1 October 2011 Insurance

Mutual concern

Whether large or small, Solvency II presents insurers with a challenge. First, there is the organisational and logistical nightmare of complying and finding sufficient resources to complete this task in good time—all while running a business.

Compliance will be costly for any company. It will be even worse for companies with multinational operations, but at least these will tend to be bigger, with greater resources to call upon.

Most mutual insurers, however, are small to medium-sized businesses (SME s). As such, it is easy to see why many are concerned about how the new regulatory regime will affect them and whether they will be able to comply in time.

“Solvency II is a challenge,” says Gregor Pozniak, secretary general of the Association of Mutual Insurers and Insurance Cooperatives in Europe. “Preparation means fixed costs and these hit SME s harder than they do larger companies. Second, through its provisions and requirements, Solvency II will lead to additional fixed costs. This is another reason why SMEs are concerned.”

Because of their size—and therefore limited resources—the cost burden of Solvency II could be further intensified by the fact that some SME mutuals without the appropriate in-house capacity or expertise will need to enlist outside resources, argues Rick Lester, lead partner of the Solvency II team at accountancy firm Deloitte.

“For SMEs, the cost of complying with Solvency II tends to be disproportionate relative to their size,” Lester says. “They are encountering significant costs, particularly in instances where they don’t necessarily have the capabilities to prepare for Solvency II internally and require outside contractors and consultants.”

Shaun Tarbuck, chief executive of the International Cooperative and Mutual Insurance Federation (ICMIF), agrees. He believes some mutuals will struggle to sell the benefits of Solvency II versus the costs to their policy holders.

“It can be difficult to justify the extra spend on one or two actuaries, who could have a huge effect in terms of the costs involved,” he says. “Whereas a large company could employ 30 additional actuaries and this not affect its cost ratio because of the size of the organisation, in a small company any additional costs have much more significant impacts on profitability.”

Size matters

This imbalance in the level of costs borne by SME s has led to accusations that Solvency II is unfair on SME s and has been conceived with bigger companies in mind.

While this may be true to a certain extent around items such as costs, it does not mean that Solvency II is irrelevant to SME mutuals. “The main aim of Solvency II is to bring about a better understanding of risk, and therefore encourage enhanced risk management, with incentives for it. This is applicable to any company, whether large or small, mutual or otherwise,” says Carlos Montalvo, executive director of the European Insurance and Occupational Pensions Authority.

“The second element is a better understanding of the insurance business and enhanced transparency, which is equally important and applicable to all insurers. We are trying to do this is through Solvency II, which is a risk-based system that determines capital requirements using a standard formula and introduces the possibility of models.

“It could be said that these models were originally intended for large groups, but this doesn’t mean that this is closed or restricted to them—on the contrary, we are happy to say that a number of small to medium-sized companies are also exploring the possibility of using them.”

Tarbuck emphasises that the primary purpose of Solvency II is to protect policy holders—the highest proportion of which will be dealing with larger insurers. “Larger organisations dominate in terms of premium income and policy holders, and so represent the largest portion of the market,” he says. “The regulators are there to protect the policy holders, as is Solvency II, so they have to make the majority their main consideration, for obvious reasons.”

While this may be understandable, it provides little comfort to those SME s that face a gargantuan struggle in readying themselves for the new regime, argues Marie-Hélène Kennedy, managing director of the Réunion des Organismes d’Assurance Mutuelle (ROAM ), a lobbying organisation specifically set up to campaign to warn on potential dangers of Solvency II on behalf of French mutuals.

“Overall, the system might be too much of a burden for them and the cost of implementation might also be too high for these small to mediumsized mutuals to compete,” she says.

But size is not the only factor counting against mutuals. They also have other characteristics that count against them under the new regulatory regime. One such factor is that many are monoliners—focused only on a single line of business and on long-term lines of business, which are badly taken into account in the new Solvency regime.

While larger, more diverse insurers will benefit from aspects of Solvency II that reward diversification, many SME mutuals will not, argues Lester.

“This is a question of policy and tradition in one’s market. One might succeed in telling its members that it is good to keep the funds for more difficult times, another may follow a mutualist doctrine, which means that they constantly plough any profits back to members, through lower prices.”

“They will be impacted because they tend to be specialist, niche players,” he says. “They don’t get the diversification benefits a larger player would potentially receive from writing multiple lines of business, potentially across geographies. This means that they can’t obtain the same kind of capital reductions that a large composite player might be able to secure.” This means that some mutuals may be tempted to diversify into other lines of business. However, this still may not be enough for them to escape increased capital charges, argues Pozniak. “While some mutuals have ventured into other risks, they may still risk being labelled monoline insurers,” he says.

Another problem mutuals face under Solvency II relates to corporate governance structures within their organisations. Mutuals elect their board members from within their membership—the model being based on having the members at the heart of the governance.

But this also presents the potential for conflict. Solvency II introduces new rules around the very high expertise needed on the board of insurers and not all mutuals will have enough expertise to comply as the system is not designed to have professional insurers as board members, argues Kennedy.

“While these elected boards represent the views of all the members, they are not professional insurers and so if Solvency II demands that the board needs to have the same level of knowledge as a CEO of the company, then it will create an issue,” she says.

“Solvency II wants to raise the competence and knowledge of board, which we think is good, but we have to be careful when we do that, by distinguishing between mutuals and joint stock companies. If we do not, we will end up killing that style of mutual governance system.”

A question of capital

A key tenant of Solvency II is that of capital requirements, which again could prove more troublesome for mutuals than for other insurers, particularly because mutuals don’t have traditional shareholders, used to having to make investments, but rather a broad base of policy holders or members, as they are known.

Given that some mutuals could have to raise substantial amounts of capital in order to comply with the new capital requirements under Solvency II, this will present a problem for some, says Kennedy.

“If you are not careful, they will have to use subordinated debt and this is a very expensive way for small to medium-sized companies to raise capital,” she says. “For example, many of my members are from tiny mutuals with premiums of only a few million euros per year, and then we have our largest members with premiums of between one and two billion euros every year. For those larger companies, it might be easier, but for those in between, raising capital efficiently, rapidly and at a good cost is going to be almost impossible.”

There will be no last minute rush to raise funds for most, however, says Pozniak. “This is not a new challenge, which is why a great number of mutuals are already very well capitalised. Their business model does not allow them to raise capital quickly, so they are already well capitalised because they have retained earnings over a long period of time.

“This is a question of policy and tradition in one’s market. One might succeed in telling its members that it is good to keep the funds for more difficult times, another may follow a mutualist doctrine, which means that they constantly plough any profits back to members, through lower prices,” he says.

For some, however, the consequences could be more serious. It is predicted that some mutuals will find Solvency II so onerous that they will either merge with another insurer to become profitable or shut down completely.

And because many mutuals provide exclusive insurance for one particular profession, there is a wider risk that such closures could have unintended knock-on effects on professions—some of whom are legally obliged to be insured. This could have far-reaching repercussions should a number of important mutuals go under, argues Kennedy.

“This could lead to catastrophic consequences for policy holders, many of whom are professionals who rely on the cover which these mutuals provide to their particular profession which enables them to carry on working,” she says.

“Some of ROAM’s members specialise in certain risk, such as doctors or architects’ liabilities, and naturally in these markets they are very important, for example around 60 percent of the French market for doctors. Other members specialise in builders’ liabilities and currently have more than 40 percent of the French market.

“Imagine if the new regulations made those companies disappear: this would mean that the insured members would not be able to work, either because they would not be able to find coverage or, even if they could find it with another company, it would probably be for a very different price.”

However, everything that can be done to avoid this occurrence is being done, according to Montalvo, who says that because companies are being given time to adjust to the new regime, there should be no excuse for a healthy mutual, of any size, to go out of business.

“There is also a transitional period that the system is bringing in to make sure that the scenario in which a company that is perfectly solvent before the deadline and then isn’t afterwards, doesn’t occur,” he says.

While many smaller insurers will be hoping that additional time will be given to them to comply, the opposite will be true for the larger insurers, who will find it difficult to accommodate changing deadlines, argues Martin Shaw, chief executive of the Association of Financial Mutuals.

“If you think of a large insurer as a large ship, once a course for that ship is set, it is much harder for it to change course than for a smaller vessel. This is why many of the larger insurers are hoping that Solvency II comes into place in 2013, because that is when they have set their internal models in place for,” he says.

“However, this contrasts with the smaller companies who would benefit from a delay, because this would give them more time to develop their internal models.”

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