POLICYBRIEF ISSUE 4 | DECEMBER 2016 EUROPEAN UNION AND HOW TO GET THERE

Dirk Schoenmaker Internationalisation of insurance, gross written premiums of European insurers

Senior Fellow at Bruegel 65% 60% 55% International business 50% 45% 40% National business 35% 30% 25% 20%

Source: Bruegel. Note: Gross written premiums (GWP) of top 25 insurers in Europe split into GWP written on domestic markets and GWP written on other European and rest of the world markets. See Figure 2 on page 4, and footnote 3.

THE ISSUE The full entry into force at the start of 2016 of the European Union’s Solvency II risk- based capital framework for insurance poses new challenges for supervisory coop- eration in Europe. Supervisory challenges are present in terms of both management of systemic risk and day-to-day supervision. The common vulnerability of insurers to market risks, in particular the current low interest rate, is a source of systemic risk, and while supervisors might cooperate in day-to-day supervision, cooperation, such as exchange of information and coordinated action, can run less smoothly in times of crisis. Furthermore, risks are present in the context of a European insurance sector that is highly integrated, with a large and rising share of cross-border business.

THE POLICY CHALLENGE The European Insurance and Occupational Pensions Supervisory Authority (EIOPA) currently plays a coordinating role in supervision, with final authority remaining with the national supervisors. A more centralised role for EIOPA in a European insurance union would overcome the fragmentation in supervision and ensure a joined-up view of the large cross-border insurance groups, enhancing the effectiveness of supervision. However, a staggered approach can be followed in a move towards insurance union. In the first stage, EIOPA can be given the authority to foster supervisory convergence. Ulti- mately, EIOPA would be given direct powers to supervise significant insurance groups, within a network of national insurance supervisors. 2 POLICY BRIEF EUROPEAN INSURANCE UNION AND HOW TO GET THEREΜ

1. INTRODUCTION 2. THE EUROPEAN INSURANCE LANDSCAPE The full entry into force at the start of 2016 of the European Union’s Solvency The single market enables insurance II risk-based capital framework1 for companies to establish branches in other insurance poses new challenges for European Union countries based on supervisory cooperation in Europe. home-country control. Host countries National supervisors must cooperate have only to be notified about the in the approval and monitoring of establishment of cross-border branches. international models used by large The proportion of non-domestically cross-border insurance groups. The owned insurers in EU countries increased European Insurance and Occupational from 44 percent in 2007 to 54 percent Pension Authority (EIOPA) plays an to 2012 (Figure 1). The global financial important coordination role, but cannot crisis of 2008-09 and the European settle disagreements between national sovereign crisis in 2010-11 did not supervisors. lead to a reduction in cross-border Supervisory challenges are present in insurance, in contrast to banking (Hüttl terms of both management of systemic and Schoenmaker, 2016). Branches risk and day-to-day supervision. The and subsidiaries in EU countries are set common vulnerability of insurers to up mainly by insurers from other EU market risks, in particular the current countries (80 percent) with a minor part low interest rate, is a source of systemic from third countries (20 percent). risk, and while supervisors might cooperate in day-to-day supervision, Figure 1: Cross-border penetration in 1. The Solvency II Directive cooperation, such as exchange of European insurance, 2007-12 (2009/138/EC). See: http:// information and coordinated action, 100% ec.europa.eu/finance/ can run less smoothly in times of crisis. 90% insurance/solvency/ 21% 22% 22% 23% 24% 25% solvency2/index_en.htm. Risks are present in the context of a 80% European insurance sector that is highly 70% 2. As defined by the Financial integrated, with a large and rising share 23% 23% 23% 22% 29% Stability Board (FSB) in of cross-border business. On average, 60% 29% consultation with the 50% International Association EU insurance groups conduct 60 percent of Insurance Supervisors of their business outside their home 40% (IAIS). See FSB, 2015. The country, rising to about 70 percent for 30% 56% 56% 55% 55% G-SII (global systemically large insurers. Europe is home to more 47% 46% 20% important insurers) list is globally systemic insurers2 than the updated annually. The FSB 10% Americas or Asia, and European insurers and IAIS are also working 0% on the designation of global are larger than their American or Asian 2007 2008 2009 2010 2011 2012 systemically important re- counterparts measured by gross written Domestic Foreign subsidiaries insurers. premiums. As the large insurers have become Foreign branches 3. Gross written premium: pan-European players, the supervisory Source: Bruegel based on Schoenmaker and Sass (2016). Note: total premium written Number of foreign subsidiaries and branches as share of total by an insurer minus balance is tilting from coordination number of insurance companies and foreign branches in the reinsurance premiums and towards centralisation in a possible European Union. The share is calculated for the aggregated EU commissions. For the full insurance union. This raises a number insurance system. methodology for measuring of questions. What are the arguments for geographic segmentation, see and against centralisation of insurance Schoenmaker and Sass (2016). supervision? What would be the scope of We can gauge the depth of the

4. We include the Swiss a possible insurance union? What would European single insurance market by insurers, which have the right the legal basis be? How rapid should splitting the gross written premium of establishment in the EU the move to insurance union be? In this (GWP) of the largest insurers into the under the Bilateral Insurance Policy Brief we set out to answer these assets held in the home country, the rest Agreement of 1989 between questions. of Europe and third countries3. Table 1 the EU and Switzerland. EU 4 insurers have a reciprocal lists the top 30 insurers in Europe and right of establishment in shows that 41 percent of GWP is earned Switzerland. in the home country, 31 percent in the 3 POLICY BRIEF EUROPEAN INSURANCE UNION AND HOW TO GET THEREΜ

rest of Europe and 28 percent in the rest of players with only about 30 percent of the world. The three largest insurers, AXA, business at home and about 50 percent in and Generali, are truly European the rest of Europe.

Table 1: Top 30 insurance groups in Europe by gross written premium (GWP), end-2015

GWP Total assets Rest of Rest of Insurance groups Country Home (€ millions) (€ millions) Europe world AXA FR € 91,938 € 887,070 26% 40% 34% Allianz DE € 76,723 € 848,942 25% 52% 23% Generali IT € 70,323 € 500,549 34% 60% 6% Prudential UK € 49,715 € 525,125 24% 0% 76% Zurich Insurance CH € 43,717 € 351,682 9% 33% 58% Group Lloyds UK € 36,192 € 113,482 18% 14% 68% Talanx-HDI DE € 31,799 € 152,760 29% 31% 40% CNP Assurances FR € 31,760 € 393,732 78% 12% 10% Credit Agricole FR € 31,200 € 342,214 81% 16% 3% Assurances Aviva UK € 30,202 € 526,331 45% 37% 18% BNP FR € 28,000 € 167,316 41% 36% 23% MAPFRE ES € 22,312 € 63,489 34% 61% 5% Chubb ACE CH € 21,467 € 94,193 3% 11% 86% AEGON NL € 20,311 € 415,729 17% 30% 53% NL € 19,922 € 92,917 94% 6% 0% Poste Vita IT € 18,238 € 105,712 100% 0% 0% ERGO DE € 16,535 € 128,777 73% 27% 0% Unipol Gruppo IT € 15,565 € 89,773 100% 0% 0% Finanziario R+V Versicherung DE € 14,536 € 91,254 30% 50% 20% Groupama FR € 13,465 € 107,295 73% 27% 0% SCOR FR € 13,421 € 41,605 15% 26% 59% CH € 13,040 € 174,018 56% 38% 6% Societe Generale FR € 11,910 € 111,312 82% 18% 0% Insurance Cooperatie VGZ NL € 10,755 € 7,674 100% 0% 0% XL Group UK € 9,898 € 54,029 20% 26% 54% RSA UK € 9,447 € 27,968 44% 26% 30% BE € 9,359 € 104,486 55% 41% 4% NN Group NL € 9,205 € 162,152 76% 13% 11% Vienna Insurance AT € 9,020 € 41,939 45% 55% 0% Group Legal & General UK € 8,707 € 540,635 78% 10% 12% Top 30 insurers in € 788,681 € 7,264,160 41% 31% 28% Europe

Source: Bruegel based on annual reports.

Table 2: Geographical segmentation of top 30 banks and insurers in Europe, 2015

Home Rest of region Rest of world Top 30 banks 54% 23% 23% Top 30 insurers 41% 31% 28%

Source: Banks from Schoenmaker (2016) and insurers from Table 1. 4 POLICY BRIEF EUROPEAN INSURANCE UNION AND HOW TO GET THEREΜ

Figure 2: Geographical segmentation of GWP of top 25 insurers in Europe, 2000-15

60%

50%

40%

30%

20%

10%

0%

Home Region Global

Source: Updated from Schoenmaker and Sass (2016). Note: Calculations are made on a weighted average basis.

Figure 2 summarises the GWP Ireland is an international insurance data, showing that the home share has centre, with domestic business reduced from 46 percent in 2000 to only amounting to only 4 percent of GWP. 40 percent in 2015, while the regional The majority of insurers in Ireland share from the rest of Europe has slightly are subsidiaries of large international increased from 30 percent to 31 percent insurance parents; some of which over the same period. Finally, the rest of are part of financial conglomerates the world share has increased over the domiciled in the EU (IMF, 2015). In other last few years and is catching up with the EU countries, the domestic share of GWP regional share. ranges from 16 percent (Luxembourg) to It is interesting to examine geographic 88 percent (Slovenia) with an average of segmentation of insurance premiums 64 percent5. compared to the internationalisation Again, we can compare foreign of the banking system, measured by penetration in the banking and insurance assets. It appears that insurers are more markets. Schoenmaker and Sass (2016) international than banks (Table 2). find that the component of business 5. A full assessment can be While banks conduct 54 percent of their from other EU countries is far higher in found in Schoenmaker and business at home and 23 percent in the insurance (29 percent) than in banking Sass (2016). rest of Europe and the rest of the world, (17 percent). The single market in

6. The domino effect is present insurers only write 41 percent of their insurance is thus more intensified than in in re-insurance, as primary business at home. banking. insurers are connected with In terms of foreign-written premium in re-insurers. EU countries as a percentage of the total 3. RISKS IN INSURANCE GWP of each country’s insurance sector, 7. Insurers are exposed whether domestically or foreign-owned, 3.1 SYSTEMIC RISKS to banks through several linkages at the asset side: the extent of inward claims coming from cash holdings at banks, loans the EU is fairly high at 29 percent of total Contagion risks arise from the intercon- to banks and bank securities country GWP. From non-EU countries, nectedness of the financial system (De (both debt and equity). In the the share is only 7 percent. Some central Bandt and Hartmann, 2002). But the , for example, and eastern European countries, such as domino effect from the failure of one the aggregate exposure of the insurance sector to banks the Czech Republic, Estonia, Hungary and institution leading to the failure of others amounts to only 7 percent of Slovakia, have limited domestic insurance is less strong in the insurance sector total insurance assets (Dutch sectors and are very internationally compared to banks, because insurance Central Bureau for Statistics). oriented with more than 80 percent of companies are far less connected6,7. Moreover, the concentration GWP written by foreign entities. As in A key source of systemic risk for risk rules stimulate insurers banking, these countries are served by insurance is common exposure to market to keep the exposure to individual banks within 3 insurers from western Europe (Hüttl and risks (see also IMF, 2016). When the percent. Schoenmaker, 2016). maturity of assets and liabilities is not 5 POLICY BRIEF EUROPEAN INSURANCE UNION AND HOW TO GET THEREΜ

fully matched, insurance companies the capital rules would thus increase pro- are subject to interest rate risk. The low cyclicality. The Solvency II framework has interest rate environment at the time of a two tier capital requirement to provide writing brings into question the viability supervisors with a “supervisory ladder of of insurance companies, in particular intervention”. Supervisors treat the breach life insurers, which have long-term of the higher capital threshold, the liabilities. Furthermore, Solvency II regular Solvency Capital Requirement forces insurers to value their assets at (SCR), as an indication that the market value, which makes the insurance financial soundness of the undertaking sector pro-cyclical. When equity or is deteriorating. In such a case, the commodities prices rise, for example, insurance company must submit a insurers’ equity capital goes up and vice recovery plan to return to its regular versa. In addition, insurers might switch SCR within six months. Breaches of the between investment categories at the lower threshold, the Minimum Capital same time, for example in the search for Requirement (MCR) trigger very strict yield in the low interest rate environment. recovery planning. If that is not complied By contrast, insurers might collectively with, the company will be closed down. sell their riskier assets in a flight to safety We recommend applying the room during crises. A potential fire sale of between the SCR and the MCR in a assets would lead to a downward spiral in macro-prudential way (De Vries et asset prices. al, 2015). In an economic upturn, the Supervisors could stress test the supervisor should require an insurer resilience of insurers against potential to return to its SCR within a very short adverse market developments and period. By contrast, in an economic could extract conclusions to support the downturn, the supervisor should give stability of the financial system. Stress the insurer more time. Solvency II allows tests are scenario-based and forward for an extension of up to seven years in looking, which is useful because most exceptional adverse situations that effect supervisory tools are static (how much insurance companies with a significant capital does an insurer need against market share9. today’s risks) or even backward-looking Finally, the insurance sector has a (regulatory reporting on positions in the common exposure to non-financial last quarter or year). shocks that play out in the long term, EIOPA’s 2016 stress test is its third such as changes in life expectancy following stress tests in 2011 and 2014. and climate change. On the latter, the The 2016 stress test is based on a ‘double insurance sector is exposed to the

8. Different from the hit’ scenario, in which, in addition to physical risk of more natural disasters, earlier stress tests, only solo low interest rates, assets prices are also and also to the transition from a high- insurance companies are stressed (EIOPA, 2016a and 2016b). carbon to a low-carbon economy. Such subjected to the stress test to The national insurance supervisors a transition is driven by stricter climate gauge the effects at the country execute the centrally agreed stress test policies, which could be brought in level. While the impact of for solo insurance companies (national suddenly, impacting asset prices: carbon- low interest rates might vary in different countries subsidiaries), after which the results are intensive assets would drop in value, (eg the share of guaranteed aggregated by EIOPA8. We recommend while low-carbon and carbon-neutral life products is country that the stress test should also be applied assets might rise in value (Schoenmaker dependent), insurance groups at group level, because insurance groups and Van Tilburg, 2016). The European aggregate internally their risks should not be regarded as a string of Systemic Risk Board suggests and manage these at solo and group level (Schoenmaker and independent subsidiaries. complementing regular stress tests with Sass, 2016). Sensitivity to market risk can also be specific carbon stress tests, incorporating reduced by making the application of carbon transition scenarios (ASC, 2016), 9. See Articles 138(4) and regulation less pro-cyclical. In the new including late and sudden transition 218(3) of the Solvency II risk-sensitive capital framework, capital scenarios. When the stress test results Directive (2009/138/EC) charges are automatically lower in good flag up vulnerabilities, insurers and http://eur-lex.europa. eu/legal-content/EN/ times, when perceived risk is lower, and supervisors should take remedial action. TXT/?uri=CELEX:32009L0138. higher in bad times. Micro-application of 6 POLICY BRIEF EUROPEAN INSURANCE UNION AND HOW TO GET THEREΜ

3.2 MICRO-LEVEL RISKS10 at subsidiaries, whether foreign or domestic. This might not be freely At the micro level, supervisors are con- available within the insurance group. cerned with risks faced by individual Insurance groups can thus be confronted insurers. However, only 64 percent of with different pockets of ring-fenced business in EU countries is under the excess capital, which they cannot use for direct control of the home supervisor the group as a whole12. and 29 percent under the control of host These supervisory challenges supervisors (see section 2). For the three clearly indicate a need for home and biggest insurers, the share controlled host supervisors to cooperate, but this by EU host supervisors is even larger cooperation might be hampered when at about 50 percent of GWP. The large interests diverge, in particular during cross-border shares suggest that there crises13. As supervisors are accountable 10. This sub-section draws on could be risks that might not appear on to their finance ministries and/or Schoenmaker and Sass (2016). home supervisors’ radars insofar as they parliaments, their primary focus is 11. Freshfields Bruckhaus originate abroad. serving the national interest, including Deringer (2003), examined Most cross-border insurance is carried that of national policyholders. They to what extent separation of out through subsidiaries, which are thus put the health of the separate legal personalities and limited separate legal entities that carry both subsidiaries in their own jurisdictions liability of subsidiaries can help reduce contagion risk the assets and the liabilities on the same above the health of insurance groups 11 within a financial group. They balance sheet , meaning the assets are as a whole. But insurance groups run find that such legal firewalls available for settling insurance claims in their businesses on an integrated basis. can help protect against direct countries where an insurer does business. As there can be group contagion (see contagion (credit exposures Nevertheless, for efficiency reasons, large section 2), there is a strong case for arising from intragroup insurance groups perform integrated group supervision and a group capital transactions or operational risk from sharing of services) asset and risk management at group level requirement, complementing national 14 but are less effective against (Schoenmaker and Sass, 2016). When a supervision and capital requirements . indirect contagion (reputation local subsidiary needs asset management Currently, EIOPA coordinates the risk and funding risk). This is expertise, there is often an internal supervision of international insurance because indirect contagion consultancy requirement to ‘buy’ that groups. EIOPA takes the lead in setting arises from perceptions and behaviour of (potential) expertise from headquarters, where asset secondary rules and harmonising EU counterparties and other and liability management policies are supervisory practices, in particular market participants. The developed and executed. with regard to Solvency II. EIOPA also strategy of most major banks This could raise issues around the participates in the so-called supervisory and insurers of developing and approval of internal models under colleges of the relevant home and host maintaining a global brand Solvency II. While the host-country supervisors of cross-border insurance reinforces contagion risk. supervisor has control over the assets groups, in order to contribute to their 12. Cerutti and Schmieder and operations of foreign subsidiaries efficient functioning and to foster (2014) provide examples of in its jurisdiction, the design and rollout coherent application of EU law. how ring-fencing can lead to of an insurance group’s internal model In the case of, for example, extra capital needs in financial are typically done at the head office, disagreement on the group internal institutions. and the host-country supervisor might model in the supervisory college, EIOPA 15 13. See Herring (2007) and need to rely, at least partly, on the home can give advice , but final authority rests the Annex in Hüttl and supervisor. with national supervisors. Similar, EIOPA Schoenmaker (2016) for an Another challenge in international can give guidance on the application application of game theory to regulation and supervision is the level of Solvency II Pillar 2 capital add-ons, supervisory cooperation. playing field. Even with a harmonised but national supervisors ultimately set

14. Title 3 of the Solvency II regulatory regime, supervisors might these add-ons. As we have noted, some Directive (2009/138/EC) sets interpret or apply ‘common’ rules host supervisors tend to set higher local the requirements for group differently (for example, the application capital requirements. supervision and group capital of capital add-ons in Pillar 2 of Solvency To address these supervisory requirements. II). Finally, supervisors have become challenges, we recommend that EIOPA

15. See Article 231 of more risk averse since the global should be given a stronger role in the Solvency II Directive financial crisis. They tend to require extra the supervision of large cross-border (2009/138/EC). capital beyond the regulatory minimum European insurance groups. 7 POLICY BRIEF EUROPEAN INSURANCE UNION AND HOW TO GET THEREΜ

4. THE NEED FOR SUPERVISORY supervisors participating. Furthermore, COOPERATION the ECB sets the Pillar 2 capital add-ons for the significant euro-area banks based Cooperation between national insurance on a common methodology. supervisors can be done through coor- But there is also an argument against dination, as currently, or in a centralised centralisation. Insurance, in particular way with the central European supervisor for retail clients and smaller companies, being responsible for the consolidated is local business, with products attuned supervision of insurers in Europe. In a to national tax and social security centralised system, the European super- laws. More broadly, the national legal visor and national supervisors would setting (eg liability law) is important for work together in a network on the day-to- insurance products. day supervision of insurers. Nevertheless, the rising share of cross-border insurance tilts the balance 4.1 ARGUMENTS FOR AND AGAINST from coordination to centralisation. We CENTRALISATION recommend that EIOPA should be given a strong role as centralised supervisor The ultimate aim is to supervise the to ensure joined-up supervision of large macro and micro risks in insurance in the cross-border insurance groups in a most effective way. Currently, insurance possible insurance union. supervision is in coordination mode, with EIOPA as coordinator, while banking su- 4.2 MOVING TOWARDS INSURANCE UNION pervision moved to the centralised mode in 2014, with the European Central Bank What scope would a possible insurance (ECB) as centralised supervisor. union have? The main argument for in- The argument for centralisation of surance union is that it would lead to the insurance supervision is strongest on more effective supervision of cross-bor- the micro-prudential front. Cross-border der insurance groups, which is an inter- insurance within the EU is significant at nal market argument. The appropriate 29 percent. A centralised model would scope would thus be the entire EU. By strengthen consolidated supervision of contrast, the main rationale for bank- cross-border insurance groups, including ing union was to break the doom loop by providing an integrated overview of between banks and sovereigns, which the asset and risk management functions. posed a problem for the euro area. The For insurance, the consolidation scope of ECB banking supervision within argument is stronger than for banking, the Single Supervisory Mechanism (SSM for which cross-border banking amounts Regulation; EU/1024/2013) is thus the to 17 percent. euro area, but the possibility is retained The early experience of the for non-banking union EU countries to banking union shows that centralised opt in because of the internal market in supervision can increase its effectiveness banking. It should be noted that the cur- (Schoenmaker and Véron, 2016). rent banking union is more wide-ranging Supervision of euro-area cross-border than the sole transfer of direct supervi- banking groups is conducted in a sory powers over significant insurance joined-up manner in contrasts to the groups to EIOPA in a possible insurance previous fragmented, country-by-country union. practice with supervisory colleges. Another question is the legal basis. A The key mechanism is the operation regulation conferring supervisory powers of joint supervisory teams, which for over significant insurance groups on each supervised banking group enable EIOPA can be based on Article 114 TFEU, information sharing between the ECB which refers to the proper functioning and relevant national supervisors while of the internal market. That would providing a clear line of command and be in line with the legal basis for the decision-making. The ECB heads the powers of the European Securities and joint supervisory teams, with national Markets Authority (ESMA) to supervise 8 POLICY BRIEF EUROPEAN INSURANCE UNION AND HOW TO GET THEREΜ

credit ratings agencies (Regulation EIOPA to conduct independent reviews EU/513/2011) and trade repositories of the supervisory oversight of national (Regulation EU/648/2012)16. markets. EIOPA could also be given the The move to banking union was power to approve and monitor insurance relatively swift, from decision in 2012 groups’ internal models. In the second 16. Article 8(1) of the to implementation in 2014. Banks are and final stage, EIOPA would be given Regulations establishing more sensitive to changes in confidence direct powers to supervise significant the European Supervisory than insurers, and are subject to runs. insurance groups. EIOPA would execute Authorities (EU/2093/2010; A staggered approach can therefore be these powers jointly with national EU/2094/2010; EU/2095/2010) allows these agencies “to fulfill followed in a move towards insurance insurance supervisors in a single network any other specific tasks set out union. In the first stage, EIOPA can be of insurance supervision. in this Regulation or in other given the authority to foster supervisory legislative acts”. convergence. These powers would enable

The author would like to thank Gabriel Bernardino, Maria Demertzis, Michel Heijdra, Olav Jones, Nicolas Véron and Guntram Wolff for comments and Brian Lewis for excellent research assistance.

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