ERM: a critical undertaking for small and medium-sized European insurers

Is the SME doomed?
For many years people have been writing obituaries for the hundreds of smaller and medium-sized insurance companies that populate the continent of Europe. The arguments in favour of size – economies of scale, greater expertise, the ability to diversify risk and gain better credit ratings – seem to be compelling.

The top 20 European insurance groups control more than 50 per cent of total premium income and, in most EU territories, many of the largest insurers are subsidiaries of international groups. Within each EU territory, both the top five life and non-life firms have an average market share of over 50 per cent. This drive towards increased concentration coincides with a steady decline in the number of insurance companies, thanks mainly to mergers and acquisitions.    

Yet, as with Mark Twain, reports of the death of the small-to-medium sized (SME) sector are greatly exaggerated.

The largest – and generally more competitive - insurance markets are significantly less concentrated than the smaller markets. Germany alone boasts around 80 medium-sized and more than 200 small insurers, whilst in many European countries new insurance companies continue to form. Our annual analysis of the UK’s hugely competitive motor market shows no clear link between size and profitability as a proportion of capital, with some smaller companies enjoying excellent combined ratios.

We must, therefore, approach predictions that Solvency II will spell doom for swathes of European SME insurers with some scepticism. Many command great customer loyalty and could still be around in large numbers for some time to come. Yet, it is certain that the change will put them under renewed pressure and give large, international insurers easier cross-border access to those domestic markets where SMEs currently enjoy an element of protection.   

Why does Solvency II favour scale?
Firstly, the new rules favour diversification; the more you spread your risk, the lower the capital requirements. This principle was accentuated by the decision to allow for group supervision – in other words to permit groups of insurers to be regulated as though they were one single entity. Almost by definition, SMEs are less able to spread risk.

Secondly, Solvency II demands skills that SMEs frequently do not possess and where investment in full-time in-house expertise has been difficult to justify, particularly as many SMEs use informal mechanisms to provide a more ‘personal’ approach to risk management.

Thirdly, most SMEs view the coming changes as a regulatory chore and are not yet taking the steps necessary to gain business advantage from them.

Specifically, Solvency II gives firms a choice between a Standard Formula method of compliance or an internal model. Under the Standard Formula the regulatory capital calculation will be less complicated and, as the name implies, more formulaic. It represents a diluted form of ERM, which confers no significant business benefits. Indeed, because it is a less accurate way to assess risk, it will probably lead to additional capital requirements under Solvency II. 

The internal model is exactly the opposite: more demanding at the outset, but it confers considerable competitive advantage. Crucially, unlike the Standard Formula, it measures the correlation between different types of risk in a meaningful way.  In many cases, this additional investment can be justified by the improved ability to manage the business effectively and a lower capital requirement. Regulation may be the cost of doing business but full ERM confers the benefit of doing good business.

Unsurprisingly, the larger players are more likely to have adopted full ERM and internal modelling, driven primarily by business rather than regulatory considerations. In simple terms, the better you understand the risk inherent in your business, the more effectively you can manage it and the less capital you need. This helps firms to make better informed decisions right across the business, including capital allocation, pricing strategy, reinsurance purchase, reserving and in relations with ratings agencies.
 
SMEs, therefore, face a double squeeze: the disadvantages stemming from limited opportunities to diversify, compounded by cultural and practical factors that make it more difficult to benefit from the upsides of Solvency II and ERM.

The challenge for SMEs
However, there is no such thing as a ‘typical’ SME insurer. There is a world of difference between a mutual for horticultural workers and an endowment specialist, or between a central European composite and a Norwegian P&I club. They also vary tremendously by size, from those SMEs that are large players relative to their own territories down to those so small that they are not even required to comply with Solvency II.

Because of this diversity, any wholesale write-off of SME insurers would be highly simplistic. Those SMEs that flourish will play to their strengths, understand and command loyalty in their core segments, and view Solvency II as an opportunity rather than as a problem.

How do SMEs vary across European markets?
There is considerable divergence between the various EU markets and their regulators’ skills, resources and readiness for Solvency II. The characteristics of SME insurers and their attitudes to the capital adequacy requirements of Solvency II are also highly variable across the countries of Europe. Below are some examples of these differences.

In Scandinavia, most SMEs are well capitalised and are more concerned about the administrative complexities of Solvency II, including corporate governance, structure and reporting and the admissibility of different assets. Together they amount to a whole sea change, a new way of thinking. This is being kick-started by an interim step known (especially in Denmark) as Solvency 1½.

Norway and, to some extent, Sweden are home to a substantial community of specialised marine insurers and P&I Clubs, which have little risk diversification. While these generally have the resources and awareness to adapt to Solvency II, they tend to be more concerned about the needs of the ratings agencies.

The benefits of using internal models are increasingly recognised by Nordic SMEs and, while many are considering using the Standard Formula approach initially, they are also developing manageable solutions consistent with their relatively modest resources that would enable them to adopt internal models in the future.

In Germany, the high level of capitalisation is even more marked, with some firms considered to have five times the reserves they need to meet official Solvency II requirements. Complacency can be more of a problem than lack of capital, although the regulator’s interim step of MARisk is causing insurers to take notice earlier than might otherwise have been the case.

There is already a significant and growing take up for ERM in the middle market. This is, though, largely a parallel movement to Solvency II. Many companies with internal models currently have no intention of showing them to the authorities even when Solvency II kicks in.

The same interest in ERM is noticeable in France. The banc-assurers – insurance companies owned by banks - have a small but rapidly increasing market share. They are mostly adopting internal models as their parent companies are already familiar with them, having been through the Basel II process.

Specialist companies and mutuals predominantly underwriting long-tail business in France have also been quick to show an interest in developing an alternative to the Standard Formula. They are particularly interested in alternative solutions to evaluate Risk Margin and Reserving Risks.

Some of the biggest stress caused to SMEs will be felt in east and central Europe, where insurers grew under the protection of communism. Many are under-capitalised and poorly rated by the agencies, and there have already been failures caused by increased exposure to competition.

With only a few exceptions, they lack the necessary technical expertise. Their position was well summed up by a delegate at one of our east European Solvency II seminars: “We’re still trying to understand Solvency I. How can we even think about Solvency II?”

Insurers in these countries may find their home regulators less demanding, but Solvency II can only accentuate the competitive pressures they already face, whilst highlighting any skill and capital shortcomings.

The UK experience
The UK illustrates how a system of risk-based regulation, one that virtually demands the use of internal models, need not prevent SME insurers from competing. When the FSA introduced the ICAS regime at the end of 2004, many complained about the additional burden. Now, however, it is almost universally seen to have forced up management standards, including accountability and transparency, and to have given the UK industry a competitive edge.

Much has been made of the cost of implementing the new regime. Despite this, the overall non-life sector expense ratio has remained virtually constant for the last 25 years and management expenses in the life sector have shown a continual downward trend as a proportion of net written premiums for the past 20 years.

Many SMEs still perform relatively well in the UK, although these are fewer in number. Those that have struggled over the last few years have generally had no significant niche advantage or have not been willing or able to reinvent themselves to exploit new opportunities.   

The highly competitive environment in the UK has also provided opportunities for new niche entrants, particularly as a result of rising internet use. Some of these start-ups, as well as a few established players at Lloyd’s and elsewhere, have chosen to base themselves outside the UK in places like Gibraltar and Bermuda. The question is how beneficial such approaches will be in the future with increased EU harmonisation and the global trend towards ERM based regulatory environments.

Long live the SME?
How will SMEs fare under Solvency II? As we have seen, there will undoubtedly be an impact and some will not survive. I believe the degree to which SMEs can be successful will depend on three main factors.

First, the ability of SMEs to harness their sector knowledge, risk selection skills and client/distribution relationships. While many firms instinctively understand this, albeit perhaps informally, the ability to entrench it into the business and ensure its sustainability demands a level of analysis and sophistication not normally found in the SME sector.    

Second, diversification. Diversification will be necessary to improve capital efficiency - identifying adjacent niches or lines of business where existing expertise can be re-used. Thus SME insurers may become serial niche players, which may drive merger activity within the sector.    

Third, the detail of the Solvency II Group regulation. The outcome of current negotiations on international Groups will be highly influential. Individual national markets could become more open and susceptible to domination by these Groups. However, in view of current market issues the rules may become more protectionist initially, and therefore offer SMEs temporary support.

Whatever the outcome, the key to success for SMEs will be to implement a business-focused, ERM approach to meeting the Solvency II requirements. It is for the Board to set the direction, drive the process, create a team and allocate responsibilities. A first step is to define what ERM means to the individual firm and how this relates to the external environment. If there is to be an internal model, it can be as complex and ambitious as required to meet the business needs. The important thing is for the business to define its requirements and to understand what it will do, why and how the output will be used.

For those who have not already started, now is the time to do so. ERM is an incremental process, involving a significant cultural journey and it cannot be rushed.

The good news is that in some respects SMEs are better placed than their larger competitors. If approached correctly, their governance structures and internal models will be less complicated, making it easier to comply with the regulatory approval criteria. Indeed, the proportionality principle in Solvency II recognises and enshrines this advantage. Just how many will exploit the opportunity to embrace best business practice will help determine the future prosperity of the SME sector in Europe.

Mike Wilkinson leads the risk management consulting team at EMB (www.emb.com), the actuarial and business consultants. More information can be obtained from www.solvency-2.com