1

DG ECFIN/C-4(2007)REP 53199

Impact Assessment: Possible macroeconomic and financial effects of

Solvency II

Contribution of DG ECFIN March 2007

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Table of content 1 Introduction ........................................................................................................................ 3 2 The Economic and Financial Importance of the EU insurance sector ............................... 5

2.1 The role of insurance.................................................................................................. 5 2.2 Key economic and financial figures for the EU insurance sector .............................. 6 2.3 Key characteristics of the EU insurance sector ........................................................ 11

3 Impact of Solvency II on the EU insurance sector........................................................... 17 3.1 Impact on capital requirements and excess capital .................................................. 17

3.1.1 Balance sheet structure and the level of capital requirements ......................... 18 3.1.2 Volatility of capital requirements..................................................................... 20

3.2 Valuation of assets and liabilities and portfolio reallocation ................................... 20 3.3 Greater transparency and market discipline ............................................................. 22 3.4 Industry structure and business model ..................................................................... 23

3.4.1 Organisational structure and processes ............................................................ 23 3.4.2 Insurance product design and prices ............................................................... 24

3.5 Overall impact of Solvency II on insurance sector .................................................. 25 4 Impact of Solvency II on the EU economy and financial sector...................................... 26

4.1 Changes in insurance products supply ..................................................................... 27 4.1.1 Availability of insurance products ................................................................... 27 4.1.2 Impact of insurance price changes ................................................................... 29

4.2 Impact of investment reallocation on financial markets .......................................... 30 4.2.1 Impact on asset prices ...................................................................................... 30 4.2.2 Deepening of the euro area bond market ......................................................... 31

4.3 Impact on competition in the insurance sector......................................................... 32 4.4 Impact on risk exposures.......................................................................................... 33

4.4.1 Transferring risks from insurers to other economic agents.............................. 33 4.4.2 Contagion effects.............................................................................................. 36

5 Conclusion........................................................................................................................ 38 Annex 1 .................................................................................................................................... 39

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1 Introduction Solvency II will introduce a new regulatory capital regime and modify the principles for the risk assessment in the management of assets and liabilities in the EU insurance sector. It should also streamline prudential practices and encourage supervisory convergence across Member States. The objective of Solvency II is to improve the solvency of the insurance sector and, by extension, underpin the stability of the broader financial system, while offering policyholders a better guarantee that their contracts will be honoured. In accordance with the Lamfalussy approach, the proposed framework Directive under Solvency II (Level 1) will be complemented by implementing legislation (Level 2). As the implementing measures are unknown at this stage, the macroeconomic and financial impacts of Solvency II are difficult to assess with precision. Accordingly, this impact assessment (IA) for Solvency II should be considered as largely qualitative and preliminary and there may be a need for revision as the implementation details emerge. The purpose of an IA is to identify the expected positive and negative effects of a proposal and to assess possible trade-offs between these effects. Prima facie evidence would suggest that macroeconomic impact of Solvency II would be marginal, while the impacts on financial sector – particularly in terms of stability – may be more significant. The approach followed in assessing the macroeconomic and financial impact of Solvency II is to review the various possible transmission channels between the insurance sector and the economy and to infer, as far as possible, from stylised facts the importance of these channels. Positive and negative transmission effects may offset, making assessment of the overall net effects rather tentative. When considering the possible transmission channels of Solvency II to the macro-economy and financial sector, two factors should be borne in mind. First, the progressive transition from the existing national regulations to a new harmonized European regulation will imply both transition effects and longer-term steady-states effects. The transition effects - which are mainly short-term adjustment costs towards the new steady-state - may differ across Member States and across firm, reflecting different starting points. The long-term steady-state effects capture the structural implications of the new framework after full implementation. However, distinguishing between these two types of effects is not straightforward. For example, the new risk assessment methods implied by Solvency II may lead to a transient increase in risk to financial stability during a learning period while the long-run effect would be stability enhancing. As far as possible, the analysis will distinguish between these two types of effect.1 Second, the transmission of the effects of Solvency II can be generally presented as: (1) the impact on the insurance industry; (2) the transmission of the (financial) impact from the industry to the macro-economy; and (3) the transmission of the (financial) impact from the industry to stability of the financial system2. The impact on the industry would include the implementation of the new computation methods for capital requirement, the possible

1 It should be noted that following the first announcements relating to Solvency II (2004), some insurance companies have anticipated the forthcoming Directive and have adjusted their risk management. Therefore, to some extent, the transition period has already started. 2 See also Annex 1 for a schematic overview.

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adjustment of business models etc. Subsequent impacts on the macro economy and financial sector would result from changes in assets-liability management techniques, changes in the demand for certain types of financial assets, reductions in insurance cover, changes on the budget constraint of firms and households etc. In terms of financial stability, changes in the supply of insurance products could result in a transfer of risks3 back to the households, firms or other financial intermediaries4. The schematic representation above applies to the majority of transmission channels but not all. Moreover, it does not account for possible feedback effects and endogeneity in the system. Possible interactions between different stages of the transmission mechanisms should also be borne in mind while reading the following sections. Moreover, the introduction of Solvency II should be seen in a broader context of rapidly changing and increasingly integrated financial markets, which would certainly influence the functioning of transmission channels from the insurance sector. The remainder of this note is structured as follows. Section 2 assesses briefly the economic importance of the EU insurance sector in the economy, while describing the main features the sector. Section 3 explores the likely impact of Solvency II on the insurance sector. Section 4 builds on the previous section and considers the likely transmission of effects from the insurance sector to the macro-economy and financial system. (A summary diagram, illustrating of the macroeconomic and financial effects, is presented in Annex 1). Section 5 concludes and assesses the scope for further and more quantitative analysis.

3 Mainly investment risk. 4 The assessment of the financial stability impact is developed in a separate note: Potential Impact of Solvency II on Financial Stability, ECB, 2007

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2 The Economic and Financial Importance of the EU insurance sector5

2.1 The role of insurance Insurance plays a role in supporting economic development and welfare by providing protection against financial losses due to the occurrence of certain contingent events. Insurance cover allows firms and households to enter into commitments that might not be possible otherwise. Without the mechanism for mitigation, pooling and transfer of risk provided by insurance, entire categories of business activity (e.g. manufacturing, shipping and aviation, the medical, legal and accounting professions and increasingly banking through credit risk transfer6) would simply be precluded. Similarly, households rely on insurance cover in relation to their house, car and healthcare etc. In this section, the economic and social role of insurance is described under three main headings that are relevant for the remainder of the analysis:

Improving risk management and facilitating risk taking: Insurance can cover risks incurred in any economic activity, thereby eliminating the need to maintain financial reserves to protect against contingent risks. In this way, insurance cover improves financial soundness and fosters economic activity by releasing idle capital for more productive purposes. Economic activity is also encouraged by the environment of greater certainty – through sensible risk-management- that is provided by access to insurance cover.

Consumption smoothing over lifetime: Insurance helps to stabilize consumption over

time. Households can protect their assets in case of adverse events, thereby guaranteeing their level of wealth and living standards. Against the background of considerable demographic and social changes, insurance can also be a complement to the State as a provider of social protection, in particular in the field of retirement and health provision.

Intermediation of savings and efficiency of capital allocation: Insurance companies

are an important and growing segment of the financial sector. They make a pool of funds accessible to borrowers and issuers of equity. By enhancing financial intermediation, creating liquidity and mobilizing savings, they increase financial resources and facilitate firms' access to financing. Insurance companies are typically willing to invest at longer-term maturities, thereby contributing to the development and modernisation of capital markets.

5 This section draws heavily on: "The contribution of the insurance sector to economic and employment in the EU, CEA, June 2006; "European insurance in figures", CEA statistics N°24, June 2006 and "Social and economic value of general insurance", ABI, March 2005. See also, Financial Integration Monitor 2006, SEC(2006) 1057. 6 Banks are increasingly transferring risk outside the banking sector through (sometimes very complex) structured products of credit risk transfer that are bought, among others, by the insurance sector as an investment.

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2.2 Key economic and financial figures for the EU insurance sector In 2004, the EU insurance sector held approximately 37% of the total worldwide premia, having gradually caught up with North America (see Figure 1). The EU is the world leader in the reinsurance sector. Figure 1: Insurance markets worldwide

Share in worldwide premium

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

1985 1989 1993 1996 1998 1999 2000 2001 2002 2003 2004

Others

NorthAmerica

Asia

Europe(*)

Source: Source SwissRe – Sigma Europe (*) = Western and Central / Eastern Europe In terms of penetration rate (i.e. the relative importance of the insurance industry in the total economy) the EU insurance sector still lags the US. The penetration rate is usually measured by the ratio of premiums collected as a percentage of GDP in a given year7. Figure 2 reports two variants of the penetration rate (i) total gross premia in percentage of GDP (Panel A) and (ii) the non-life premia in percentage of GDP (Panel B)8. In 2004, the ratio of total gross premium to GDP was above 10% in the US but only 8.5% in the EU. The gap is larger when measured on the basis of the non-life premium. The EU25 aggregate hides substantial differences across countries, with the UK and France having relatively high penetration rates and much lower rates in the recently acceded Member States.

7 The explanatory power of these comparisons based on penetration rate is however limited by the structural differences and framework conditions on the various national markets. 8 A comparable figure to panel A and B for the life segments is unfortunately not available.

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Figure 2: Penetration rate (Panels A and B)

Total gross premium to GDP ratio - %

6.7% 6.8%

2.1%

6.4%

10.7%

8.6%

3.5%

4.8%

1.6%

8.4%

9.4%

8.5% 8.8%

3.5%

7.0%

12.7%

9.8%

7.5%

5.7%

3.3%

7.1%

10.6%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

UE25 UE15 UE10 DE UK FR IT ES PL JP* US*

1995 2004

Non-life premium to GDP ratio - %

3.3% 3.3%

1.5%

3.9%

4.3%

3.2%

2.2%

2.9%

1.1%

2.1%

5.7%

3.4% 3.4%

2.1%

3.8%3.9%

3.3%

2.6%

3.3%

1.8% 1.8%

6.2%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

UE25 UE15 UE10 DE UK FR IT ES PL JP* US*

1995 2004

Source: CEA9 * OECD data for 1995-2003

Source: CEA10 * OECD data for 1995-2003

Figure 3 shows the shares of countries (including Switzerland) in the total gross premia in Europe in 2004. The five largest shares are held by the UK, France, Germany, Italy and the Netherlands, comprising almost 75% of total.

9 CEA, The contribution of the insurance sector to economic growth and employment in the EU, June 2006. 10 CEA, The contribution of the insurance sector to economic growth and employment in the EU, June 2006.

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Figure 3: Share of EU25 countries

Total premium in 2004: €917,424 million Source: CEA The distribution of premia between life and non-life products varies across countries within Europe (see Figure 4). In general, the relatively large and/or mature markets have a relatively high share of life products, although this observation does not apply to Germany and Spain. The differences in the shares of life and non-life products across countries can be largely explained by differences economic development, saving capacity and social security systems (e.g. transferring the pillar two or/and pillar three pension savings to the insurance sector). Figure 4: Differences life and non-life segments across countries

Share of life and non-life direct premium in 2004

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

LU FI BE GB FR IE IT SE DK EU(25)

CEA PT MT NL CY GR PL DE AT ES HU SK CZ SI EE LT RO BG LV

Non-life

Life

Source: CEA The insurance sector has emerged as a significant actor in financial markets. In 2005, the total investment portfolio of the EU insurance sector was equivalent to almost €6 billion.11 The bulk of this investment is in fixed-income securities markets (see Figure 5), although a substantial share is allocated to equities and other variable-yield products. This allocation between fixed and variable yield investments is a relatively recent phenomenon and the 11 CEA, Annual Report 2005-2006.

Share of each country in the total 2004 premium

GB24.0%

FR17.2%

DE16.6%

IT11.0%

NL5.3%

ES4.9%

CH 3.6%

BE 3.1%

SE2.1%

Others1.9%

Other EU10.3%

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combined effects of increased risk aversion after the global equity-market correction in 2000 and, more recently, the implications of adopting International Financial Reporting Standards (IFRS). Figure 5: Investment of insurance industry by category (CEA average)

Investments 2004 per category

(a)4.3% (b)

4.4%

(c)28.2%

(e)11.9%

(f)3.1%

(g)5.0%

(d)43.2%

(a)

(b)

(c)

(d)

(e)

(f)(g) Other investments

Debt securities and other fixed-income securitiesLoans, including loans guaranteed by mortgagesDeposits with credit institutions

Land and buildings and participating interestsInvestments in affiliated undertakings and participating interests

Shares and other variable-yield securities and units in unit trusts

Source: CEA, European Insurance in Figures, June 2006.

Share o f d eb t securit ies and o t her f ixed - inco me securit ies ( % o f t o t al, C EA averag e)

43.2%

36.6%

42.3%41.7%

37.2%37.4%

38.7%

40.4%

39.1%38.9%

35.5%

35.1%1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Share o f shares and o t her var iab le- yield secur it ies and unit s in unit t rust s

( % o f t o t al, C EA averag e)

28.2%

37.1%

37.0%

32.3%

30.7%

26.7%26.0%

25.4%

33.2%

27.1%27.9%26.4%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 The importance of the insurance sector as an institutional investor is reflected in its share of total capitalisation of securities markets. For example, the EU insurance sector held 26% of the EU equity market capitalisation in 2004 (see Figure 6). 12

12 As insurers typically hold shares in listed companies, this is a rather precise estimate of insurers' involvement in EU equity markets.

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Figure 6: Importance of the sector as institutional investor

Investments / Market capitalisation 2004

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

DK LU DE SE AT IE UK EU 25 FR NL EU 12 SI FI BE IT CY PT PL

Source: CEA The degree of competition in the EU insurance sector varies across Member States, based on a C-5 indicator (see Figure 7). The link between concentration levels and the level of market development can assessed on the basis of correlations between C-5 indicators and the relative shares of life and non-life segments (which can be used as a proxy for level of market development). A negative correlation has been found between C-5 indicators and the relative share of the life segment in the total insurance market, implying that the larger and more mature markets tend to be less concentrated. On the other hand, the insurance sectors in Finland, Belgium, the Netherlands Italy and Sweden are characterized by high levels of concentration despite being relatively mature markets. In the recently acceded Members States, high concentration rates reflect the presence of former national monopolies. For Malta, Latvia, Lithuania and Cyprus, the difference in concentration between the life and non-life segments is rather striking (as is also the case for the Netherlands and Greece).

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Figure 7: Concentration of the EU insurance markets

Market share of the 5 largest insurers, 2004

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

MT LV LT CY FI SI PT PL CZ SK

HU NL BE SE IE GR ITCEA

EU (25) FR DK AT UK ES

CR5 Non life CR5 Life

Source: CEA Legend: No 2004 figures for DE, EE, LI and LU. Non-life figure for NL is 1993.

2.3 Key characteristics of the EU insurance sector The figures presented above indicate important differences in the economic and financial weight of the EU insurance sector when viewed on a disaggregated basis. These differences are also evident from a more detailed examination of the key characteristics of the sector, such as types of product sold and main distribution channels. Based on a topography prepared by the CEA13, it is possible compare the key characteristics of the insurance sector in a selected number of EU Member States: France, Germany, the Netherlands, Sweden and UK. These Member States have been selected on the basis of their relative weight in the EU insurance sector and/or on the basis of specific features that distinguish them from the EU average. In comparing the insurance sectors in these Member States, it must be borne in mind that the definitions for insurance products are not harmonised across the EU.

13 CEA, Topography of EU25 Insurance Market, 2007

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Table 1: France Life products Non-life products

Life insurance - euro based 77% Automobile 36%

Life insurance - unit linked 16% Bodily injury 16%

Bodily injury (accident, health) 4% Property – personal 12%

Capital redemption bonds 3% Property - commercial 12%

Property – agriculture 2%

Miscellaneous 7%

General liability (1) 6%

Construction (2) 4%

Natural disasters 3%

MAT (3) 2%

Total 100% Total 100%

Main Distribution channels

Life Business Non-life Business

Multiple intermediaries (Brokers) 13% 18%

Tied agents and employees 7% 35%

Salaried sales associates 16% 2%

Financial Institutions 62% 8%

Direct writing company - 3%

Others 2% 34%

Total 100% 100%

In France, more than 65% of total gross premia relate to life products (see Figure 4). Of these premia related to life products, 77% are traditional products (euro based) and only 16% are unit linked (although these products have become more popular in recent years). There is a wide range of non-life products available, with motor insurance constituting the main component of the market. The channels of distribution for both life and non-life products are diverse. Financial institutions (mainly banks) are the main distribution channel in the life segment, while tied agents are the most important distribution channel in the non-life segment. According to the CEA, intense competition among distributors is leading to a consolidation in the brokerage field, forcing insurance companies to restructure tied agency networks and spurring the development of alternative distribution channels.

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Table 2: Germany Life products Non-life products

Endowment 46% Motor insurance 41%

Annuity 26% Property 26%

Unit linked (capital and annuity) 14% General Liability 12%

Group insurance 10% Accident 11%

Term 4% Others (legal expenses, marine, credit) 10%

Total 100% Total 100%

Main Distribution channels

Multiple intermediaries (Brokers) 20%

Tied agents and employees 70%

Direct Marketing 3%

Others 7%

Total 100%

The German insurance market is relatively evenly distributed between life (45%) and non-life (55%) segments. Endowments (guaranteed products) represent the bulk of life products, with unit-linked products having a share similar to that in France. Similar to France also, motor insurance represents the biggest share of the non-life segment. It is notable that the distribution channels for insurance products in Germany are rather concentrated, with the bulk of products distributed by tied agents and employees. Table 3: The Netherlands

Life products Non-life products

Pensions 25% Accident and health 50%

Deferred annuities 15% Motor vehicle 20%

Direct 11% Fire 14%

Mortgages 9% Transport 3%

Others 40% Others 13%

Total 100% Total 100%

Main Distribution channels

Life Business Non-life Business

Multiple intermediaries (Brokers) 54% 50%

Tied agents and employees 15% -

Banks 21% 11%

Direct Marketing 10% 32%

Others - 7%

Total 100% 100%

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The Netherland insurance market is more or less equally split between the life and the non-life segments. In the life segment, there is no dominant product although pensions represent the largest share. In the non-life segment, health and accident insurance is the most popular product, followed by motor insurance. The distribution channels are dominated by three main actors: brokers (which are the most important), direct marketing (which is relatively developed in comparison with other EU countries) and banks. Table 4: Sweden

Life products Non-life products

Unit linked 44% Business & house owner 21%

Occupational pension 37% Householder & homeowner 17%

Others 19% Motor third party (TPL) 17%

Other motor 18%

Accident and health 23%

Others 4%

Total 100% Total 100%

Main Distribution channels

Life Business Non-life Business

NA NA

The share of life segment in the Swedish insurance market is almost 65%. Another prominent feature of the life-segment is the high share of unit-linked products. Property policies are the most popular non-life products (38%) followed by motor insurance (35%) and accident and health products (23%).

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Table 5: United Kingdom Life products Non-life products

Life insurance 36% Motor 31%

Individual pensions 28% Property 29%

Group pensions 34% Accident and health 1) 14%

Income protection and critical illness 2% General liability 14%

Pecuniary loss 12%

Total 100% Total 100%

Main Distribution channels

Personal lines

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Commercial lines

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Other

Affinity groups

Direct

Banks

Company agents

Other intermediaries andbrokers

National, chain and telebrokers

The UK insurance market is also characterized by a very high share in the life segment (69%) of the total market. Pension products (for individuals and groups) represent over 60% of the life segment. The remainder of the life market is mainly allocated to life insurance products. The non-life segment is dominated by motor and property insurance. Brokers still play a dominant role within the commercial product lines (although there is evidence of change). In retail product lines, brokers have already lost significant market share to direct marketing channels, banks and affinity groups.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Other

Affinity groups

Direct

Banks

Company agents

Other intermediaries andbrokers

National, chain and telebrokers

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The investment behaviour of insurance companies in these Member States also differs considerably. In the Netherlands, 40% of the assets are invested in debt securities and other fixed-income securities and slightly less than 30% in equities and other variable-yield securities. The remainder (between 10 and 15%) is allocated mainly in loans (including loans guaranteed by mortgages). In Germany, 50% of investment is allocated to loans, while equities and variable-yield securities represent about 20%. In contrast with all other Member States, German insurers invest only marginally in fixed income securities (around 10%). Meanwhile, insurers in France invest the bulk of their assets in fixed-income securities (almost 70%) and the remaining 20% in equities, leaving portfolios among the least diversified in the EU. Insurer investment patterns are broadly similar in the United Kingdom and Sweden, with portfolios allocated more or less equally (about 40%) between fixed-income securities and equities. Figure 8: Categories of investments for selected countries

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

DE FR UK NL SE CEA

Investments by categories, 2004

(a) (b) (c) (d) (e) (f) (g)

(a) Land and buildings and participating interests (b) Investments in affiliated undertakings and participating interests (c) Shares and other variable-yield securities and units in unit trusts (d) Debt securities and other fixed-income securities (e) Loans, including loans guaranteed by mortgages (f) Deposits with credit institutions (g) Other investments Source: CEA

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3 Impact of Solvency II on the EU insurance sector Section 2 illustrates the extent of diversity in national insurance sectors across the EU and highlights the various "starting points" in different Member States in the context of the regulatory reforms implied by Solvency II. Allowing for this difference in starting points, this section examines the possible effects of Solvency II on the EU insurance sector14. This is the first stage in the schematic framework of analysis (see yellow column in Annex 1 of this document) and is based on a Level 1 Directive (i.e. principle-based legislative proposal). As many of the detailed elements of the Directive are not yet available, the analysis is substantially inspired by the experience of the Swiss Solvency Test15 which has many parallels with the Solvency II project.

3.1 Impact on capital requirements and excess capital The first direct effects of a new regulatory capital regime implied by Solvency II would relate to the assessment of technical provisions and capital requirements, and particularly excess capital. The impact of Solvency II on overall capital requirements will depend on the starting point (e.g. legal environment, supervisory culture etc.) in the Member State and the risk profile of both individual insurers and insurance sectors. Accordingly, the initial effect on capital requirements is likely to vary significantly across Member States but will derive from the balance sheet structure proposed under Solvency II, which is presented schematically in Figure 9. Figure 9: Balance sheet structure under Solvency II

Excess Capital

Solvency Capital Requirement

Market consistent Value of Assets

Market consistent Value of Insurance

and Other Liabilities

Assets Liabilities

14 It is not the purpose of this note to present a comprehensive overview of the Solvency II regulation. The focus rather lies on the expected impact of such a regulation. For a more extensive presentation of the regulation please refer to "Solvency II - proposal for a framework directive". 15 This section is also inspired by a study published by Swiss Re: "Solvency II: an integrated risk approach for European insurers", Sigma N°4, 2006, Swiss Re.

18

The main principles with respect to balance sheet structure and capital requirements under Solvency II are: • Insurance and reinsurance companies are required to maintain technical provisions16,

according to the value of their insurance liabilities. These provisions will be calculated according to methods and parameters, which will be modernized and harmonized throughout the EU.

• Insurers and reinsurers will be required to hold at all times enough capital (i.e. essentially an excess of assets over liabilities) to meet the Solvency Capital Requirement17 (SCR) and to serve as a buffer against unexpected losses. The amount of required capital will be calculated, either in accordance with a standard formula, or using an internal model possibly reflecting better the individual characteristics of the company and its risk profile.

Solvency II builds on a "total balance-sheet" approach in which technical provisions and SCR add up to total capital needs of the insurance company. In meeting such needs, the insurance company is required to hold at least an equivalent amount of assets of sufficient quality18. The amount of asset holdings over and above these capital needs is termed excess capital. Accordingly, the net impact of Solvency II on the financial position of the EU insurance industry - the excess capital in particular - will stem from changes in the assessment of all three components of the balance sheet - technical provisions, SCR and assets.

3.1.1 Balance sheet structure and the level of capital requirements Assessment of the likely impact of Solvency II on balance sheet structure is based on the results of the QIS 1 and 2 exercises19. However, the objective of these exercises was to test the structural design of Solvency II so their implications for balance-sheet structure must be treated with some caution.20 Under Solvency II, the calculation of technical provisions should be based on available market information for the valuation of insurance liabilities. An important change introduced by Solvency II would be use of the risk-free interest rate term structure for discounting technical provisions, which in not the case under Solvency I in several Member States (e.g. France, Italy, Germany). Discounting technical provisions using a market interest rate instead of a maximum guaranteed rate would imply a significant decline in valuation. The Solvency Capital Requirement (SCR) under Solvency II is expected to better reflect the true risk profile of the insurance company than the current regime by capturing more risks, such as, mortality-longevity risk, catastrophe risk, credit risk, market risk, operational risk. This could lead to additional capital requirements, although the use of risk mitigation tools such as diversification and reinsurance could allow insurers to lower their overall risk profile.

16 Technical provisions = the regulatory valuation of insurance liabilities. In Figure 9 they are included in "other liabilities". 17 Note that the regulation will also foresee a Minimum Capital Requirement (MCR). The MCR reflects a level of capital below which the operations of an undertaking represent an unacceptable risk to policyholders. If basic own funds fall below the MCR, ultimate supervisory action is triggered. In other words, as part of the SCR, the MCR is the lower bound that, once breached, triggers the intervention of supervisors. 18 I.e. invested in accordance with the prudent person principle, relying on good asset management practices, rather than in accordance with general quantitative prescriptions and they should be selected on the basis of their economic ability to absorb risk. 19 QIS 1was an exercise for the valuation of technical provisions; QIS2 was testing different options for the SCR and MCR. 20 When considering QIS 2 results, some caveats listed in the QIS 2 report should be borne in mind.

19

QIS 2 results indicate a different balance-sheet impact for the life and the non-life segments. The SCR for the non-life segment is likely to be significantly higher than the current level (2 to 4 times the current minimum) because Solvency II would demand higher capital charges for "low-frequency, high-severity" risks. The SCR for the life segment should be closer to the current level (0.5 to 3 times the current minimum). On balance, the QIS 2 results indicate that the EU insurance sector holds enough capital to withstand these balance-sheet adjustments. The situation varies across Member States, with some having already developed their own risk-based capital requirements (such as the UK and Netherlands) and moved in the same direction as Solvency II. For individual insurers, the change in capital requirements linked to Solvency II will very much depend on the starting point, i.e. the prudential supervisory environment and the insurer's specific risk profile. As the existing regulation does not really discriminate between risk profiles, Solvency II will probably lead to increase capital requirements for some companies and a decline for others. Insurers exposed to investment risk, insufficient portfolio diversification, disability and surrender risks, may be confronted with higher capital requirements, while insurers with a conservative investment strategy, resorting to reinsurance and writing retail insurance policies may need less capital. Accordingly, large insurance firms or groups, with well diversified insurance portfolios (e.g. geographical diversification) will face relatively lower capital requirements than small mono-line companies, exposed to one type of risk concentrated in one region (although they will try to manage their risk actively). Therefore, a decline in capital requirements would be expected in relatively large companies, while the effect on capital requirements for small and medium-sized firms is more difficult to predict. The choice of risk evaluation model will have important implications for the capital requirements of individual insurers. Insurers will be generally free to choose between a standard formula and an internal model. Specialised firms, for which the standard formula would be likely to underestimate their risk profile, could be required to build an internal model. As internal models are expected to result in lower SCR than the standard formula, there will be strong incentives to use internal models21. For insurers using an internal model, the supervisory review process will need to take account of control and model risks and will need to demonstrate the extent to which the internal model(s) appropriately reflects the actual amount of required capital. Where incentives to implement an internal model are not strong enough, insurers will opt to calculate their SCR using the standard formula. Firms using the standard formula will need to assess the extent to which it adequately captures their particular risk exposures, while setting-up internal control, risk management and governance systems (Pillar Two measures) and decide if internal model would not be more appropriate. The design of the standard formula would be crucial as the extent of risks and their interdependencies should be appropriately assessed. It cannot be excluded that a poorly designed formula would create some financial stability risk, by increasing the risk of default of an insurer and the risk of contagion to other insurers (see Section 4.4.2).

21 See also, CEA, "Results and discussions on the impact assessment of future Solvency II framework on insurance products and markets", February 2007. This study shows that only 5% of large insurers and 52% of smaller insurers intend to use the standard approach.

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3.1.2 Volatility of capital requirements The new rules for calculation of capital requirements under Solvency II could induce more volatility in capital requirements. Under existing rules, the required solvency margin is essentially calculated on the basis of collected premia, claims and technical provisions. As a result, changes in the capital requirements mainly reflect changes in the volume of business written by the company. Under Solvency II, the calculation of capital requirements will be based on the assessment of the insurance company risk profile using updated market information. Therefore, the amount of capital required may change substantially from year to year, depending on changes in the risk profile of the insurer and financial-market developments. This phenomenon is expected to be more marked for companies using an internal model, since internal modelling should reflect the risk profile of an insurer even more accurately than the standard formula. A particular source of volatility in capital requirements would be changes investment-risk exposure (e.g. equity vs. bond allocation), in operational-risk exposure (e.g. fraud, mis-selling, IT issues) or in underwriting-risk exposure (e.g. changes in the business mix), which will be assessed at least once per year. The overall risk profile will take into account the correlation between these different types of risks, which may also change in the medium to long term. It is worthwhile highlighting some cases where capital requirements may become particularly volatile under Solvency II. The introduction of risk-related capital charges for both underwriting and investment risks could result in more stringent capital requirements for products with a high claims volatility (e.g. certain property covers), long-term products and products with guarantee and option features. One-off transfers of required capital to lines of business showing a higher risk exposure could take place. In other words, a reallocation of capital compared to the current situation could be observed (although the overall amount of capital required in the sector would not necessarily change). The direction of the shifts in capital allocations would be from "high-frequency, low-severity" to "low-frequency, high-severity" lines of business. Those reallocations could occur either within the company or from one company to another and would depend on the company's business model. (see Section 3.4) As a general conclusion, it is likely that insurers will choose to hold additional capital as a buffer in response to increased volatility in capital requirements under Solvency II.

3.2 Valuation of assets and liabilities and portfolio reallocation In the risk-based economic approach implied by Solvency II, assets and liabilities would be valued as closely as possible to their true economic value, i.e. marked to market. Indeed, Solvency II is expected to emphasise the importance of realistic balance-sheet valuation as the foundation for the development of a risk-based capital regulatory regime. To this end, Solvency II should – as far as possible – provide prudential valuation standards for assets and liabilities for insurance undertakings. These standards should be compatible with the accounting rules elaborated by the International Accounting Standards Board (IASB). The IASB is currently working on an "Insurance Contracts" project (which concerns measurement of insurance liabilities for accounting purposes) and the final standards will not be known for some time yet. For the purpose of this analysis, we assume market-consistent valuation of

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assets and financial liabilities, based on the information provided in "Amended Framework for Consultation on Solvency II"22. The value of assets held by insurers will be affected by a move to a mark-to-market valuation in several ways.

First, the average value of the total balance sheet may change in comparison with amortised historical cost accounting. For example, the current low level of interest rates would imply an upward revision in the value of fixed income assets bought with higher yields, while the valuation of intangible assets could decline in value. However, QIS 2 suggests that the new prudential valuation standards should have a positive overall impact on the amount of available solvency capital, as it is likely to reduce technical provisions and increase asset valuations. 23

Second, the implementation of market consistent/fair value accounting24 of financial

assets may give incentives to investment managers, particularly in the case of life-insurance policies, to focus excessively on short-term investment results. The market value of assets, at any given time, may not provide the best estimate of their intrinsic value and so result in a distorted view of the long-term financial health of an insurer. This is especially true for long-dated assets where the value may be particularly sensitive to short-term market developments (and which are likely to constitute a major part of the investment portfolio of an insurer for reasons of assets-liability management).

Third, capital charges for investment risk may encourage insurers to shift to safe

investment especially when the expected financial returns of risky assets do not offset the additional capital requirement.25 In this context, insurers could reduce the share of equity and real estate in their portfolio and switch to high-rated bonds, in order to reduce their SCR. Again, the direction and amount of portfolio reallocation will depend on the initial structure of the insurer's investment and insurance portfolios. However, as insurers are aware of changing regulation and have been rebalancing their portfolios accordingly, there should not be any significant sudden portfolio reallocations in the transition period. (See: Potential Impact of Solvency II on Financial Stability, ECB 2007) Another possibility to reduce investment risk would be hedging, either by natural means or by using derivatives. Insurance companies could hedge their exposure to investment risk e.g. by buying put options for equities or buying swaptions to reduce interest-rate risk. Alternatively, insurers with a high share of long-term, guaranteed products could improve their asset-liabilities matching, which is a cheaper means to reduce interest-rate risk than buying swaptions (See Section 4.3). The cost26 of identifying and developing hedging strategy may be prohibitively high for smaller insurers.27

The impact of assets revaluation and portfolio reallocation will vary from Member State to Member State, depending on the overall investment pattern of their national insurance sectors

22 MARKT/2515/06, www.ec.europa.eu/internal_market/insurance/docs/markt-2506-04/framework-cons_en.pdf 23 The extent of those variations should be seen against the background of interest rate conditions. 24 When market valuation is not possible, assets should be valued following the fair value accounting principles. 25 In the context of the whole portfolio, i.e. including the possible diversification benefits. 26 Mainly personal and software. 27 However, smaller companies with the need for lower amounts of long-term fixed income assets for ALM would be able to meet those needs more easily than larger insurers.

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i.e. the distribution of variable-yield versus fixed-income holdings (See Section 2). Moreover, portfolio reallocation may vary across Member States because the exact criteria for assets-liabilities matching are laid down in domestic legislation even though current EU legislation determines which categories of assets are eligible to cover technical provisions. Rebalancing of the investment portfolio will also depend on the stage of development and integration of financial markets. In countries where more sophisticated products are not yet available, the possibility of hedging will be limited, unless they are well integrated with other more developed markets. Life insurers offering long-term guaranteed products in countries where the supply of long-dated (e.g. more than 10YTM) is scarce would have to provide higher solvency capital because of an unavoidable maturity mismatch in their assets and liabilities. In terms of currency risk, the euro-area and non-euro area Member States must be distinguished. Insurers from the euro area enjoy access to a large, liquid and developed financial market, where they can more easily access securities matching their liabilities without taking into account currency exposure. Insurers outside the euro area (particularly in Member States with small financial markets) do not enjoy the opportunities and will face either additional capital charges for currency risk or will be required to hedge that currency risk at additional cost.

3.3 Greater transparency and market discipline Solvency II should achieve greater supervisory convergence across the EU insurance sector. This will help to ensure that there is a level playing field for all insurers and should provide a common standard for protection to all EU consumers regardless of the insurers’ legal form, size or location. Convergence in supervisory practices should imply enhanced transparency and disclosure among insurers across the EU. Solvency II is expected to require that insurance and reinsurance companies provide the supervisory authorities with information on internal governance provisions, risk models, scenario testing, and other internal procedures as well as financial and investment information (so-called Pillar Two measures). Consequently, supervisors will be provided with a more complete picture of the solvency situation of the insurer and therefore should be able to react to any deterioration in the solvency position and take corrective actions. This additional information could improve the timing of intervention by supervisors, particularly in relation to an insurer experiencing a deteriorating solvency position. Solvency II is also expected to require supervisors to work much more on risk assessment of individual insurers and on decisions regarding ultimate supervisory action.28 Under Solvency II, there will be specific measures requiring public reporting and disclosure as a means to enhance market discipline (Pillar Three measures). Regulated insurers will be required to make key information available to financial markets. Greater transparency should help shareholders and potential shareholders to understand risk exposures and accurately value the company by reducing information asymmetry. To the extent that potential investors are more confident in the state of their financial health, insurers should find it easier to raise capital. Nevertheless, there may be additional costs in complying with Pillar Three provisions. The current very different levels of transparency required in the Member States implies that compliance costs will vary among insurers but, for cross-border providers, there will be offsetting savings from more convergent transparency requirements across the EU.

28 These features should positively contribute to enhancing financial stability (see Section 4.4). This would also require additional resources for the supervisors (see Report on the Impact of Solvency II on Supervisory Authorities, CEIOPS 2007).

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3.4 Industry structure and business model The greater emphasis on the risk measurement and management implied by Solvency II can be expected to impact on the structure of the EU insurance sector and on business models pursued by insurers. By linking the amount of required capital with the level of risk, Solvency II should eventually result in a more efficient allocation of capital across lines of business and enhanced competition in the provision of insurance products. To this end, insurers will have a stronger incentive to seek the best premium/risk profile combination and optimal scale of operation, which is likely to induce structural changes in the sector. Insurance companies will also need to critically analyse individual products (risks covered, guarantees, pricing, options etc.) and the impact of product features on their SCR. A comprehensive revision of some business models (product design, marketing and sales, asset-liability management) could be expected. While these changes will impose adjustment costs, it should be remembered that the financial sector is in a process of continuous change and changes in the insurance sector must be seen in this context. Indeed, regulatory reform is not the only driver of upgraded risk management in the insurance sector, where shareholder activism, pressure from ratings agencies and intensified competition are also relevant.

3.4.1 Organisational structure and processes In order to minimise operational risk under Solvency II, insurers would need to adapt their activities to eliminate potential "weak links" in their organisation. Since capital requirements should be determined on a group basis, minimising operational risk may mean that branches become more specialised in their activities or develop entirely new business lines (e.g. create specialised distribution companies that sell brand and white-labelled29 products). Insurers will also need to decide whether to be a product provider or to focus on distribution and tailoring existing products for customers. In such a context, insurers could opt to focus more on core competencies and no longer pursue an integrated business model30. Insurers may also have incentives to consolidate further, as the implementation of Solvency II could require substantial investment in data collection, IT and risk management systems and expertise. Similarly, strengthening risk management will give rise to fixed compliance costs which are likely to fall more heavily on small firms. While this effect should be smoothed by applying the proportionality principle (limited reporting requirements for small firms), the higher weight of compliance costs for small firms could be a further driver of consolidation. Moreover, the use of relatively sophisticated internal models for risk management could ensure lower regulatory capital requirements - and a consequent pricing advantage – for bigger insurers.

29 White-labelling occurs when a supplier packages an existing product or produces new products for another company with that company's own label. For white-labelled services, a provider re-brands processes with the name of the user firm. Customers of the user firm believe that it is the user firm that is providing the service and not a third party. 30 This scenario is not very likely in the short term but could materialize in the longer term.

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3.4.2 Insurance product design and prices 31 A revision of product design in some insurance segments is a likely outcome of Solvency II, implying a change in the range and/or prices of products offered.32 In this process, insurers might review profit sharing arrangements and the need for options and long-term guarantees. They might introduce terms and conditions, which allow for adjustment (like indexation of premiums to inflation or regular review of the annuity conversion rate), guarantees to consumers may be reduced and surrender value terms changed. Other possible approaches to risk mitigation via product design would include offering combined risk products, extending the risk base to benefit from better diversification, hedging risks, passing them on to the reinsurers, or securitisation. The type and scope of modifications to product design would be likely to vary from insurer to insurer. Life insurers, focusing on traditional guaranteed products, could be more affected than those who offer mainly unit-linked products (See Section 2) and could face a trade-off between modifying their product design and accepting an additional capital charge. In the case of life product modifications, it should be noted that modifications could mean the transfer of investment and longevity risk to households (see Section 4.4.1). In the non-life sector, similar changes in product design could be observed, especially for "high severity, low frequency" lines of business (e.g. professional third-party liability insurance and natural catastrophes insurance). Again, insurers could decide to transfer more risk to policyholders, for instance by reducing the scope or extent of the coverage they provide (see Section 4.1). Since the sunk costs of product design are independent of an insurer's size, smaller companies are likely to bear relatively higher costs in this process. The need for modifications in product design due to Solvency II would vary across Member States, depending on the stage of development of the market and its characteristics. In Member States with relatively undeveloped markets (where the non-life segment dominates and the bulk of non-life business is motor insurance, i.e. "high-frequency, low-severity") the need for product re-design could be relatively less pronounced, as such products require less capital backing. In Member States where the markets are relatively developed and mature (with high insurance penetration ratio, a large life-segment and a wide range of products) the need for product redesign could be greater (see Section 2). Solvency II could also impact on the price of insurance products. Under the existing regulatory rules, insurers tend to price their products on two levels. First, they price products according to economic value, with the use of actuarial techniques. Second, they price products according to their position on the market compared with the competitors' prices. Solvency II would mean a shift to more "risk-based" pricing. While insurers might try to limit the impact on prices by redesigning products, price increases (potentially significant) could be unavoidable, especially for "low-frequency, high-severity" risks. In extreme cases (especially for non-life insurance), some products might disappear from the market because consumers would be unwilling to pay the required price. The opposite could be the case for products covering "high-frequency, low-severity" risk, where the reduced capital requirement and competitive pressure could lead to lower prices. More accurate product pricing could also 31 See also, CEA, Results and discussion on the impact assessment of the future Solvency II framework on insurance products and markets, February 2007. 32 From an insurer's point of view, these two elements are interrelated as changes in product's features involve changes in prices. However, for presentational purposes (and sequential relation to Section 4) the product design and the prices variations are discussed as two separate issues.

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give the industry less incentives for cross-subsidisation between market segments and could encourage greater product differentiation and market segmentation. It is, however, difficult to predict the overall effect of Solvency II on product prices. Cross-border prices comparability is constrained by the absence of harmonized definitions, so that apparently similar products can differ in terms of risks covered, conditions, built-in options, indexation, eligibility, fiscal incentives attached to them, etc. As Solvency II is not expected to create "uniform" products, product comparisons across countries would remain problematic. Nevertheless, the improvement in policyholder information and transparency implied by Solvency II should at least strengthen competition at the national level. In a transition period, "new" products could be developed progressively and, even though they would gain market share, they will coexist with the more established ones. For non-life products, the transition period would probably be relatively short since the average duration of contract is shorter. For life products, the transition period could be much longer, because of longer-term contractual arrangements.

3.5 Overall impact of Solvency II on insurance sector Solvency II should improve risk management and therefore enhance risk-adequate pricing in the EU insurance sector. The sector should become healthier, as a result of the better alignment of risks and capital requirements. Insurers should also be more adequately rewarded for diversification and for using risk mitigation tools which are key ingredients of risk management. Eventually, a more efficient allocation of capital in the economy and a greater stability in financial performance of insurance companies should be achieved. The improved stability of the sector should contribute to policyholder protection and enhance competition in the market. The implications of these changes in the insurance sector for the performance of the EU economy and broader financial sector are discussed in the following section.

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4 Impact of Solvency II on the EU economy and financial sector

This section explores the possible consequences of internal changes in the EU insurance sector due to Solvency II for the rest of the economy (See blue and green columns of the table in Annex 1 of this document). Quantifying the importance of insurance availability to the performance of the economy is not straightforward. As a result, existing empirical evidence in the economic literature is rather mixed33, mostly because of the difficulty in isolating the effect of insurance from the general economic environment (including financial market development). The findings of Outreville (1990)34 suggest that economic development in developing countries is supply driven by the availability of insurance products (property-liability insurance) and the degree of financial development. Similarly, Webb, Grace and Skipper (2002)35 established that insurers contribute to economic growth by facilitating an efficient allocation of capital. For the period 1980-1996 and 55 countries (including many EU countries), they find evidence that bank and insurance (life and property-liability) penetrations are robustly predictive of increase in productivity. Their results also suggest that higher levels of banking and insurance penetration jointly produce a greater effect on growth than would be indicated by the sum of their individual contributions. For the UK and using disaggregated data36, Kugler and Ofoghi (2005)37 show a long run relationship between insurance market size development and economic growth rather than a cyclical effect. However, the direction of the causality is not clear. For some products, they find that UK insurance availability is demand-led but supply-led for others. Finally, Adams et al (2006)38 investigates the historical relation between banking, insurance and economic growth in Sweden over the period 1830-1998. They conclude that the development of domestic banking, but not insurance (life and non-life), preceded economic growth in Sweden during the nineteenth century, while the causality was reversed in the twentieth century. Over that period, banking seemed to be the dominant influence on both economic growth and the demand for insurance. Another strand of literature offers a clue to the households' perspective. Examining the desire of households to avoid income volatility, Lin and Grace (2005)39 identify the relationship between financial vulnerability and the amount of term life or total life insurance purchased. Results indicate that older consumers use less life insurance to protect a certain level of financial vulnerability than the younger consumers. Also, housing seems to be a substitute for insurance purchase, while other types of financial assets are complements. Overall, although

33 This literature is moreover characterized by non-negligible problem of endogeneity. 34 Outreville, J-F., 1990, The economic significance of insurance markets in developing countries, The Journal of Risk and Insurance, 1990, Vol. LVII, No. 3, 487-498. 35 Webb, I., Grace, M. and H. Skipper, 2002, The effect of banking and insurance on the growth of capital and output, Department of Risk Management and Insurance, WP 02-1, Georgia Sate University. 36 The disaggregated database includes: Life insurance with yearly and with single premia, motor, accident and health, liability, property, pecuniary loss, reinsurance and MAT (Marin, Aviation and Transport). The authors explain the mixed results found in other research by an aggregation problem, which they circumvent by using disaggregated data. 37 Kugler, M. and R. Ofoghi, 2005, Does insurance promote economic growth? Evidence from the UK, University of Southampton. 38 Adams, M., Andersson, J., Andersson, L-F. and M. Lindmark, 2006, The historical relation between banking insurance and economic growth in Sweden: 1830 to 1998, School of Business and Economics, WP SEB 2006/2, Swansea. 39 Lin, Y and M. Grace, 2005, Household life cycle protection: life insurance holdings, financial vulnerability and portfolio implications, Department of Risk Management and Insurance, WP 04-7, Georgia Sate University.

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insurance seem to gain importance as a financial asset; housing would seem to remain the dominant source of wealth and protection against income volatility. Against the background of uncertainty on the importance of insurance to economic performance and regarding the exact details of Solvency II, the evaluation of possible macroeconomic and financial effects is a hazardous task. Accordingly, the analysis in this section provides only a broad review of possible transmission channels for these broader effects of Solvency II. Two main effects are identified – a reduction in the price of risk leading to a lower cost of capital and increased access to external financing due to changes in the broader financial sector.

4.1 Changes in insurance products supply A first channel of transmission relates to the impact on all insurance policyholders (for example corporates and households) of changes in the insurance product supply. A "new insurance product supply" could have an impact on consumption, savings and investment decision (among other things). As indicated in Section 3, these changes could occur via product design modification or price variations.

4.1.1 Availability of insurance products As discussed in Section 2, the availability of certain insurance products, featuring particular characteristics, can be critical to specific economic activities. The term "availability" includes the suitability of insurance contracts for the policyholder (i.e. risks covered or not) and, to some extent, the affordability of the insurance service offered. In consequence of Solvency II, insurers could require their policyholders to convert existing policies into contracts which would better reflect the new risk environment. The emergence of new products would help individuals and firms to manage better the level of risk entailed in some economic decisions. A greater availability of insurance products could spur consumption, investment and eventually economic growth. However, it is possible that changes in capital requirements could make it unprofitable for insurers to provide certain products, resulting in the disappearance of these products from the market. The disappearance of insurance products could preclude certain economic activities, although "total disappearance" of products is unlikely as price rise (see below), product modification or "risk-sharing" solutions could be a preferred option for the insurers. 40 Overall, it is likely that policyholders would be offered a wider range of products, possibly at a better price and the products could be more flexible. As discussed in Section 3, the modifications in product design due to more accurate pricing of risk under Solvency II would be likely to result in changes in the price of insurance products in both retail and commercial segments. In this way, the effects of the new regulatory capital regime would impact on both households and businesses by changing the share of their budget allocated to insurance cover. Increased spending on insurance could crowd out spending in other areas, while reduced spending on insurance could free budgetary resources

40 In this context, it should be stressed that some insurance products could disappear from the market for reasons other than Solvency II.

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and stimulate consumption and investment. In extreme cases, price increases could be such that the buyers of the insurance product would be unwilling to pay, precluding the economic activities for which insurance cover is required. It is difficult to assess the magnitude of these price effects but, for illustrative purposes, Figure 10 presents the share of households’ budget spent on insurance products in 1999 in selected Member States. Except for the Netherlands and to some extent France, the percentage of income spent on insurance is rather marginal. Figure 10: Insurance expenses in some EU countries

Share of households budget spent on insurance products in 1999 (%)

0

2

4

6

8

10

12

EL FI PT UK ES IT LU SE DK BE AT FR NL

Source: Eurostat, Households budget survey, 1999. (2005 survey forthcoming) Drawing inferences from Figure 10 is hazardous, as there is no available data on the demand elasticity41 for insurance products and the possible substitution effects between households' expenses. However, it could reasonably be speculated that the impact of insurance price changes would be relatively less important than a proportional variation in prices of housing or food. Once again, the situation is heterogeneous across Member States suggesting that macroeconomic effects of price changes for insurance cover - however marginal – would vary across the EU. Corresponding figures for the corporate sector are difficult to find. A recent study published by ANIA provides data on the insurance-taking habits of small- and medium-sized Italian manufacturing firms42. A survey of more than 600 firms reveals that 88% of the firms have at least a P&C (property and casualty) insurance policy (fire, natural disaster, theft, etc.). It is estimated that the cost of these insurance contracts (covering on average 62.5% of their assets) amounts to 0.27% of their revenue. Similarly, 72.5% of the firms are covered for risks involving their civil liabilities (excluding car insurance) against an expense of, on average, 0.08% of their revenue. The insurance-taking habits depend on the size and the sector of the firm. Larger firms have a high probability of taking insurance and have a higher coverage as a percentage of their assets. However, their expenses as a percentage of their revenue are lower. Firms producing investment goods buy more insurance (unlike intermediary goods producer for example). Overall, the authors observe a relatively low propensity to take insurance, which is illustrated by a comparative table for some EU countries (Figure 11).

41 Possibly we face rather inelastic demand and the price effect is going to be contained by the fact that the provision of insurance is mainly supply driven. 42 Focarelli, D. and P. Zanghieri, 2006, L'assicurazione delle imprese manifatturiere, ANIA Trends, Novembre 2006 – Numero speciale.

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Figure 11: Insurance premia (P&C) for the corporate sector in 2002 (% of GDP)

Source: ANIA, 2006, p.2. As it is the case for households, it is hazardous to draw conclusions from Figure 11 on the possible impact of changes in insurance cover on corporate sector activity. Nevertheless, the relatively low share of insurance expenses relative to revenues could indicate a rather marginal potential effect. This effect could, however, vary considerably across countries as substantial heterogeneity in the insurance propensity seems to be confirmed again. Another aspect to be taken into consideration is the effect on insurance product prices of increased competition stimulated by Solvency II. In such conditions, prices could decline overall and particularly for the most competitive sectors of insurance market, i.e. the "high-frequency, low-severity" products that have lower volatility and therefore would require less capital backing (e.g. motor insurance, household insurance). In a highly competitive environment, cost savings are more likely to be transferred promptly to customers. In this case the effects for the households' disposable income would be exactly opposite to those cited for price increases. The impact on the economy in this case would depend on the households' spending decisions and possible substitution effects. If they decided to purchase additional insurance or savings products, this could translate into a stimulus for the insurance sector (and eventually possibly higher investment via capital markets and economic growth). If they decided to increase their consumption of goods and services, it could have a positive impact on the broader economy.

4.1.2 Impact of insurance price changes A possible consequence of price increase for certain insurance products could be inflation, if there were no fully compensating price declines for other insurance products. If customers would accept to pay higher prices for certain insurance products, inflation pressure could be created, in particular in the case of "mandatory" products, such as specific professional liability insurance. However, the final impact on the overall inflation will depend on demand elasticity and the weight of insurance products in the Harmonized Indices of Consumer Prices (HICP) aggregate.

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Figure 12: Weight of insurance in HICP in 2006

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

DE FR DK BE SI PL EU27

AT IT IE CY NL ES SE LU UK PT MT SK LT CZ EE LV FI HU GR BG RO

Source: Eurostat, HICP, items weights (Coicop classification), Note that the HICP basket includes house, accident, motor and other insurance (non-life). From Figure 12 it can be concluded that any changes in prices of insurance would vary significantly across Member States. Nevertheless, the size of the effect should be limited in view of the relative low weight of insurance in the inflation basket (for the EU 27 approximately 1.6%).

4.2 Impact of investment reallocation on financial markets An investment reallocation among insurers due to Solvency II (as described in Section 3) could impact on financial markets in terms of prices, volumes, volatility and liquidity.

4.2.1 Impact on asset prices The possible portfolio reallocation among insurers would inevitably involve trading that could influence asset prices. The trigger for this phenomenon would stem from modified capital charges for investment risks, which would prompt insurers to reduce their exposure to equity markets and shift toward investments with lower charges, such as fixed-income securities. Under Solvency II, each insurer will have to consider the trade-off between the expected return on its investment portfolio and the cost capital required to cover the investment risk. If the cost exceeds the expected return, the insurer will most probably try to reduce the level of investment risk, by reallocating into lower-charged investments. A sudden reallocation by all insurers would inevitably cause sharp price increase of fixed-income securities, particularly the market segments with relatively low liquidity. The rise of fixed-income prices would imply a decline in corresponding yields which, ceteris paribus, would imply a lower cost of capital. Taking into account the increased focus on assets-liabilities matching and the fact that duration of insurance portfolio in life insurance companies is quite long, the impact would be most pronounced in longer-dated securities.

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The impact on fixed-income prices could vary across the EU. Member States with relatively less-developed financial markets and/or a relatively large insurance sector investors would be most affected. To the extent the euro area bond market is relatively integrated, the impact would be less pronounced. Nevertheless, there is already evidence that the supply of long-dated bonds is insufficient to meet institutional demand. As a consequence of the Stability and Growth Pact (SGP), EU Member States have been encouraged to reduce their degree of indebtedness, thereby reducing their financing needs and bond issuance. Moreover, most governments have been reluctant to issue ultra-long bonds, limiting the supply of very long-term risk-free securities. This potential structural shortage of long-term risk-free securities could make the impact of Solvency II on bond prices even greater. On the other hand, this situation on the sovereign bond market could create room for long-duration corporate issues and could facilitate corporate sector access to capital. (See Section 4.2.2) Conversely, a reallocation of insurers’ investment portfolio would be likely to reduce demand for equities, ceteris paribus. The most liquid stocks would be affected immediately, but the most durable impact would be on less liquid stocks, for which relatively low trading volume increases the probability of significant changes in prices. Price volatility in equities could be transmitted back to insurers balance sheets via volatility in the value of their assets (and related capital held for investment risk), making them even less willing to hold this kind of equity. In the longer term, the decline of equity prices could impede access to new capital for companies, possibly undermining new investment in the economy. In the household sector, it could cause negative wealth effects43 either directly or indirectly via holdings in pension funds. Again, the impact on equity prices would probably vary across Member States and would depend on the relative size of insurer's equity holdings compared to the size of the total equity market. Finally, there could be an impact on property prices. The investment risk of property is mainly related to its lack of liquidity and problems with valuation. Since Solvency II will probably require capital charge for property, some switching by insurers’ from property investment to lower-charged securities would be expected. As in the case of bonds and equities, this could cause some decline in property prices and in the prices of securities linked to property (real estate funds). However, given the relatively low share of property in insurers' portfolios (see Figure 5, Section 2.2), the effect should not be significant. In general, the likely impact on asset prices described above could be overestimated, as insurers could already be anticipating Solvency II as well as IFRS and adjusting their portfolios to take account of the new risk assessment principles. On this basis, changes in prices would be smoothed over a longer period of time and there should not be any sudden price changes in either direction on the implementation of Solvency II. (see also: Potential Impact of Solvency II on Financial Stability, ECB 2007)

4.2.2 Deepening of the euro area bond market As explained in the above paragraphs, Solvency II is expected to favour more conservative investments thus contributing to a higher demand for instruments such as sovereign bonds. A

43 Wealth effects are the implications for household consumption of a change in the wealth (financial or housing). Agents tend to consume more when they feel "richer" (see also Section 4.4.1)

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possible mismatch between the demand and the supply for longer-dated sovereign bond could create room for high-rated long-term corporate issuance. Moreover, if the yields in the long-end of the yield curve fall significantly, it could be expected to boost the supply in this sector. Insurers could be willing to invest in relatively high-rated corporate bonds since they offer higher yield, are only slightly more risky than the benchmark and would provide diversification benefits within the fixed income portfolio. Therefore, easier access to financing could be granted to firms with high credit ratings. As mentioned above, increased demand for bonds and lower yields would, ceteris paribus, translate into a lower cost of capital and should therefore contribute to higher investment and economic growth. In addition, a developed corporate bond market diversifies access to corporate financing, eventually leading to a more efficient capital allocation44 and enhanced financial stability.

4.3 Impact on competition in the insurance sector The calculations of capital requirements under Solvency II will probably be conducted on the basis of a group-based approach. This group-based approach could have a substantial effect on Mergers and Acquisitions (M&A) activity. Insurers might be willing to create groups with optimal (from the capital requirement point of view) risk profile, which could spur M&A activities (see Section 2.2. for concentration figures). Another factor spurring M&A could be the significant resources necessary for setting up and maintaining an internal risk-assessment model. Insurers would need data not only for determining the value of assets and liabilities, but also to calculate the size of risks and their interdependencies. New or more sophisticated IT systems could be necessary to run the capital requirement calculation and the designated scenarios. However, some companies have already implemented the risk-based system, which could smooth the transition. (See Section 3.4) The initial effect of the new regulation will depend both on the financial position and size of the company. Those insurers for which recalculation of the value of assets, SCR and technical provisions will have little effect would be less likely to look for merger opportunities. On the other hand, the insurer whose balance sheet is negatively affected would most probably look for opportunity of merger or leaving the business. Those scenarios could be more likely in the case of small companies, less able to benefit either from diversification or group based calculation methods. The retreat from the market would also be more likely for the commercial insurance ("low-frequency, high-severity") as the capital requirement will be set on the higher level for these types of risks. Another possible outcome are mergers between retail and commercial insurers in order to create more diversified portfolio that will result in lower overall capital required. In the long run and against the background of globalizing financial markets, small insurers, independently of the financial position, could be looking for merger opportunities, as it would improve their balance sheet and take an advantage of the economies of scale, which would further improve their use of capital. Moreover, as (re)insurers could be seeking markets with higher growth rates than in the home market and a more efficient allocation of capital across the EU; more cross-border activities could take place. Besides the common supervisory standards (Pillar One: capital requirement), Solvency II will harmonise supervisory practices (Pillar Two), hence, creating a level playing field for companies across the EU. As a result, enhanced competition and an increase in cross-border

44 ECB, The Euro Bond Market Study, December 2004.

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M&A could be expected to create a better integrated single market in insurance services. This could give consumers access to a wider range of more competitively priced products. For example, increased transparency in pricing the same types of risks could enhance price comparisons of insurance products and possible increase the competition among insurers. However, price decreases would not be straightforward as the European insurance market would probably remain segmented as a consequence of existing legal barriers (corporate or consumer protection law) at the national level and lack of harmonisation of insurance products. The competitive advantage would be mainly for risk management activities (see also Section 3.4).

4.4 Impact on risk exposures In addition to portfolio reallocation, insurers would be likely to react to Solvency II by seeking to transfer investment risk45 from their balance sheets to other parties. This section examines the various means for this transfer and the likely implications for households, capital markets and the reinsurance sector.

4.4.1 Transferring risks from insurers to other economic agents Unit-linked products For life-insurance providers, the most direct means of transferring investment risk from their balance sheets would be wider use of unit-linked products, which tie a policyholder's return directly to the return on the underlying investment. This operation could create a situation where some economic agents "a priori less able/knowledgeable to manage risk" would be more exposed to investment risk than in the current situation. However, as unit-linked products offer insurers lower profit margins, they would be likely to continue to offer some guaranteed products but with built-in options to limit their risk exposure. In the longer term, this trend could result in the unbundling of products, with insurers offering only insurance cover and any savings element in policies being directed towards mutual funds. Life insurance is an important (and still growing) financial instrument for household's savings. In view of the growing uncertainty concerning pension systems in many European countries, individuals may recourse more and more to the insurance sector as a complement/substitute for the public pension. In particular, the demand for unit-linked policies has been increasing recently across Europe, amid increased awareness of longevity risk and buoyancy in equity markets. To the extent that increased investment risk exposure could lead to temporary volatility in household wealth, there could be macro-economic effects (financial wealth effects). For example, more direct risk exposure may influence households' consumption although theory predicts that it is more sensitive to changes in permanent income than to temporary shocks. In European countries (and contrary to the US), the propensity to increase consumption (investment) from a financial wealth effect is not very

45 The investment risk is defined as the potential for the investment return to fluctuate - increase or decrease - in value from year to year. All investments carry some risk, but some carry more than others. In order to obtain higher returns, the investor needs to be comfortable with accepting a higher level of risk in his portfolio holding. Investment risk is attached to insurance investment products but also to comparable financial investments such as: investment in mutual funds, pension funds or directly on stock markets.

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strong and lower than in the case of housing wealth effect46. Nevertheless, there is evidence that uncertainty and financial risk can have an impact on high-wealth households. Hence, on the aggregate level, the modifications of households' behaviour or spending should not be substantial in the short run and the eventual macro-economic impact via consumption and savings could be reasonably expected to be marginal. In the longer run, in parallel with the expansion of unit-linked products (and equities holding in general), these wealth effects could become stronger. Securitisation A means for both life and non-life insurers to transfer risk would be through securitization, whereby the income stream from insurance premia is repackaged as securities and sold on the capital markets. To date, use of securitisation in the insurance sector has been mainly confined to re-insurers as a means to increase their capacity to absorb risk from direct insurance companies (mainly on commercial lines). If the market develops, i.e. new participants appear and liquidity is increased, securitization could allow insurers to absorb an ever broader range of risks and manage their capital more efficiently. Both life and non-life industries could have an incentive to transfer the risk away from their balance sheets to capital markets; however there will be differences in the purpose and tools used.

For the non-life sector there is a variety of mechanisms for transferring risk and managing capital. The tools include traditional reinsurance, catastrophe bonds (cat bonds), cat swaps, contingent capital and others. Catastrophe bonds transfer peak risks to the capital markets, while catastrophe swaps offer an exchange of a series of fixed, predefined payments for a series of floating payments whose values depend on the occurrence of an insured event. Contingent capital addresses capital needs through risk financing rather than risk transfer and is based on the mechanics of "put options". It provides the buyer with the right to issue and sell securities at a fixed period of time if a predefined event occurs. The structure chosen depends on the specific needs of the protection buyer and the availability of fixed-income investors to support the structure.

Life insurers most often use non-cat (life) bonds as a financing vehicle. The life sector

has quite a long payback period (when underwriting the policy, the agent commissions and underwriting costs must be paid) and needs this type of financing in order to use its capital efficiently. Life bonds typically securitize the flow of future premium payments of traditional life insurance policies. The burden of life insurance risks, such as mortality and lapse risk, are assumed by the investors. As a result, life insurers can use capital markets as a means to finance the acquisition costs and other origination expenses. It all contributes to achieving a higher return on equity (ROE) for the insurance business and increases ability to write new business.

On this basis, it can be argued that Solvency II provides incentives for greater use of capital markets as outlets for risk transfer, it could contribute to higher efficiency of the sector and (via ROE) higher growth. Insurance-linked securities will be able to improve capital and risk management for insurers, lowering the cost of insurance to consumers and making it more 46 Altissimo, F., Georgiou, E., Sastre, T., Valderrama, M-T., Sterne, G., Stocker, M., Weth, M., Whelan, K. and A. Willman, Wealth and asset price effects on economic activity, 2005, ECB Occasional Paper N°29. Please note that there is also substantial heterogeneity across EU countries.

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available. Nevertheless, securitization (any form of it) involves costs. The costs can be divided into capital costs (at which the issuing company is able to raise capital) and structuring costs (fees to lawyers, costs of advisors, actuarial consultants etc.). Structuring costs decline with the number of transactions done, therefore we would expect large insurance groups to be using it most extensively. Nonetheless, as the market matures smaller transactions become feasible and ease the issuance of this type of securities. This increased supply by insurers could be matched by increased demand from financial intermediaries (hedge funds, investment funds etc.). Insurance-linked securities (ILS) are an attractive tool of achieving diversification benefits of fixed income portfolios. Since corporate bonds carry credit risk, while cat bonds carry natural catastrophe risk, the correlation of these two different fixed-income asset classes is negligible. Hence, the addition of cat bonds to a portfolio improves the performance and lowers the risk of the portfolio. On the other hand, if supply of ILS increases rapidly, it could outstrip demand. Investors could require wider spreads, at least until their interest catches up with supply. In terms of financial stability, securitization could reduce the volatility of insurance pricing cycles47 by providing an ongoing window into pricing of risk. This would provide insurers with more certainty and allow them to plan better their activities and investments. Even more importantly securitization gives wider range of risk mitigation tools and increases insurance sector's growth capacity by making capital available for high frequency risks and protecting against extreme losses from "low-frequency, high-severity" risks. Securitization offloads these risks to the fixed-income market, which has enormous capacity compared to the (re)insurance industry. However, the complexity of those specific financial instruments, used to diversify and mitigate risks, would make the identification of the final risk bearer less obvious. Households are typically the ultimate holders of these securities via pension funds, mutual funds and banking products. This could have implications for financial stability. (see: Potential Impact of Solvency II on Financial Stability", ECB 2007) Hedging Another strategy for insurers to manage investment risk post-Solvency II would be hedging, implying increased demand for alternative instruments and notably derivative products. The demand for derivatives (i.e. structured products) among insurers might also rise in response to a structural shortage of fixed-income securities. This phenomenon would be positive for innovation and diversification in the financial system, while the implied risk transfer and increased returns on capital could make the insurance sector more resilient and financially stable. To the extent that any risk transfer implies a redistribution of risk to a broader range of investors rather than an increase in overall amount of risk, the stability of the financial system might also be enhanced. Reinsurance Solvency II could create more opportunities for companies to use reinsurance efficiently while Solvency I did not recognize the use of reinsurance. It is also likely to make reinsurance decisions more critical and complex as there are now additional issues to consider.

47 Insurance pricing cycle has two basic phases: soft market, when prices are relatively low leading insurers to produce breakeven profitability results or even operating losses, and hard market, where insurance prices are relatively high and profitability of the sector rises.

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Reinsurance is a transfer of part of an insurer's risk to another insurer which has no direct contractual relationship with the policyholder. A direct insurer uses and needs reinsurance to limit annual fluctuations in the losses borne and to be protected in case of catastrophe. Direct insurers can transfer large individual risks (e.g. risk linked to natural catastrophes) or whole portfolios (e.g. motor insurance). The reinsurer is directly exposed to these risks but diversifies by pooling risks across regions and branches. This diversification allows the reinsurer to charge less than the cost of the regulatory capital cost linked to the investment risk on the primary insurer's balance sheet. By allowing primary insurers to manage their risks and capital in the most efficient way reinsurance makes insurance more secure and less expensive. At the same time, it broadens the range of products and coverage primary insurers can offer. Reinsurance is used widely in the non-life sector, while its use in the life sector remains marginal. From the Solvency II perspective, reinsurance will probably be an effective risk-management measure, which could provide substantial capital relief. If the insurer can underwrite more business for the same amount of (required) capital, he could achieve higher ROE. Therefore, the demand for reinsurance is expected to grow after the new solvency regulation comes into force or possibly before, in anticipation of the regulation. In practical terms, primary insurers will need to consider how much capital relief reinsurance can provide, how reinsurance can support business plans and strategies and how much this support will cost. Insurance companies will likely be weighing the cost of reinsurance against alternative sources of capital, such as traditional shareholder capital and its incumbent expected return on invested capital or capital provided by debt instruments. Besides its role as a provider of capital relief, reinsurance plays an important role in strengthening the financial stability. Firstly, reinsurance helps insurers to limit the annual fluctuations in the losses. Secondly, companies that have stronger risk management capabilities (i.e. those that use adequate reinsurance tools) are less likely to default on insurance obligations. Solvency II undoubtedly acknowledges the stabilising effect of reinsurance by giving credit for its use at the moment of calculating SCR. A possible higher risk concentration within the reinsurance sector could raise some concerns in terms of financial stability. Nevertheless, it should be noted that reinsurance sector has its own risk mitigation tools (retrocession and securitisation) and is, by regulation, limited in the amount of risks it takes on its balance sheets. This could result in reinsurance capacity limitation. Therefore, additional demand for reinsurance could result in appearance of new entrants in the reinsurance sector, which should enhance competition in the sector, assure even better risk diversification and, possibly, reduce prices.

4.4.2 Contagion effects48 Financial markets and various financial intermediaries are exposed to the insurance sector. The insurance sector is indeed an important institutional investor and it uses extensively numerous financial instruments to export its risk outside the sector. Inter-linkages via financial instruments and portfolio holdings with the banking sector, pension funds, hedge funds, etc. are substantial. Hence, one important issue could be a possible contagion effect among all these financial actors. To the extent that Solvency II encourages the insurance to

48 This issue shortly presented in this subsection is elaborated further in: Potential Impact of Solvency II on Financial Stability", ECB 2007.

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"get rid" of the risk and that those repackaged and sold risks are held in portfolios of other financial intermediaries, the risk of systemic contagion could be real. In particular, the banking sector could be exposed. A significant convergence in the regulatory frameworks for banks and insurance is currently observed. Basel II and Solvency II are expected to share many common principles and approaches such as the 3 Pillars principle or the valuation of risk. This similarity could lower the resilience of the banking sector as a growing number of financial intermediaries could follow the same risk management strategy. Moreover, to the extent that insurers operate a risk transfer back to policy holder (households and firms), banks could be exposed to some additional credit risk. Along the same lines, the financial markets could be faced with a substantial cohort of financial intermediaries (bankers and insurers) that are supposed to satisfy the same regulatory principles and therefore possibly look for the same type of long-term safe investment or try to reallocate their investment portfolio in a similar way and at the same time. In other words, herding behaviour could take place, "overload" financial markets and possibly trigger second-round effects. Another "contagion effect" could arise because of the possible pro-cyclical nature of the supervisory regulations. For example, in a period of economic downturn, insurers could consider that the risk of loans default increases and therefore adjust accordingly (upwards) the risk premia charged on loan-insurance policies; thereby increasing the cost for the policyholder (possibly leading to non-insurance). Finally, it is worthwhile drawing attention to the special case of bank-insurance conglomerates. Although, there is no perfect level-playing field yet, the increasing consistency in supervisory practices could spur the creation of bank-insurance conglomerates (which is actually already observed as a growing trend). Regulators should make sure the same standard apply to both banks and insurers in order to avoid regulatory arbitrage opportunities.

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5 Conclusion This note has tried to review the various channels through which the implementation of a new solvency regulation in the insurance sector could affect the economy. It is very difficult to draw conclusion at this stage, while the details of the implementing legislation and the first exercise of calibration (QIS 3) for the quantitative requirements are not yet available. Accordingly, the analysis has focused on qualitative macro-economic impacts. The main impact of Solvency II on insurance sector should be an improvement of risk management and therefore a more adequate risk pricing. The sector should become healthier, as a result of the better alignment of risks and capital requirements. Eventually, a more efficient allocation of capital in the economy and a greater stability in financial performance of insurance companies should be achieved. The improved resilience of the sector should contribute to policyholder protection and enhance competition in the market. The possible consequences of internal changes in the EU insurance sector due to Solvency II will have an impact on the rest of the economy. Based on a preliminary review of the various transmission channels, it would appear that the direct macroeconomic effect of Solvency II would be rather marginal. It is likely that policyholders would be offered a wider range of products, possibly at a better price and the products could be more flexible. Nevertheless, the relatively low share of insurance expenses relative to budget constraints both for household and corporate sector could indicate a rather marginal potential effect. Moreover, the impact of a change in insurance availability to the performance of the economy is not clear-cut. As far as financial markets are concerned, two main positive effects are identified: a possible reduction in the price of risk leading to a lower cost of capital and an increased access to external financing due to changes in financial sector (additional demand for long-term fixed income assets). However, other implications of Solvency II could be less favourable, such as reallocation of investment risk among economic agents, possibly leading to macro-economic effects. On balance, the net macroeconomic impact would seem to be neutral or possibly slightly positive. Overall, the major challenge in designing Solvency II will be in assessing and monitoring of the stability enhancing properties of the new regulation.

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Annex 1

Changes within the insurance sector following on regulation of Solvency

II

Transmission channels outside the insurance sector

Implications for the insurance business

Possible reaction of the insurance companies

Agents and markets affected Macro-economic aggregates “growth”

Agents and markets affected

Financial stability risks

Corporates Investment / Profitability / Inflation

Households Investment / Consumption / Savings / Inflation

Corporates Investment, Profitability, Survival of certain types of economic activities

Corporates

Households Investment / Consumption / Savings

Households

Insurance sector Increased volatility of capital requirements

Bonds market

Equities market

Possible restructuring Insurance sector Possible consolidation / Competitiveness

Corporates Investment, Profitability

Households Consumption, Savings

Second round effect: contagion, procyclicality and herding behaviour

Financial intermediaries (including banks)

Contagion, Systemic risk

Other financial instruments

Macro-economic impact

Possible transfer of risks to policyholders

Risk transfer, Liquidity, Volatility, etc Potential stability effects

Liquidity, Volume, Price, Volatility, Interest rates Impact on growth via impact on cost of capital/ access to finance/ financial markets integration Financial intermediaries

(including banks) Contagion effects, reduction of risk sharing among the banking and insurance sector

Impact on insurance product supply

Insurance product design and diversification

Investment of insurance companies

Structure of the insurance sector and competition

Reallocation of financial assets

“Wealth effect” for the insurance takers

Price effect

Insurance sector and whole economy

Macro-economic environment

Types of effects observed

Effects of Solvency II: Synthetic table

Better risk management Impact on capital requirements, assets and liabilities valuations, transparency and market discipline of the sector, industry structure and business model

Possible transmission channels (comprehensive overview)

Financial markets

Financial stability impact (*)

Indirect effects

(*) These effects are only partially discussed in this note. For further detail please refer to "Potential Impact of Solvency II on Financial Stability", ECB, 2007.