Solvency II - Its impact and implications

Life & Pensions - Has the German insurance industry understood the implications of Solvency II yet?

Jan Wicke - I was formerly working within a large multinational for northern, central and eastern Europe, and I would say that, in comparison to some other countries, I think we are quite advanced in our preparation.

Wolfgang Weiler - I would agree, to a considerable extent. This is confirmed by the strong participation in QIS and the high level of expertise now achieved in many companies.

Ulrich Leiterman - The Solvency II processes present a fundamental change in approach compared to the present solvency requirements under German law. The German insurance industry has confronted this challenge and has substantially mastered the associated tasks by making the required resources available and building up the required know-how. We can now say that Solvency II and its implications have, for the most part, been implemented by the insurance companies.

Dietmar Meister - With the amendment of the Insurance Supervisory Act, all market participants have become aware of the far-reaching implications of Solvency II, which go beyond the quantity-based risk models, in the current year.

Though the insurance industry has been able to gather some first-hand experience in the past due to the Act on Control and Transparency in Enterprises (KontraG), the integrated and holistic approach provided for within the scope of Solvency II will require concepts with a broader range across pillars.

Ulrich Gericke - The German insurance industry has a significant understanding of the principles and the impact through the participation in QIS. However, our experience in markets like the UK, Scandinavia, the Netherlands and Switzerland tells us that it can take several years until a organisation fully embeds the implications into its management decisions.

The big advantage of Solvency II is the comparability of different risk sources in a standard framework. As recent securitisation trades of some international insurance groups in Germany show, parts of the industry have already well understood the inherent risks since those trades have been executed on the basis of internal risk management constraints. Unfortunately, they do not show their full beauty under the current solvency regime, but I am sure they will under Solvency II.

Life & Pensions - Adoption of internal models has been identified as a key benchmark for the success of Solvency II. What is the German experience likely to be?

Jan Wicke - From my point of view, the adoption of internal models depends on the size and ownership of the company. The bigger the company and the more capital-market-orientated, the more interested they are in the use of internal models. Generally, I have the feeling that German companies have a greater-than-average interest in internal models. It is, of course, a heavy investment. But, the success of Solvency II does not only depend on internal models that are more or less based on economic risk capital views, it also depends on - and this is an extremely important point in Germany - regulatory rules that are currently in place and have to be looked at. It is rather rare that it's really the economic view that forces you, for instance, to reduce your equity exposure or change your duration in the portfolio. It is usually a regulatory clause. As long as the regulator has not abolished those rules, you have these additional restrictions on top of your internal model. Solvency II will be a significant move forward but it will depend on how many of the old rules are abolished so that we really can make use of it.

Ulrich Leiterman - The introduction of a risk-based regulatory concept will also bring further improvement in the internal decision-making and management processes in companies in the future. With regard to internal safeguards, the resources required for implementation and maintenance of risk management systems are regarded as very considerable. Transitional regulations are regarded as desirable in some areas during implementation of Solvency II to ease the transition for smaller companies.

Ulrich Gericke - In order to fully benefit from the Solvency II regime, an internal model will be vital. The standard model would typically be too crude and, in many cases, too capital-intensive. We believe that fine-tuning of this process and the fit of the appropriate risk management strategies are the absolutely crucial factors to differentiate the company versus the competition.

The model should not be in place just to satisfy the Solvency II requirements, but should follow the real risk situation as closely as possible and the appropriate decisions should be derived from it - indeed this is a requirement under the 'use test' of the directive.

Life & Pensions - In hindsight, was hedging against falling rates in 2003-2005 a good idea?

Dietmar Meister - Any decision has to be judged in the framework given at the time of decision-making. Certainly a hedge against declining interest rates did make sense in 2003-2005, taking into account that market rates fell well below the average guarantee rates. In addition the risk of entering a deflationary period was obvious. On the other hand, it has not been advisable to agree a full hedge in 2003-2005. At the same time as when the hedge was rational we had to take into account that rates will rise again at some time in the future. Therefore, our hedge had to be done in a way that the life companies would not find themselves in an unacceptable lock-in situation if interest rates were to increase again. Another reason why the hedges in 2003-2005 have been a good idea can be seen in today's markets. During the current liquidity crisis, interest rates dropped quite significantly and reached levels just above 4%. This proves that we have not left the low-interest danger zone yet and that it makes sense to stick to the hedge positions.

Wolfgang Weiler - Identifying risks and adopting measures or programmes to control or reduce them is certainly the right thing to do. But the cost-benefit ratio of such measures is not the same at every point in time. Choosing the right combination at the right time is important. Moreover, it does not make sense to discover afterwards that certain measures to control risks would not have been needed, given what the situation was really like.

Jan Wicke - I think hedging against falling rates was a good idea as long as it was part of the risk management strategy in life insurance (it was not a necessity in non-life) and as long as the convexity issues were recognised in the strategies.

Ulrich Leiterman - In hindsight, hedging against falling interest rates in 2003-2005 was not a good idea with regard to investment return, but it did present a way of hedging against the risk of falling rates during that situation. In the period in question, given the situation that prevailed and presuming Solvency II had already been in place, addressing interest risk would, in fact, have been a regulatory requirement.

Ulrich Gericke - The life insurance contracts written by insurers contained out-of-the-money options that had slid into the money. The insurers were therefore short these options from an asset-liability perspective and had the choice of either going long the same option (for example, with a 'receiver swaption') or eliminating the time value of the option by locking into rates with a combination of bonds and derivatives.

The benefit of hedging against a risk should not be judged retrospectively, on whether the risk actually materialised, but rather by its prospective impact on the risk capital profile of the firm. Viewed in this way, the premium on hedging with options represents cheap contingent capital.

When advising clients on hedging strategies we consider the trade-off between the benefit - the reduction in the cost of economic risk capital - versus the cost, for example, the wasting time value of options in benign conditions and the opportunity cost of locking-in low rates. We would usually recommend making strategic decisions based on the asset/liability management (ALM) risk situation, with market timing as a tactical point for execution.

Life & Pensions - Has a new ALM consensus emerged?

Dietmar Meister - In recent years we have learned that liability-driven investments (LDIs) are a pure necessity. This does not mean that we have to have a risk-free position and that we need to be perfectly matched in the one or the other asset/liability (A/L) definition.

But there is no question that we have to link our investment decisions to the liability structure and that we have to know our overall risk position. The final decision may accept A/L risks deliberately but we have to be aware of it.

Jan Wicke - I wouldn't go as far as stating that there is an ALM consensus within the industry. I agree that the necessity of an LDI style is accepted. But the understanding of the meaning of it widely varies. Just take the VVG reform and its adoption in ALM. The new law defines new guarantees with regard to surrender values and the participation of policyholders in the hidden reserves, which of course generates new optionality for our customers and further increases the convexity on the liability side. I doubt we all have a common view on how to deal with that.

Ulrich Gericke - I do not think that we necessarily have a broad ALM consensus today, given the amount of negative convexity that has been bought on the asset side, for instance, via callable bonds. This is an example of where a more holistic risk model, as encouraged via Solvency II, will lead to change in behaviour.

We believe that certain strategies are more en vogue than others, but the job description of an insurance fixed-income portfolio manager has not significantly changed from the past, he should be long convexity and produce a high running yield compared to the liabilities. If he does so, he will create value (and vice versa).

Life & Pensions - What will be the impact on insurance company innovation of the following:

INSURANCE CONTRACT LAW REFORM (VVG)

Ulrich Leiterman - I think the impact will be negative. From January 1 2008, all contractually relevant terms and conditions must be presented to the customer or prospect prior to contract closing. With the current 'policy model' (Policenmodell), customers only receive the contract documentation with the policy, but the contract is already in effect at that time. A right of rescission is granted to make up for that.

This procedure has proven effective to date, and the insurance industry rejects this change in law because the rescission rights were entirely adequate. Contract closing would become more expensive under the new law, and the insurance industry regards the benefit for customers as more than doubtful.

Another change resulting from the reform is the increased surrender value: Here, the actuarial reserve is calculated based on a distribution of contract-closing costs over five years.

In addition, a participation of the insured in valuation reserves is being introduced. It must be feared that this will give rise to restrictions in investment policy, which will result in lower net interest to the disadvantage of loyal customers.

Dietmar Meister - A risk-relevant impact of the VVG reform is primarily expected in life insurance. Due to the new rule concerning profit shares (allocation of hidden reserves), the available risk capital is expected to decrease, which might have serious consequences, depending on the development of capital markets and lapses.

In addition, the VVG reform leads to a higher transparency of the parameters entering premium calculation (for example, information on costs), which may result in a higher pressure for cost savings.

The spread of acquisition costs over a period of five years may have an impact on the commission system and on the controlling/planning of distribution. Higher surrender values could lead to an increase of early lapses, which would be to the detriment of the portfolio.

Jan Wicke Overall, I think this VVG reform has turned out to be a negative issue. It has started as a reform from a customer point of view as our industry was not very good in creating transparent products. As a consequence, politics punished the industry with a bureaucratic approach. Now the complexity of life business is increasing and, given the new optionalities and ALM challenges of traditional products in this context, the risk capital requirements are increasing. The initial target of increased transparency is not met. Even from a customer point of view it is highly questionable if the reform is a success.

IFRS PHASE 2, IN PARTICULAR FAIR VALUE REPORTING

Dietmar Meister - The introduction of the revised IFRS 4 will have two main impacts on life insurance companies in Germany. Determining the market value of insurance products will, in the future, require a valuation of implicit options and guarantees on a market-value basis. On the one hand, traditional products could experience a general price increase, since the options and guarantees will, for the first time, be priced in line with the market. As an alternative, the product structure may change towards products without guarantees or towards products with more differentiated options and guarantees more in line with customers' requirements. At any rate, insurers will have to reconsider their positioning and they may have to withdraw from unprofitable segments.

On the other hand, fair-value reporting for assets and liabilities will increase the volatility of income and equity, since it will no longer be possible, as it was in the past, to smooth fluctuations (caused by changes of interest rates, for instance) by building up and winding up hidden reserves. In addition, the profits resulting from contracts are generally disclosed earlier than in the past, in some cases even when they are shown for the first time in the balance sheet (when the premium exceeds the fair value of the liability). These fluctuations involve a higher need of equity capital and thus also a higher cost of equity capital. Furthermore, there could be price increases for products that require a particularly high amount of equity capital.

Jan Wicke - Overall, I am positive. IFRS Phase 2 will increase the information value of company reporting and, by doing so, support more rational decision-making and transparency for the capital market.

Ulrich Leiterman - IFRS Phase 2 will initially cause high internal costs, because incomes and expenditures must be calculated very reliably over extended periods of time in the case of life insurance. However, there will be no innovation effect, since - as currently provided in the draft for discussion - the products subject to IFRS4 Phase 2 correspond to Phase 1. It can, however, be expected that the intensive consideration of products necessitated by IFRS as well as Solvency II will result in the development of new products nonetheless - in particular products that make a positive contribution to the performance of an insurance company.

Ulrich Gericke - If IFRS Phase 2 can be properly aligned with Solvency II, then this will provide a powerful incentive for insurers to make more economically rational decisions, including innovative product design, since this will no longer be constrained by artificial accounting and solvency rules.

SOLVENCY II

Dietmar Meister - The biggest tasks involved in the implementation of Solvency II, besides an adequate risk modelling within Pillar I, will probably refer to Pillar II (Supervisory Review Process). Naturally the focus will lie on those risks which are difficult to model or quantify (especially so-called operational risks) and on the internal development and process structures. In this context it is important to ensure that there is a consistent and integrated enterprise risk management, which does not look at the individual pillars separately. Also, under Solvency II, assets and liabilities will have be shown at fair value in the future. In this context, the valuation criteria should be comparable to and consistent with those of IFRS.

Jan Wicke - I think Solvency II will be an accelerator to product innovation. It will also drive the sophistication of ALM, which has already been started by peers who are more advanced in this area. It will also drive the data warehousing for all the different risks. Quite some investment is necessary to provide for a risk management infrastructure in Solvency II environments in order that you can make use of the diversification benefits within life companies that you're targeting. It is certainly also an issue for our non-life entities.

Thomas Schubert - In the future, companies will have much more freedom than in today's regulated market. Today, supervisors are really risk averse and it is much more difficult to create new products. They don't see the market opportunities; they just see the risk. Because companies will have much more flexibility, it is in the interest of the consumer. Now, perhaps we can think about how you can bundle products or what is interesting. It's not that we won't have any more failures in the future, but companies are really forced to think what might happen in terms of scenarios. They are forced to be transparent. So, in the future nobody should say 'oh, I didn't know that'.

Ulrich Gericke - One can look at the development for example under the British realistic solvency regime to predict the likely level of innovation. In the UK, this led to a reduced emphasis on traditional business, with opaque embedded guarantees that were undervalued by policyholders and difficult to hedge. The product design focus has switched to more transparent and hedgable guarantees, and more recently to variable annuity business. We already see a number of initiatives in Germany that are pointing in this direction.

Life & Pensions - Reform of German corporate, civil service and individual pensions: What is the impact on life companies?

Dietmar Meister - Recent changes to retirement and tax law have given life insurance companies attractive new business opportunities. It it is now possible to claim partial tax-exemptions on contributions towards a basic annuity. This change led to stronger sales of the basic annuity within the last months. Following a simplification of the bonus application procedure and the allocation of the calculated acquisition costs, sales of second-layer Riester annuities have boomed since the beginning of 2005.

Meanwhile, the second-layer occupational pension plan/direct insurance (Direktversicherung) is put on a par with the staff pension insurance (Pensionskasse) and is growing more attractive. In addition, it is also possible to transfer existing pension scheme liabilities tax free into a pension fund (Pensionfonds). It can be expected that this option will be increasingly taken advantage of in the next 10 years.

On 1 January 2009, the government is introducing a new flat rate tax of 25% on all private investment returns. The returns of tax-privileged life insurance are not included in this flat rate. Consequently, the tax situation of life insurance is ameliorating in comparison to investment funds. Finally, from 2012, the retirement age in the social pension programme will progressively increase from 65 to 67 years. The benefits offered by the state are reduced and only private provision can breach this gap. This offers insurance companies good prospects in the future.

Jan Wicke - Overall, I am rather positive that the reform of individual pensions accompanied by a rising awareness of pension issues should result in additional demand.

Ulrich Leiterman - Demographic trends have already given rise to legislative measures in the past, which result in markedly lower income from statutory pension insurance and civil servant pensions. The impact of these laws will intensify further in future, as currently effective legacy entitlements are phased out. More legislation of this kind must also be expected in future. This results in a widening of the personal provision gap, which in our view will lead to growing demand for second- and third-layer capital-funded life insurance products.

The reforms of company pension schemes have primarily affected big companies so far, but here there is also demand for capital-funded provision solutions in place of the currently widespread direct solutions funded internally by pension reserves. In small and mid-sized companies, company pension schemes including coverage of formerly excluded employees are gaining ground. This business field, too, presents business opportunities for life insurance companies.

Wolfgang Weiler - Increasingly, people will recognise that additional personal old-age provision is indispensable and not something to leave to chance, and that it requires a number of components (pensions, available capital).

Thomas Schubert - The key question is whether we have rules that ensure equal competition? I think it is important that the pension customer has the same safety net. Remember the discussions with guarantee funds. The banking guarantee funds imply a guarantee but they're not as valid as the guarantee with life insurance. The life insurers have their own funds to cover this guarantee. The funds are not required to have their own funds and, if you remember, in the past they just closed the funds when there was a problem. I think it is a similar situation with the pension system. The customer believes in it but, if there are not the same capital requirements, it is misleading.

Life & Pensions - Has the industry correctly judged the political and consumer mood at national, EU and international level?

Ulrich Leiterman - The German insurance industry has, by and large, judged the mood among consumers correctly. This is reflected in the number of contracts closed despite the fact that the media often presents a misleading view of the life insurance industry. There have also occasionally been court rulings that cannot always be regarded as appropriate. What will happen in future in this area is difficult to predict.

Jan Wicke My personal view - and it may be a different opinion to that of the industry - is that I am critical with regard to the German life insurance's idea of transparency towards the customer. If you look at VVG reform and what is currently going on in terms of customer participation, hidden reserves on a year-to-year basis, granting of surrender values and so on - the rules are so complicated that even specialists in German statutory accounting have difficulty in following them. Perhaps models from other countries, where you have policyholder participation that is government bond index minus guarantee, multiplied by 80%, which is easy to follow from a customer point of view, might be easier to communicate. I'm not quite sure whether we adequately fulfil the political requirement of product transparency and I think the industry overall still has to work to communicate their product in a more understandable way. It is not just about fulfilling rules - it's about thinking about the customer.

Dietmar Meister - The increasing awareness of the need for supplementary retirement provision (such as the response to the Riester policy) has had a positive influence on the insurance industry in Germany.

It seems, however, that consumer behaviour is generally developing towards a 'critically informed' and 'price-aware' attitude. The political environment on a national level (VVG reform, EU Insurance Mediation Directive) aims at enhancing transparency and at strengthening the position of consumers.

Amid intensifying competition, also from non-German competitors, the insurance industry is thus under growing pressure to develop favourably priced and innovative products oriented at the requirements of customers. The insurance companies are on their way to meeting the increasing challenges by process optimisation and cost reductions in all areas and to align their distribution more effectively and efficiently.

Small insurers with a low level of economies of scale could be affected by the development of the environment as described above, unless they operate in market niches. Also, with a view to Solvency II, consolidation is expected to increase.

Wolfgang Weiler The insurance industry faces an (overly) critical public, as well as legislators who partly lose sight of the necessary balance between consumer protection and viable providers. Insurers in turn must improve and broaden their communication and transparency.

Life & Pensions - Do German life insurers need a German balance sheet, and what is the best ownership structure?

Dietmar Meister - A major special feature of the German balance sheets of life insurers is the special profit-sharing system and, in particular, the (profit-related and not profit-related) surplus funds (RfB). By premiums, which are prudently calculated (too high), the German life insurers earn a surplus. Policyholders can get a direct transfer or participate in that surplus by means of the RfB. The disclosure of the RfB in the balance sheet of an insurer thus reflects the principle of prudence in preparing the balance sheet, which traditionally is the prevailing principle in Germany. A changeover to IAS/IFRS or US-GAAP would probably not adequately reflect the particularities of the German product structure.

Starting from 1994, the current 90:10 profit-sharing rule between policyholders and shareholders is no longer applicable to the risk and cost profits. Depending on the percentage of the risk and cost profits in the total profit, the participation of shareholders can thus be markedly increased above 10%. An increase of the profit participation rate could make the German insurance industry more interesting for investors. This would also be to the benefit of policyholders since a sound equity basis is an efficient protection against financial risks.

Ulrich Leiterman - If a German balance sheet is understood as meaning that the available surplus funds (RfB) are carried as part of equity, such a special formula is certainly indispensable in the German life insurance model. This was also communicated to the European Solvency II bodies by the German insurance industry.

Under the legal form of a VVaG (mutual), the insured are also owners of the company. In contrast to stock corporations that also have to meet the capital requirements of their shareholders, there is no clash of interests between owners and insurers here. A long-term policy of increasing company value to the benefit of the insured and the company is therefore more possible in a VVaG than a stock corporation.

What is regarded as a disadvantage of the VVaG are the limited external funding options. Recently, however, the scope to do so has been broadened, for example, by a higher set-off ratio for hybrid capital.

Jan Wicke - In the German mutual fund industry we have had overregulation that led to a situation where - as German regulation was suboptimal - all German banks set up mutual fund providers in Luxembourg. I just hope that we won't end up with the same situation in German life insurance. From a shareholder's point of view, it's not a given that you have to be in Germany in order to provide German people with life insurance.

Wolfgang Weiler - They don't need a 'German' balance sheet, but accounting rules that allow a clear and correct view to the business, for example, in figuring the profit-sharing formula and its legal implications.

Life & Pensions - What lessons should German insurance companies and regulators learn from the current banking crisis?

Dietmar Meister - The German insurance industry is not really affected by the current crisis (apart from price moves at stock and interest rate markets). The industry's exposure to structured credits was and is fairly limited.

However, there are some relevant conclusions. First, about the fundamental role of trust and transparency in any financial business; and second, we had to realise that, in crisis situations, correlations break down. We have to question whether capital adequacy models that are built on historical experiences are able to describe a future crisis. Finally, we should learn from the squeeze in liquidity and consider the possibility that important components of the present risk capital will not have a (fair) market price in a crisis.

Jan Wicke - I think that credit risks were underpriced and that there were deficits in risk management. Even the ratings agencies need to improve their assessments. Of course, industry players on the capital markets need to reassess how we deal with results from ratings agencies. The overall message is that you have to know the risks to which you are exposed.

Thomas Schubert - An important conclusion from the current crisis is that the Basel II approach is not as far reaching as Solvency II. Although I am not familiar with the details, it seems that there are gaps in the accounting and supervisory procedures so that banks have obligations without putting them in their balance sheet or in their risk management process. I feel, at least, with Solvency II we are more on the safe side because we look at the risks of the whole company and where there is a goal - 99.5% confidence level - and here there is no similarity in the banking industry.

Ulrich Gericke - If it looks too good to be true, then it is too good to be true. We had an intensive dialogue with a number of our clients earlier this year about some specific ideas on credit hedging. We thought that the credit market was too expensive. Transparency of the underlying risk is key. The banking crisis was caused due to concentration risks and the lack of knowledge of the underlying structures. Simple stress tests won't give you the full picture specifically in extreme scenarios and in structures where the risk factors are cross influencing. I think the regulators are aware of this complexity and this is one of the best reasons to move to the Solvency II world and to implement internal models.

Nicholas Dunbar, Editor, Life & Pensions

Ulrich Gericke, Director of risk advisory, UBS Investment bank

Ulrich Leitermann, Board member, Signal Iduna

Dietmar Meister, CFO and Board member, AMB Generali

Thomas Schubert, Head of risk management, German Insurance Association

Wolfgang Weiler, Board member, HUK Coburg

Jan Wicke, CFO and Board member, Wustenrot & Wurttembergische.