Solvency II, a new directive regulating the insurance market within the EU, could lead to tighter restrictions within the sector. This could further dent FDI inflows into a region that is already suffering from a year-on-year decline in inward investment.

Given that FDI in the finance sector, of which the insurance industry is one part, makes up three-fifths of world FDI stock by some estimates, any restrictions to this sector will be felt globally. But some insurers see Solvency II as a boon to the insurance market, providing greater stability and confidence, and view the knock-on effect for FDI into Europe as positive.

Solvency II explained

Solvency II, due to be implemented in 2012, is the equivalent of the Basel II measures put in place within the banking industry. It introduces what is known as a solvency capital requirement (SCR) for insurers, which means they must align the level of capital they hold with the risk they take on; they will have to hold much more capital than they do currently or diversify their risks. There are new corporate governance principles too, including risk management, compliance and internal audits.

The implications of the Solvency II regime for FDI are first structural: any company wishing to penetrate the EU insurance market will have to subscribe to Solvency II. Non–EU multinationals with a head office outside the EU may be obliged by regulators to set up an EU sub-group to operate within the EU. The company would then ring-fence its EU sub-group and only apply Solvency II within it. But this will create barriers and disjunctions for such groups between their operating entities, which could create problems such as inhibiting the transfer of capital around the group.

Then there are operational challenges raised by Solvency II’s demanding capital requirements. The SCR can be reduced if a company creates its own internal modelling to calculate the SCR. But internal modelling is extremely complex and expensive and only insurance companies of a sufficient size will be able to exploit this.

Size matters

Size also dictates whether or not an insurer can diversify its risks, which is one way to reduce its SCR. So there is real concern that only outfits of a certain size will be able to operate profitably. Indeed, it may be the case that existing smaller companies will disappear or be swept away by a wave of consolidation in the market, which could limit opportunities for investors. Ulrich Zink, a policy advisor at the Association of British Insurers, says: “A non-EU insurance company that wants to directly invest in the EU may have no alternative but to buy a company that is already operating.”

Also, Solvency II requires that the location of a risk and the location of the capital are matched, again to reduce instability. So unlike the current situation, where a holding company can locate its assets and liabilities with a level of flexibility across legal entities and jurisdictions, under the new regime companies will be expected to align their location with their operations. At worst this could mean that foreign groups with major interests in the EU might have to consider relocating to the EU – or reconsider those interests.

It is not only FDI inflow into Europe which could be affected. Solvency II could act as a deterrent for investing companies looking to move into other jurisdictions. If the investor is an EU holding company or has EU subsidiaries – and thus is under the Solvency II banner and subject to its SCR – it will have to assess whether it is still sufficiently competitive as an overall operation to enter these markets with existing, cheaper local operators. John Hume, chief financial officer for reinsurance company XL Re, explains: “A European holding company with non-EU subsidiaries may need to carry higher levels of capital in the non-European jurisdictions than local companies, and this could dramatically impact the overall business strategy.”

Much hinges on the level at which the proposed SCR is set: if insurers are prepared to commit to these capital standards in principle, they are cautious about those requirements being levelled unrealistically high. As Mr Hume says: “Recent advice seems to have moved the target environment to a far higher ‘risk of ruin’ standard and this could seriously damage the global competitive landscape and make it more difficult for European companies to compete in certain markets.”

Yet others argue that Solvency II is an open door, not a dead end. If, for instance, the regime really does radically shake up the insurance sector and lead to consolidation, it could trigger a number of mergers and acquisitions as the market concentrates, and this M&A activity could be a profitable entry point for FDI.

Benefits for FDI

It could have benefits for FDI more generally, beyond the insurance market, as it could make countries under its regime more attractive as a result of their better capitalised systems. Charles Allen, chief executive of Heritage Insurance Management, an insurance management company with offices both within and outside of Solvency II’s jurisdiction, says: “More capital means more stability in other sectors too, with fewer corporate failures, and this should make investment a better proposition.”

Perhaps Solvency II is not in fact the bogeyman, but more of a pioneer. Already other jurisdictions (such as Guernsey and territories in the Middle East) have indicated they could take the Solvency II path. Given that the recent financial crisis has triggered a fundamental reassessment of the relationship between the level of risk and capital, the directive’s tightened regime is where many financial sectors are heading anyway.

Catherine Bannister, a financial services lawyer with Malta law firm Simon Tortell & Associates, says: “Solvency II will probably be the leader in the likely global convergence of standards for capital allocation and accounting. Companies that embrace an enterprise approach to risk management [could] establish a strong competitive advantage.”