the regulator has a continuing dialogue with the industry and listens to its concerns as well as to the needs of the community and is able to balance those competing demands.
No doubt the Hong Kong government and insurance industry will be looking forward with great interest to the first reviews of the Irish 2010 vintage regulator; its success will provide impetus to Hong Kong’s own plans. Of course, it is hoped that Hong Kong will learn from the Irish experience and adopt those elements which succeed while avoiding those elements which prove impractical.
Who’s Who Legal: What effect has government financial support had on the industry? How has this altered the insurance landscape?
Natalie Vloemans: In the Netherlands, we have seen several Dutch financial institutions being recapitalised by the Dutch state. This appears to result in the large “bancassurance” companies changing policies, in that the banking and the insurance operations are being separated. The bigger financial institutions wish to streamline their company while reducing risk, costs and leverage (“back to basics”).
Peter Mann: In Australia, as elsewhere, the global financial crisis has affected investment income and therefore the profitability of the insurance industry. A large part of the Australian government’s financial support of the Australian economy through the global financial crisis was its guarantee of large deposits and wholesale funding. The guarantee helped to reduce the counterparty risk of insurers in relation to their capital adequacy and investment income. The guarantee is arguably one of the reasons why Australia has experienced one of the fastest recoveries from the GFC and looking at Australia, in isolation, it has not experienced any great alteration to the insurance landscape as a result of the GFC.
Martin Lister: The Hong Kong government has not provided any direct financial support to the insurance industry, though the insurance regulator has taken a sympathetic, supportive and accommodating role in helping insurers where they were under stress as a result of the financial crisis. For those insurers where overseas government intervention has resulted in a change of controllers, the regulator has not acted aggressively against the insurer other than to ensure that Hong Kong policy holders were adequately protected by requiring that relevant assets were adequately ring-fenced and not expatriated to the home jurisdiction. Arguably this has resulted in a slightly distorted insurance environment in Hong Kong, but given the enormous sums that have been injected in other jurisdictions into some insurers to guarantee their survival, this distortion is negligible in comparison.
Current Business Models
Who’s Who Legal: Are current business models for the insurance industry sustainable, or will they too need to be changed?
Martin Lister: The financial crisis has emphasised the need to conserve capital and focus an insurer on prudent underwriting, as has been noted in both Australia and Europe. Consolidation of insurers within an insurance group has been encouraged by the insurance regulator for years (for the purpose of reducing the regulatory burden, releasing capital and freeing management to focus on their core insurance business, among other things) and the financial crisis has given impetus to that initiative and rationalisation within groups is already occurring in Hong Kong and further consolidation is anticipated in the next year or two.
There is also a greater focus on profitable business lines and efficient distribution models. The quality of the agency and broker force in Hong Kong has been improving over the past 15 years but there is still room for further improvement, particularly with regard to knowledge of the product, the client and product suitability; the fall of Lehman exposed a range of mis-selling by banks and other intermediaries. Experience with the bancassurance model has been mixed. There has been the continuing difficulty in motivating banks to sell insurance, and bancassurance relationships have often foundered with the result that the traditional agency and broker models are likely to continue to be the preferred distribution mechanism. However, where the interests of the bank and the insurer are well aligned, the model has been tremendously successful, as in the case of market leader HSBC.
Those business lines which have proved only marginally profitable and capital and management-intensive may well be discontinued by the international insurers as not being viable in a post-crisis world. This may leave opportunities for more efficient or specialised insurers, or it may leave a gap in the market where participants either have to self-insure or pay a substantially higher premium. Given the soft market, the latter seems to be an unlikely scenario. However, one unusual feature of the Hong Kong insurance market is that a number of domestic insurers are part of a larger, closely held property or industrial group and, despite being relatively inactive and unprofitable, may continue to provide cover to their group and related parties in these unprofitable or marginally profitable lines. How long this effective intra-group subsidy can be justified will depend on the success of the larger group but no significant change in this regard has yet been noted in the Hong Kong market.
Peter Mann: The crisis reinforces the point that the current business models of Australian insurers have to be completely aligned to the prudential standards set down by APRA. To do insurance business in Australia, insurers need to meet minimum capital adequacy requirements under APRA’s prudential standards and ensure that they have the resources available to meet APRA’s strict reporting, governance and risk management requirements.
Given that the insurance industry has been adapting to APRA’s prudential requirements since the collapse of HIH, it is not envisaged that the crisis will lead to any great change in the business models of Australian insurers. As a result of the HIH collapse, Australian insurers are very much aware of the lack of wisdom in relying on investment income above underwriting income to sustain a business model.
Even though confirmation was not necessary, the GFC and the consequential drop in the investment income of insurers once again points to the need for insurers to pay close attention to strict underwriting and appropriate pricing of risks in order to maintain appropriate underwriting profit.The global financial crisis has provided a very loud “wake-up call” for insurers to “stick to their knitting” (to mix metaphors).
James Grennan: In contrast with Australia (which, from Peter’s comments, has already come to grips with new capital requirements) for many insurers in the European Economic Area, the twin drivers of the financial crisis and regulatory change are currently prompting a rethink of business models.
Internationally, the credit crisis has increased the emphasis on capital efficiency. For the foreseeable future, it will not be easy to raise cheap capital. Therefore, insurers are very focused on using existing capital as efficiently as possible.
Within the EEA, the focus on capital efficiency will be accelerated by the need to prepare for Solvency II. Solvency II is likely to increase capital requirements for many insurers. However, well-managed insurers whose books of business are diversified geographically and across risk categories are likely to fare better than smaller, more focused, insurers.
With the removal of group support mechanisms in the final version of Solvency II, insurance groups will have to look critically at business models that involve a string of local subsidiaries authorised across the EEA. Also putting pressure on the multi-subsidiary model is the fact that group internal models for determining solvency capital will not necessarily be automatically accepted under Solvency II by regulators of individual subsidiaries.A significant amount of work may be needed to adapt group models for individual subsidiaries and to keep these diverse models under review.
What this will mean in practice is a slowdown in development in new business (capital constraints meaning that the funds won’t be as easily available to take the new business strain).We should also see an impetus towards mergers of smaller of insurers, acquisitions of smaller insurers by bigger groups and streamlining of larger groups to reduce the number of individual authorised subsidiaries maintaining independent solvency capital.
We’ve already seen examples of insurance groups deciding to rationalise their European operations by transferring business to a single regulated hub and converting their existing subsidiaries in other places into branches of the regulated hub. We can expect more of this as insurers amend their corporate structures to address capital constraints and new regulatory requirements.
While this type of change may not be right for everyone, insurers should at least be considering it. Insurers who don’t take these steps could be placed at a significant disadvantage.
We’ve seen quite a bit of evidence of this, so far, in Ireland. Has anybody else seen evidence of this trend?
The bank-owned bancassurance model is also likely to come under pressure.
Banks repairing their balance sheets are likely to want to sell profitable assets such as asset management companies and bancassurance operations.This could lead to a new model for bancassurance where independent insurers provide “white label” products for banks to sell but won’t be exclusively tied to an owner-bank.
Natalie Vloeman: Yes, the trend described by James Grennan in Ireland can be seen in the Netherlands as well. Prior to the crisis, the combination of a banking and insurance company gave advantages of scale, capital efficiency and earnings stability. Now that the landscape has been transformed by the crisis, the widespread demand for greater simplicity, reliability and transparency brings the bancassurance companies to separate their operations.
Martin Lister mentions the focus on efficient distribution models. The call for transparency when it comes to costs and remunerations can also be felt in this field. We expect that the relations between insurers and brokers, in particular in the retail sector, will change drastically so that brokers will no longer receive remunerations from the insurers, but from their clients: the insureds.