Forbes.com

Rewriting the rules for insurers

Changes to European insurance rules could have wide-reaching implications for the industry.

By Gunther Schwarz, Andrew Schwedel, and Degenhard Meier

First published on junho 13, 2012
min read


Insurance executives have long known they would have their work cut out to satisfy the stringent new capital, risk management and disclosure requirements imposed by Solvency II, the European Union’s regulatory makeover of their industry. But with the new rules due to phase in beginning in January 2014, it is beginning to become clear how steep a climb many insurers will face. While Solvency II may have been made in Europe, its impact will reverberate across the globe. For big multinational insurance groups that are headquartered in the EU or have subsidiaries that operate there, Solvency II’s long reach will significantly tighten requirements for how much capital they will need to hold, impose tough new rules governing how they identify and monitor risk, and set strict disclosure guidelines to increase transparency. Bain & Company’s recent analysis of the EU’s 20 largest insurance groups found that 25 percent of German life insurers and 21 percent of UK life underwriters currently fail to clear Solvency II’s new capital hurdles. In the property and casualty segment, half of the Italian insurers lack sufficient capital. We estimate that to securely close the capital gap, the insurance companies we examined would cumulatively need to raise €37 billion ($42 billion). Adding the companies’ profit profiles to the analysis, the outlook for insurers becomes even starker. Half of the companies we examined fail to earn their cost of capital. Their weak returns leave these insurers a blunt choice: either find a way to make their business lines more profitable or shut them down. Solving the Rubik’s Cube problem to shore up their balance sheets while improving risk-adjusted profitability will be a daunting task for many organizations and a major opportunity for others. The options will be neither easy nor attractive for insurers that are currently undercapitalized and unprofitable. The first priority for these restructuring candidates will be to satisfy minimum solvency requirements, but tapping new sources of capital will strain their capabilities. Best positioned are a group of companies that are poised to be potential “consolidation leaders.” Already profitable and fully capitalized, these insurers will set the industry’s competitive tempo. They will be able to acquire assets that their weaker rivals may need to sell to raise capital, invest in product innovation, and use pricing tactically to target the most attractive customer segments. A second group, “complacent underperformers,” meet Solvency II capital ratios, relieving pressure to strengthen their balance sheets, but they fail to earn back their cost of capital. As the jockeying for competitive advantage intensifies, these companies may fall farther behind the more aggressive consolidation leaders. A final cluster of insurers that we call “borderliners” is perched precariously between having insufficient capital and inadequate returns. They face delicate tradeoffs. If they stretch the risks they are willing to take to boost profits, they will need to add even more capital to remain Solvency II compliant. However, if they decide to plug their capital shortfall by withdrawing from riskier, higher-return lines of business, they could end up further weakening their bottom line. As they maneuver to address weakness or lock in competitive advantage, the starting point for every insurer will be to define its risk appetite to determine how much volatility the organization is prepared—or can afford—to accept in order to achieve a targeted rate of return in each line of business. But whether they currently face a capital shortfall or are already in compliance, look for the leaders to act in three critical areas to strengthen their capital position while improving their risk-adjusted returns. First, they will reinforce their product portfolios to ensure that the premiums they charge adequately cover the risk-adjusted claims they are likely to face. They will also take care to align the time horizons of investments they rely on to generate the income streams they will need to cover future payouts. By judiciously using reinsurance to shift risks off their balance sheets, they can stabilize profits and relieve pressure on capital. Complementing the steps they take on the revenue side, the leaders will also reduce costs by making claims management more efficient and cutting administrative overhead. Under Solvency II, cost savings are powerful because they help reduce capital requirements. Finally, look for the leaders to strengthen the customer experience. Targeting high-value policyholders, winning their loyalty and focusing on retention take on new importance, especially at a time of far-reaching organizational and business-process change, when customer relationships are apt to fray and attrition rates spike. The months ahead will be a crucial time of testing for every company Solvency II will touch. Insurers that use this time to align their strategies, risk readiness and operating processes with Solvency II’s mandates will have new opportunities to pull away from the competition. Written by Gunther Schwarz, a partner at Bain & Company in Düsseldorf and a member of the firm’s Financial Services practice; Andrew Schwedel, a partner in Bain’s New York office and leader of the firm’s Financial Services practice for the Americas; and Degenhard Meier, a principal in Bain’s Düsseldorf office who is affiliated with the Financial Services practice.

Insurance executives have long known they would have their work cut out to satisfy the stringent new capital, risk management and disclosure requirements imposed by Solvency II, the European Union’s regulatory makeover of their industry. But with the new rules due to phase in beginning in January 2014, it is beginning to become clear how steep a climb many insurers will face.

While Solvency II may have been made in Europe, its impact will reverberate across the globe. For big multinational insurance groups that are headquartered in the EU or have subsidiaries that operate there, Solvency II’s long reach will significantly tighten requirements for how much capital they will need to hold, impose tough new rules governing how they identify and monitor risk, and set strict disclosure guidelines to increase transparency.

Bain & Company’s recent analysis of the EU’s 20 largest insurance groups found that 25 percent of German life insurers and 21 percent of UK life underwriters currently fail to clear Solvency II’s new capital hurdles. In the property and casualty segment, half of the Italian insurers lack sufficient capital. We estimate that to securely close the capital gap, the insurance companies we examined would cumulatively need to raise €37 billion ($42 billion). Adding the companies’ profit profiles to the analysis, the outlook for insurers becomes even starker. Half of the companies we examined fail to earn their cost of capital. Their weak returns leave these insurers a blunt choice: either find a way to make their business lines more profitable or shut them down.

Solving the Rubik’s Cube problem to shore up their balance sheets while improving risk-adjusted profitability will be a daunting task for many organizations and a major opportunity for others. The options will be neither easy nor attractive for insurers that are currently undercapitalized and unprofitable. The first priority for these restructuring candidates will be to satisfy minimum solvency requirements, but tapping new sources of capital will strain their capabilities.

Best positioned are a group of companies that are poised to be potential “consolidation leaders.” Already profitable and fully capitalized, these insurers will set the industry’s competitive tempo. They will be able to acquire assets that their weaker rivals may need to sell to raise capital, invest in product innovation, and use pricing tactically to target the most attractive customer segments.

A second group, “complacent underperformers,” meet Solvency II capital ratios, relieving pressure to strengthen their balance sheets, but they fail to earn back their cost of capital. As the jockeying for competitive advantage intensifies, these companies may fall farther behind the more aggressive consolidation leaders.

A final cluster of insurers that we call “borderliners” is perched precariously between having insufficient capital and inadequate returns. They face delicate tradeoffs. If they stretch the risks they are willing to take to boost profits, they will need to add even more capital to remain Solvency II compliant. However, if they decide to plug their capital shortfall by withdrawing from riskier, higher-return lines of business, they could end up further weakening their bottom line.

As they maneuver to address weakness or lock in competitive advantage, the starting point for every insurer will be to define its risk appetite to determine how much volatility the organization is prepared—or can afford—to accept in order to achieve a targeted rate of return in each line of business. But whether they currently face a capital shortfall or are already in compliance, look for the leaders to act in three critical areas to strengthen their capital position while improving their risk-adjusted returns.

First, they will reinforce their product portfolios to ensure that the premiums they charge adequately cover the risk-adjusted claims they are likely to face. They will also take care to align the time horizons of investments they rely on to generate the income streams they will need to cover future payouts. By judiciously using reinsurance to shift risks off their balance sheets, they can stabilize profits and relieve pressure on capital.

Complementing the steps they take on the revenue side, the leaders will also reduce costs by making claims management more efficient and cutting administrative overhead. Under Solvency II, cost savings are powerful because they help reduce capital requirements.

Finally, look for the leaders to strengthen the customer experience. Targeting high-value policyholders, winning their loyalty and focusing on retention take on new importance, especially at a time of far-reaching organizational and business-process change, when customer relationships are apt to fray and attrition rates spike.

The months ahead will be a crucial time of testing for every company Solvency II will touch. Insurers that use this time to align their strategies, risk readiness and operating processes with Solvency II’s mandates will have new opportunities to pull away from the competition.

Written by Gunther Schwarz, a partner at Bain & Company in Düsseldorf and a member of the firm’s Financial Services practice; Andrew Schwedel, a partner in Bain’s New York office and leader of the firm’s Financial Services practice for the Americas; and Degenhard Meier, a principal in Bain’s Düsseldorf office who is affiliated with the Financial Services practice.