Central Europe - insurers look to overcome region's ALM challenges

International insurance groups have moved to central and eastern Europe in their droves since the region emerged from the shadows of communism. The potential for growth is obvious – but are the risks understood? Aaron Woolner reports

Victory Square in Romania

Rapid economic development and a very low level of insurance penetration due to the region casting off the shackles of communism only in the last 20 or so years leaves central and eastern Europe (CEE) as a potential growth market for the insurance sector.

And the major insurers certainly think so. Spearheaded by Trieste-based Generali, Munich-based Allianz and the lesser-known Vienna Insurance Group, multinational insurers have colonised the region, particularly on the life side, during the past decade.

According to Violeta Ciurel, president and chief executive of Axa's recently acquired Romanian subsidiary, the case for investment is compelling: "CEE is the only region in Europe where companies can build and grow value."

Ciurel is not alone in recognising the CEE's potential; Olav Cuiper, Amsterdam-based executive director for Reinsurance Group of America (RGA), the leading reinsurance participant in the region, is similarly bullish over future market growth. "If you look at the potential in CEE, it is huge. There is a strong, growing middle class population that not only wants to protect its belongings but also its future income. That is why all the major international players are looking at the region."

Potential is one thing, but practicalities are another. Simply defining what is CEE is a headache; for example, French reinsurer Scor places Poland in the category of north-east Europe (NEE) alongside former Soviet states such as Russia and Ukraine. Whereas other firms place Poland in the heart of CEE and even include countries such as Turkey and Greece as part of the region.

Unless otherwise stated, CEE in this article refers to former communist states that are now part of the European Union, excluding the Baltic countries. Even then, the heterogeneity in terms of population and economic development makes generalisations about the CEE difficult.

However, there are some common trends: a dearth of long-dated bonds, and a general lack of liquidity of all financial instruments make asset liability management (ALM) a challenge. Added to this is Solvency II, and while international groups dominate the region and can be expected to bring their experience with market consistent valuation and internal modelling to bear on adapting to the new standard, regulators in the region are less prepared.

Asset liability management

With local interest rates touching 8%, one would expect Romanian life insurers to be relaxed about their risk exposure. But while these returns are higher than the 5% guarantees that are the industry standard, according to Adrian Allot, Bucharest-based senior life actuary for consultancy Milliman, finding assets to match this promise is less easy. "In Romania, as just one example from the CEE region, a deep and liquid bond market simply doesn't exist, government bonds are issued only up to a term of five years and the secondary market is low in volume".

According to Scor's head of market for NEE, Jens Sonnenschein, a similar story can be found across the post-communist European states. "It is a big challenge for insurers to find balance on the ALM side given the state of the region's capital markets and, in the future, this could represent a barrier to growth."

For Adrian Lupescu, chief risk officer (CRO) at ING's Romanian subsidiary, the lack of ALM options is concerning. The firm's life business is split between unit-linked (60%), and traditional business, more than 90% of which have guarantees of 5.5%, with the remainder requiring a minimum 3.5% annual uptick. With interest rates in Bucharest at their current level, he says he is unconcerned about ALM in the short term; the long-term outlook, however, is less clear.

What is obvious to the CRO is that with Romanian interest rates far outstripping those of the eurozone it is unlikely that a large-scale government bond issue will provide the necessary local-currency denominated hedging instruments in the near future.

"In the medium term this won't happen. We had discussions with the government and at the moment it prefers to fund itself externally using the eurozone market where rates are lower. And the local currency has been pretty stable against the euro recently which makes this alternative more attractive."

So without the traditional means of hedging out duration, Lupescu has to be creative and find an alternative source of matching. He does this by using the different interest rate sensitivities of the unit-linked and traditional businesses. Unit-linked business is fee-based so that when interest rates increase the present value of these fees goes down - meaning they have a positive duration, whereas traditional business is at risk when interest rates go down. So, by keeping the size of ING's exposure to both unit-linked and traditional businesses roughly equal, Lupescu can minimise the firm's exposure to sudden shifts in interest rates.

And according to RGA's Cuiper, Lupescu is not the only one adopting this approach - the executive director says he has heard several firms adopt a similar attitude to managing their interest rate risk.

Another solution is to invest in non-domestic bonds of sufficient duration, hedging out the foreign exchange risk, but Axa's Curiel is sceptical about the economic rationale of this approach. "You can hedge out the forex risk - this is common practice for some life firms - but it is quite expensive, so the gains from closing your duration mismatch may be countered by the cost."

And Cuiper points to a lack of liquidity in the region's forex markets, which make this an unlikely option if all insurers wanted to move at the same time. He also warns that given the interest rate disparity between the level of guarantees on CEE life business relative to the yields available on sterling and eurozone bonds, that a push into these assets could actually worsen the ALM picture.

"Yes, there is a different shape to the interest rate risk in the CEE region but what lies beneath in CEE is let's say the local insurers have to change their ALM or they will have to go to other types of bonds, almost all of which will have a different, i.e., lower, interest rate structure.

"In my view, this is a phase that has to happen - insurers now launch products with say, a 5% interest rate structure, and while that is doable with their current interest rate structure, if that changes and they have to go to other bonds, it might ruin their ALM position."

Lapses

According to Jan Svab, the Prague-based CRO at Vienna Insurance Group's CPP subsidiary, the Czech Republic has longer duration government bonds, but while these have a duration as far as 15 years, the lack of liquidity at the long-end of the curve means the ALM perspective is similar to his Romanian peers.

But Svab is not concerned, at least about this aspect of ALM, citing a conservative investment strategy that places more than two-thirds of the assets backing the life portfolio in shorter-dated Czech government paper. He is sanguine about the risks, and also the potential for increased capital levels under Solvency II. "I don't see ALM issues as a main driver of increased capital - for us the main risk is lapses," he says.

While consumer behaviour is rarely entirely economically rational in the dictionary sense, in the mature markets it is possible to at least predict some of the correlation between moves in interest rates and the level of customers lapsing. But ferocious competition for new business leaves Czech insurers exposed to commission-chasing sales agents, a scenario that insurers have no control over and only marginally more ability to predict.

"There was some dependency between lapses and the broader economic scenario during the economic crisis," says Svab. "However, there is a much bigger risk from the sale channels as increasing competition in the region means the sales channels can receive very high commissions. After a policyholder has held a policy for two or three years they go back to the clients and sell them another policy with a different firm - so these lapse rates are driven by sales channels, not the clients.

"Policyholders are not so educated in this area and follow the advice from the sales channels - and this advice is clearly not objective. So we are exposed to a potential increase in lapses but without the ability to affect the underlying dependencies."

And the negative impact of price-driven competition is not restricted to the Czech Republic. Ciurel says that while Axa is interested in expanding its business across the whole region it is definitely cautious about expanding its non-life business in Romania, an area of the market she says is exposed to "unhealthy" priced-based competition. "At the moment, the market is very competitive for market share based on pricing rather than other metrics such as distribution or customer service," she says.

One function of the relative youth of the CEE market is the lack of insurer data. In the UK, for example, Equitable Life has mortality figures dating back to the 18th century, while life insurance has only been sold in some CEE countries since 1998. The result is insurers are forced to rely on general population data, with its consequent basis risk, and add a prudent margin.

Cuiper concedes that the lack of a mortality/longevity table does create an issue for insurers looking to do business in the region. He says RGA is building up its knowledge of CEE "country by country, and case by case, but it certainly does create an issue, particularly as some of the insurer's own data is not so reliable".

Italian insurers facing the similar issue have taken the trend data from the UK's Continuous Mortality Investigation (CMI) and applied it to general population data in a bid to come up with accurate longevity data and Cuiper says this is an approach RGA has taken on reinsurance treaties it has negotiated in the CEE.

Extrapolation

"It is possible to extrapolate from western European experience, like we did with Poland; the existence of a big insurer such as PZU meant there was a decent amount of data and it's possible to then extrapolate the western European experience. This enabled the creation of a reasonable pricing basis for the treaty," says Cuiper.

An extrapolation approach might be the only recourse to insurers in the region - it is one that will suffer under Solvency II, which imposes capital add-ons for model risk. But Cuiper says that the relative youth of the CEE market means managing and estimating longevity risk is not a huge issue for insurers in the region.

"It is not a huge issue because there simply isn't a lot of longevity risk in CEE countries, it is more of an issue with mortality and disability figures. The relative youth of life markets is an advantage because we are not stuck like in the UK, the Netherlands or the Nordics where you have huge blocks of annuity business with large amounts of longevity risk," he says.

The estimation of longevity risk may be a surmountable issue with regard to Solvency II but others remain. According to ING's Lupescu the creation of an auditable risk management structure will pose significant problems for insurers in the region which are currently based on a desktop system.

"Increased levels of capital under Solvency II are going to be an issue - but it's not a showstopper, certainly not for the larger companies," he says. "The issue is more in terms of creating an internal model, we have one in place already but the additional governance requirements of the directive will be onerous. ING has been calculating its economic capital using an internal model for over eight years but this is done on manually, using an excel spreadsheet.

"But once this model forms the basis of our Solvency II capital calculation, the regulators will ask us to prove no-one has come in and moved the data around. It will prove a difficult process to automate this to meet the directive's timing and governance requirements."

While Lupescu is concerned regulators in the region may be unsatisfied with the sophistication of the internal models presented to them, others view getting regulators to understand the actual requirements of Solvency II as the main issue. "I think regulators are moving in the right direction across the region, but nonetheless, the implementation of the Solvency II directive is creating challenges for the industry both in terms of the implementation of the Solvency II directive and the development of the industry in general. The key point is the lack of sufficiently skilled experts in the region, particularly qualified actuaries," says Scor's Sonnenschein.

A senior risk manager in the region explicitly questioned the competence of the region's regulators to actually understand the theoretical demands of Solvency II, and the move away from book-valuations. "Regulators have traditionally been used to book value supervision and now there is a wholesale change to market value balance sheets and the economic capital approach is difficult for them to understand, and I'm not confident they will."

But CPP's Svab is more optimistic and argues that the lack of history of life insurance in the CEE region makes it easier for firms in the region to meet the requirements of Solvency II. "There are issues to overcome with relation to Solvency II, but this is a young market and I think that gives us an advantage when it comes to the implementation of the directive.

"This is because insurers in the Czech Republic started with a greenfield and the development of many things subsequently have not been linked to traditional processes. This process has not been stable and therefore Solvency II is simply a continuation of an ongoing process of change that began in the 1990s. I would call this a mental advantage."

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