Structure in context
Many insurers, including both international groups and domestic operations, have legal entity, operating and capital structures that have evolved organically over time, partly as a result of mergers and acquisitions and partly from piecemeal initiatives, often driven by considerations of tax efficiency. As a consequence, the results can be complex and unwieldy involving multiple underwriting platforms, administration and service companies, and out-dated holding and finance structures which themselves lead to inefficiencies. Such inefficiencies include dividend traps, additional regulatory and compliance burdens, fragmented reporting and increased operating costs.
Typically, a complex group will reconsider its structure only every few years, or when a major acquisition or divestment stimulates a review. A program of simplification and reorganization may follow, with legal entities being rationalized and the group structure being re-cast to match contemporary tax and regulatory requirements more closely. However, in light of the current unprecedented pace of regulatory change the world over, and the fiscal and market environment facing insurers, all three key characteristics of this pattern are now out-of-date:
- it is no longer appropriate for structure to be dictated by narrow technical considerations, or primarily by tax; it is essential that structure reflects the commercial and operating realities
- the key structural issues facing insurers are no longer simply those of legal entity structure but also those of regulatory and capital structure, the target operating model and the risk and control infrastructure
- such issues cannot be put on one side for review once every few years; instead, they need to be matters of constant concern and attention at board level.
In a nutshell then, insurers need to ensure that, as their businesses evolve to accommodate changes in the market environment, their corporate structure is aligned to the business strategy, so as to optimize the overall effectiveness and competitive positioning of the business.
Broad structural drivers
The key drivers of broad structural change currently impacting on the insurance industry (see diagram below) are:
- efficient use of capital
- effective access to markets
- operational efficiency.
The force of these drivers is being felt against the backdrop of evolving regulatory and fiscal regimes and market developments, including changing consumer demands and the emergence of new/growth markets, government intervention and investor demands. Shareholders, members and policyholders continue to demand enhanced value, whilst at the same time insurers both across the globe and in Europe must cope with increasing regulatory intensity, extra tax complexity and competition. For European businesses this competition arises internally within European markets and also from overseas.
Many insurers are also concerned to improve their group risk governance, and to address constraints in their ability to attract business – for example due to insufficient capital in insurance operations, and fragmented distribution and product offerings. All of these issues point to the need to use capital efficiently, a topic that is high on the executive agenda. Insurers are seeking to optimize the quantum, allocation and profile of their capital structure with a view to reducing the cost of capital, satisfying stakeholder demands and financing new business initiatives.
Within Europe, despite a common framework for insurance regulation underpinned by European Directives, a wide array of different national practices and policies has emerged. Furthermore, additional prudential capital rules are imposed in many instances, from simplistic asset admissibility restrictions to sophisticated risk-based capital overlays, and supervisory approaches and practices vary greatly from country to country. Thus insurers active in the European market currently have a wide range of options in terms of how their business should be capitalized, structured and controlled.
The existing framework will change radically under the Solvency II regime which is now expected to be introduced in 2014. Solvency II will significantly impact insurance capital requirements across Europe, and fundamentally change the way in which insurance businesses with a European presence are organized, managed and reported. The Solvency II regime is already prompting insurance groups to engage in large-scale projects that will bring about major restructuring to take advantage of opportunities such as diversification and group capital fungibility, and to minimize the potential and expected burdens of the more sophisticated regulatory environment. It is also driving mergers and acquisitions, as well as divestment.
Under the Solvency II regime, insurance groups with European subsidiaries will be subject to group supervision. This is a major step change in regulatory approach and is aimed at addressing group risk. It means that groups will need to meet the Solvency II requirements for the entire European group (considering all entities, insurance and otherwise) or, in the case of non-European groups, for the European sub group. Furthermore, non-European groups potentially need to comply with Solvency II at worldwide level too. A single group-wide lead supervisor will be appointed to oversee the supervision of the European business. Group supervision will have significant implications for group structures, in fact structure significantly influences how the regime bites, and the commercial implications should not be underestimated. Groups will benefit where they are able to use the group requirements and related changes to capital components to adopt a much more flexible and efficient structure. This will allow them greater freedom to respond to changes in market conditions and to take advantage of emerging market opportunities.
In other regions, for example jurisdictions in the emerging and growth markets of the Americas and across Asia, enhanced regulation promoted by the International Association of Insurance Supervisors (IAIS) that comes into force later this year is expected to drive changes in solvency capital requirements and wider risk management practices, on a jurisdiction-by-jurisdiction basis. In many cases the future shape of regulation in these regions is uncertain – the lack of formal mandate on the part of the IAIS means that organizations will likely face varying levels of change under different timescales in each jurisdiction – and the added layer of group supervision requirements means that the impact and future regulatory landscape in these regions is difficult to predict.
All this means that instead of complex structures driven for example, by narrow considerations of tax efficiency –which in any case fiscal authorities are increasingly penetrating – structure in the broader sense needs to reflect and support the realities of the business within a more sophisticated and challenging environment. It should now be a core responsibility of boards and chief executives to ensure that this is so.
Retaining unwieldy group structures and inflexible capital profiles is potentially highly damaging to performance. While in the past insurers and their stakeholders may have tolerated inefficiency, perhaps in the group structure, its capital or operations, competitive forces are unlikely to allow this to continue. Further, the extensive disclosure under Solvency II and related regimes will lead to significantly greater transparency concerning the efficiency of insurer structures. Taking a strategic view of the group organization and capital structure can offer significant competitive advantages; restructuring of this type is becoming increasingly common.
Restructuring is not a one-off, once-a-decade activity. A regular reappraisal of company and group structure should be part of insurers' business as usual strategy. For insurers to maintain their performance and competitive edge, it should become an iterative process. Insurers that act now to improve their structures can expect to generate both immediate rewards, such as improved returns and market value, and opportunities for the future. These opportunities include the ability to respond to changing market conditions, and to self-fund new investment. These combine with the benefit of a simpler structure through which to implement enhanced risk management and solvency capital change, and to cope with other regulatory, accounting and fiscal changes.
Ensuring the right result
It is critical to approach a potential restructuring of a group in a logical and considered manner, ensuring the involvement and engagement at the appropriate time(s) of all relevant parties in the organization, in addition to external stakeholders such as the range of regulators of the group and rating agencies. But since structure needs to reflect the specific realties of the individual business, there can be no one solution or special formula to determine the most appropriate structure: each organization will have its own set of circumstances driving its optimal structure. But the key message for tax professionals is that it is vitally important that account is taken of the business aims and the drivers, and that any constraints and deal breakers are identified at the outset and used as a reference point in benchmarking any restructuring options. The key is to ensure that the correct decisions are taken and the implications understood.