What is the backdrop for European insurers’ need for capital management?
European insurers’ capital positions have remained strong throughout 2022, despite the economic headwinds of inflation and high interest rates, with average Solvency ratios in the European Economic Area (EEA) stable at over 200%.
However, a simple pan-European average hides some significant issues at the bottom of the range, with many countries experiencing significant declines in solvency in entities at the bottom of the scale.
Many European insurers that sought to strengthen their balance sheets by issuing debt in the low interest-rate environment will be now faced with a significant hike in interest costs once the instruments mature, potentially opening the door for cheaper reinsurance-based solutions.
A succession of natural catastrophes in Europe – including floods in Italy, Slovenia, Croatia and Greece; the earthquake in Turkey and Syria,; wildfires in southern Europe, particularly Greece; and heavy rainfall in the Nordics – are likely to result in higher retentions in certain jurisdictions.
Reinsurers are actively promoting multi-year spread loss solutions to provide coverage at lower layers, albeit with a larger share of losses being borne by the cedant. However, the message to insurers is clear: where such solutions offer potential relief, it is vital to start the discussion process immediately.
What impact will IFRS 17 have on European capital strength and earnings?
On 1st January 2023, IFRS 17 went live for listed European insurance groups, as well as individual entities in certain jurisdictions, after lengthy and costly implementation projects. It is still too early to gauge properly the impact on equity or earnings, with companies only recently having published their first half-year results.
Nevertheless, we can already see that the elimination of implicit prudence reserving buffers and the impact of higher discount rates have increased earnings volatility for non-life insurers. Life insurers, on the other hand, have been forced to explain falls in equity of up to 50% as future profits are deferred and recognized over the contract duration.
While European insurers still plan to manage capital based on Solvency metrics, which remain unchanged, there will inevitably be increased pressure from shareholders and regulators to explain variances in financial results.
In addition to the direct impact on capital, accounting for reinsurance contracts under IFRS 17 differs from historical practice, which could significantly influence the viability of some structures, and so insurers are strongly advised to review the terms and conditions of existing and future reinsurance treaties.
What should companies learn from the broader challenges of the past 12 months?
The lesson is that companies need diversified sources of capital. Over-relying on a single form of capital such as a quota share treaty or a low-attaching catastrophe excess of loss, or relying on your own surplus or your own retained earnings, may lead to operational weaknesses. Recent market volatility has exposed weaknesses in a number of balance sheets, and so we’re talking to our clients about the need for considered and diversified capital solutions.
Furthermore, if you’re nimble and flexible and have a capital framework that allows you to move capital around quickly, it is easier to take advantage of opportunistic market conditions. Having a capital framework that incorporates multiple forms of capital is hugely important too for optimising your capital and being able to match capital and risk effectively.
How important is it for capital advisors to provide clients with an holistic outlook?
Holistic means understanding all available forms of capital, and it’s essential that our clients are aware of the options available to them. There are a number of forms of capital available to insurers and reinsurers: traditional reinsurance, structured reinsurance such as legacy reserve sales or capital relief quota share, debt, and equity to name the obvious ones. But clients should also examine alternative risk transfer solutions such as catastrophe bonds or parametric covers and structuring solutions such as captives and Internal Reinsurance Vehicles (IRVs) to support capital optimization.
We help clients to review a wide range of capital opportunities in order that they can make better business decisions.
What impact do legacy dynamics have on capital provision?
Legacy is becoming a bit of a misnomer because the transactions now often include both discontinued lines, and for a number of companies, active lines of business as well.
In this particular area of the market, there is actually material capital coming to support these transactions, which makes for an interesting dynamic when you compare it to the rest of the reinsurance sector where capital is entering at a trickle.
Reserve transfers entail insurance organisations handing reinsurers their assets and insurance liabilities, and the asset managers aligned with the reinsurers have the opportunity to invest a bit more aggressively than an insurance company because they are regulated in a slightly different way, which is how the reinsurers make most their profit on these transactions
How are clients responding to your advice, and are you seeing any trends in your service provision?
There’s an increasing interest in private debt deals in the U.S. We’re also seeing the structured reinsurance market step-up to support some of the property catastrophe retention increases we saw earlier this year, meaning that structured reinsurance, which is a small piece of the reinsurance market, will offer multi-year, multi-event type solutions as well as capital relief quota shares and other structured quota share solutions. So, we’re seeing a part of the market gaining momentum in order to support some of the more challenged areas.
There are some reinsurers retrenching and reducing the volume of property catastrophe exposure, but then we see other reinsurers that are really good at capital allocation and have a nimble capital framework being able to allocate capital quickly take advantage of reinsurance market conditions in the property catastrophe space. It’s interesting to see how all these dynamics are at work in the market, and consequently, the range of strategies being deployed.
