Les assureurs européens et plus encore britanniques doivent-ils s’inquiéter du Brexit ? Tout dépend de leur exposition à la livre, de la part de leurs activités au Royaume-Uni et de leur ratio de solvabilité actuel, celui-ci étant sujet à une plus forte volatilité. Mais, au global, l’impact devrait rester limité par rapport à celui sur le secteur bancaire.
Brexit will likely have limited impact for UK insurers. Our rationale is based on the strong resilience of insurers to a potential slowdown in the economy because of the compulsory nature of most insurance products and the limited impact on the potential fall in value of their investments (in particular for Life insurers). During the financial crisis of 2008 to 2010, the insurance sector demonstrated its resilience to the financial crisis because of the insurers' strong levels of liquidity. In the article below, we highlight five risks as a consequence of Brexit: (i) a weaker demand for insurance products, (ii) a sharp fall in the value of UK investments, (iii) the devaluation of the Sterling, (iv) regulatory changes for UK insurers and (v) the consequences of the loss of the European passporting rights for UK insurers. We believe that the investment and the devaluation of the Sterling are the most important risks for European insurers.
UK insurers with a strong UK focus and a relatively lean Solvency II margin are likely to be at risk in the event of a slowdown of the UK economy and the devaluation of the Sterling compared with other currencies. Legal & General and RSA come to our attention. European insurers with large UK operations could be at risk in the event of a slowdown of the UK economy and the devaluation of the British Pound. Ageas, Zurich Insurance and Talanx seem to be the most at risk.
In contrast, a potential devaluation of the Sterling relative to other currencies will be beneficial for UK insurers that have significant operating entities outside of the UK. Pru plc, Aviva, Society of Lloyd's and RSA are likely to benefit from this situation.
In the event of a continuing slowdown of the UK economy, UK insurers could become a defensive sector compared with UK banks. Our view is supported by the compulsory nature of insurance products and the fact that UK insurers would not have to relocate their operations to a European jurisdiction if the UK were to lose their European passporting rights (i.e. ability to sell products from the UK to European jurisdictions).
A resilient European sector
During the financial crisis of 2008-2010, the insurance sector has demonstrated its resilience compared with banks. Only a few had some financial concerns while numerous banks faced severe financial difficulties and some went bankrupt. In Europe, Aegon received the support of the Dutch state through a €3 bn loan while Ethias was rescued due to its significant stake in Dexia, a European bank that had liquidity problems. In the case of Aegon, the insurer is predominantly US driven considering its large and significant operations in North America, which still represent c. two-third of its revenues; the insurer's financial difficulties stemmed from its exposure to Variable Annuities in the US (i.e. capital market risks associated with such products) and increase in lapses.
The insurance sector is resilient to financial crisis due to (i) its reverse cycle of production and (ii) the compulsory nature of most insurance products. The reverse cycle of production that characterises the insurance industry makes it resilient to financial crisis given the abundance of liquidity. Furthermore, in a sluggish economy, insurers tend to benefit from the continuing strong demand for insurance products. This is particularly true in the P&C segment; in most jurisdictions, Motor and Property insurance products are compulsory. Policyholders may opt for reduced coverage, which in turn will translate into lower revenues; but, in most cases, the decline in revenues is immaterial. In Life, Protection and Pensions products also tend to be compulsory but their demand is more dependent on the cycle of the economy.
Insurers face five main risks
We admit it is difficult to have a strong view on the consequences of the UK referendum on European insurers. A good summary of the consequences of the referendum could be found in an article published on the last page of Reactions' publication dated July/August 2016: "Mocha Re chief executive and chairman Sir Norbert "Nobby" Johnson, has stunned the reinsurance world by announcing his resignation following the Brexit referendum result. […] I was planning on retiring in a few years' time, and spending my remaining days in Tuscany at my home there. I now realise that this will be severely impacted by Britain being out of the EU, with the possibility of my forced repatriation to Surrey, where Chianti will double in price, and Cognac will go through the roof. If Lady Johnson and I were able to stay in the villa, my pension will be worth half its value thanks to the weak pound. And I expect passporting rights for our two Labradors to travel freely to Europe will also be curtailed. So I am getting over there sharpish while we're still in the EU and try to enjoy what I can – and meanwhile hope for a second referendum", he explained.
We can highlight five main risks as a consequence of the UK leaving the European Union ("EU"): (i) a weaker demand for insurance products, (ii) a sharp fall in the value of UK investments, (iii) the devaluation of the Sterling, (iv) regulatory changes in the UK and (v) the consequences of the loss of the European passporting rights for UK insurers.
From a demand perspective, considering the compulsory nature of most insurance products, we do not expect a sharp decline in demand if the UK were to face a slowdown in its economy.
Regarding the risk associated to a sharp fall in the value of UK assets, UK P&C insurers will be more at risk than pure Life players. Our rationale is based on the fact that, in Life, the investment income is shared between policyholders and shareholders; for traditional with profit Life products without guaranteed rates or with relatively low guaranteed rates, the split is usually 90 %-10 % (90 % for the policyholders and 10 % for the shareholders). Therefore, most of the decline in value of the assets would mainly be carried by policyholders. In P&C, the investment risk is fully borne by shareholders; as a consequence, it is therefore our view that P&C insurers are more vulnerable to a sharp fall in the value of their investments.
Among the reinsurers, Munich Re is the most exposed to UK investments. Among Primary insurers excluding UK insurers, Zurich Insurance seems to be the most exposed with a gross exposure of $27 bn; nevertheless, since we do not have the split between Life and P&C, it is difficult to estimate the insurer's net exposure to shareholders. Among the UK insurers, Aviva is the most exposed on a net basis (net of policyholders' exposure) with a £15,991 mn. The Society of Lloyd's is the second most exposed on a gross and net exposure considering its P&C focus; it disclosed an exposure of £9,662 mn. In the case of Prudential plc, most of the equity exposure relates to Unit-Linked products; the risk is carried by the policyholdersand not the insurer.
Interestingly, Legal & General is the least exposed insurer with a net exposure of only £1,351 mn (see Table 1). Instead, the majority of L&G's shareholder backed investments are in North America and Europe (see Table 2), which means its investment portfolio could benefit from Sterling devaluation. Compared with their shareholders' equity, we believe that Aviva and Standard Life are the most vulnerable on a net basis.
A potential devaluation of the Sterling relative to other currencies will be beneficial for UK insurers that have significant operating entities outside of the UK (e.g. Pru plc, Aviva, Society of Lloyd's and RSA) but detrimental to European and US insurers with exposure to the UK (e.g. Ageas and Zurich). If insurers hedge their foreign exchange risk from a revenues perspective (i.e. hedge the cash-flow streams from their future earnings), we believe that they will still be vulnerable to the decline in value of the investments of their UK subsidiaries. The decline in the value of the assets due to the devaluation of the Sterling compared with the currency of the group company will be reflected in their shareholders' equity (decline in the AFS valuation reserve).
European reinsurers like Munich Re and Swiss Re will be the most at risk considering the importance of their UK revenues. Primary insurers such as Ageas, Zurich Insurance and Talanx are are the most exposed to the UK. Nevertheless, we are less concerned about Aegon's exposure to the UK market as the company has significantly scaled down its UK exposure recently.
In the short-to-medium term, we do not expect a substantial change in the prudential regulation for UK insurers. Indeed, we believe that they will continue to report their solvency margins under Solvency II. Hence, we see limited regulatory risk for UK insurers.
The key point of European passporting rights
The consequence of a potential loss of the European passporting rights, which allow an insurer in any European jurisdiction to operate and sell insurance products across all European jurisdictions without having the need of setting up a subsidiary or branch locally, will have limited consequences for UK players. Our view is supported by the fact that most UK insurers already have local operating subsidiaries with local staff; a very good example could be found in Aviva's European organisation chart with subsidiaries in France and Italy. Compared with banks, we think that the loss of the European passporting rights will be less dramatic for insurers; banks usually have massive trading activities in the UK from where they sell cash and derivative products to their European customers.
The recent observed volatility in capital markets following the UK referendum on 23 June 2016 has led to an increase in volatility in the value of assets. This situation has led to volatile Solvency II ratios. For example, Legal & General disclosed that following the UK referendum, its Solvency II margin fell by 13 pp to 156 % at the close of 27 June 2016. Prospectively, we believe that UK insurers will likely present volatile Solvency II margins reflecting the current and prospective likely volatility in capital markets. From this perspective, we expect UK insurers to be more at risk than their European peers. Since Solvency II margins are difficult to compare due to the use of (i) internal models and (ii) transitional rules, we believe it is difficult to comment on the Solvency II margins because they are not comparable from one insurer to the other. Nevertheless, UK insurers that present a relatively weak Solvency II ratio from a quantitative or qualitative perspective are likely to be the most at risk: RSA (Solvency II ratio of 143 % at year-end 2015) and Legal & General (Solvency II ratio of 169 % inflated by the insurer's VIF).
The UK insurance sector to become a defensive sector
Compared with UK banks that may face some major organisational changes in their capital market activities if they were to lose the European passport to sell their products, we believe that UK insurers could become a defensive sector in the UK. Our view is supported by the resilience of the insurance sector to financial crisis and the compulsory nature of insurance policies.
Based on the 5-Year Subordinated CDS spreads, it appears that the spreads of UK insurers have not materially widened relative to banks. In fact, only the spreads of Barclays and RBS have widened significantly over the past six months.
In the very short-term, we see limited consequences for UK insurers as it will certainly take time for the UK to quit the EU; the UK has a two-year time period to endorse the referendum. And so many things could happen until then… The current monetary policy from the ECB might be more of a challenge for European insurers than the consequences of Brexit for UK based insurers.