Capital conundrum

Concern is mounting in some quarters of the insurance industry over the potential impact of forthcoming Europe legislation on the amount of capital insurers must hold.

There are fears that the EU's forthcoming Solvency II legislation, due to be published in the coming weeks, could force insurers to hold an excessive amount of capital, pushing up insurance premiums and making certain classes of business less attractive.

Some go further and argue that the directive could depress the insurance sector and make it less attractive to new capital investment, stifling the growth of start-up companies.

Henri de Castries, AXA group chief executive, last year issued a stark warning to the drafters of Solvency II, saying that there was "no free lunch" when it came to the trade-off between increased capital requirements and growth in the insurance sector.

"If you want more capital [to be held] you will have less growth and higher prices," de Castries told the Financial Times.

He said there was a danger that the new solvency legislation, due to be implemented in 2010, could force insurers to hold more capital, unrelated to the real risks they face, which would reduce investment in the sector and push up premiums. "If so, it is going to be very nasty," he said.

De Castries is not the only person within the insurance industry to have these concerns, although he is the most vocal.

Insurance Times understands that at least one other UK insurer is concerned about the level of capital that it may have to hold. "Alarm bells are already ringing at the company," says a market source.

The Solvency II directive is an attempt by the European Commission to harmonise the insurer solvency requirements across Europe. It will replace a patchwork of local regulations and aims to ensure that the amount of capital held is more closely aligned to the risks they face.

To some extent the UK has already anticipated this move with the introduction by the FSA of a risk-based capital model.

The problem for the insurance industry is that the detailed proposals for Solvency II have yet to be published, creating a haze of uncertainty around the new regime. The rules are due to be published next month.

Given the FSA's risk-based requirements in the UK, experts says it is less likely that UK-based insurers will find themselves having to stump up a lot more capital. It is more likely that European insurers will find themselves under-capitalised when the regime finally kicks in.

But owing to the uncertainty surrounding the formal rules this outcome is by no means certain. Indeed, the FSA is understood to be lobbying hard to encourage the Commission to use its risk-based model.

Beyond the potential for increased capital loading, there is the prospect of wider commercial effects from the new regulations.

Mark Winlow, a director at consultancy firm LECG and former head of personal lines at Zurich, says that increased capital requirements will discourage investment in new insurance companies and could also depress the price of existing insurers.

"It will be less attractive to put capital into insurance and risk carrying organisations," says Winlow.

Deloitte partner Rick Lester predicts the Solvency II regime could lead to more consolidation as companies look to diversify their portfolios and reduce their level of risk. He also argues that some lines of business, such as long-tail liability lines, may become less attractive as they could be more capital intensive.