Solvency II — The only constant is change
By Jeff Reed
Kestler Financial Group
The balance of the strategies that may help us all deal with this are truly fundamental and are already being employed by some carriers and practitioners. An increased level of scrutiny of in-force contracts as well as formal annual reviews, including not only policy performance but also carrier level considerations, is essential.
What's changing? It's called Solvency II, and when it eventually makes its way over to American shores, it is going to have a very, very large impact.
Solvency II, which goes into effect in Europe in 2013, is roughly equivalent to the stress testing process that U.S. banks have recently endured, but it's applied to insurers. It represents a major departure from current reserving requirements in the U.S. and Europe. The underlying rate of return assumptions a carrier can use when pricing product under Solvency II is a 1 percent rate versus 4 percent or higher on current U.S. and European product. If you are asking yourself why this matters now if it does not go into effect in Europe until next year and its arrival in the U.S. is purely speculation, just keep reading.
Reserving in Europe is not nearly the issue that it is here in the States. Quite simply, based on fundamental differences between European and U.S. insurance products, there is not as much net amount at risk tied to long-term guarantees there versus here in the U.S. Things become complicated, however, for European companies subject to Solvency II that also own U.S. subsidiaries. Those U.S. subs do have significant net amount at risk tied to long-term guarantees in both the life and annuity markets.
Those same U.S. subs are subject to Solvency II based on their relationship to the European parent. Combine these facts with a finite amount of capital and a mandate to maximize profits, and the European parent faces a tough decision: allocate a significant amount of additional capital to a part of their business that is already under-performing or contemplate divesting themselves of what could become an anchor around their necks from a profitability standpoint as a result of the new reserving requirements. This is an important distinction — it is less about solvency than it is about profitability. What may be a relatively unattractive asset to an entity operating under one set of rules in Europe may be very attractive elsewhere. Of course, there must be other remedies than selling the operation, correct? Absolutely. The U.S. insurance carriers are deploying some of them currently based on the pressure on their bottom line from the current economy. Increased prices, limitations on first-year premium and the like are some ways we see this play out.
The problem with Solvency II is that, unlike the current economy, which primarily impacts currently available product, Solvency II also applies to in-force business. Any price increases on current product that would be large enough to address the reserving for in-force business would be so massive that the carrier would never be able to sell enough product to put a dent in it. All of the sudden, the possibility of selling off the U.S. operation makes more and more sense to the European parent.
Now that we understand the forces in play, we can understand the possible sale of any number of U.S. insurance operations that are owned by European parents (I can think of at least a half a dozen). With that behind us, it is time to tackle the issue of how to deal with this as producers and consumers.
I think the first issue is what could happen to in-force business when, and if, a carrier is sold? In some ways that is easy; any current assumption product or indexed product will be subject to possible rate reductions. Guaranteed product appears simpler on the surface. It is guaranteed after all, right? Sort of. While there is no direct precedent for guaranteed death benefits and their corresponding premiums being subject to change in the aftermath of the sale of a company, there is precedent when it comes to guaranteed interest rates. Essentially, the carrier that bought the business went to court for relief on the guaranteed rates and was able to reduce them. While I have not reviewed the actual case, this is from a source I trust at one of our carriers. The bottom line is that even with guaranteed product, we need to be paying attention. If we all agree that we need to pay attention, the next logical question is what to pay attention to? There are a number of strategies to consider, starting with staying informed. If any of the players in our business are potentially going to change hands over the next 12 to 24 months, separating rumor from fact is critical going forward.
Further, I would consider the use of products with flexible exit strategies and shorter surrender schedules to provide the client greater flexibility. Another tactic we see playing out in the LIMRA statistics is taking a second look at whole life, and by extension, considering the truly top-rated carriers in our business. While their products may be a bit more expensive currently, the fact that they are more likely to be a buyer than a seller at the carrier level is something to think about.
The balance of the strategies that may help us all deal with this are truly fundamental and are already being employed by some carriers and practitioners. The movement away from the singular focus on price to "total policy holder value" will only become more important when the prices associated with guarantees rise dramatically. An increased level of scrutiny of in-force contracts as well as formal annual reviews, including not only policy performance but also carrier level considerations, is essential. This is particularly true in our overly litigious environment.
Perhaps the most effective strategy, however, is to fall back on one very fundamental premise: life insurance continues to be unique in its ability to provide timely liquidity as well as very attractive tax equivalent returns without market risk. A price increase that primarily impacts one segment (albeit the largest one currently) of our business does not mean we are out of business. Rather, it simply means we need to adapt as we always have and continue to serve our clients.