Specialty: Insights for the specialty insurance and ... - Ernst & Young

SpecialtyInsights for the specialty insurance and reinsurance marketIssue 1 | December 2012The growthissueMy five most courageousdecisionsMeeting the challenge of change —what’s next for specialty insurerslooking to achieve growth?Tax leakage: more than a drop inthe oceanSST versus Solvency II — shining aspotlight on how Swiss companiesare working successfullyTaking a closer look at the latestflurry of transactions in theLondon market

In spring 2012, we published our final London andBermuda journal, our main insight for the specialty(re)insurance markets. While this new publicationreplaces it, we maintain many of the things that workedwell. Indeed, you will notice great similarities betweenthese publications as we present our point of view onthe most pressing issues facing this industry and its keyplayers. However, we’ve changed our focus slightly toreflect the increasingly global nature of specialty(re)insurance: companies face common issuesregardless of their location and there is little certaintyaround how the industry will look in five years.As advisors to this market segment, we continue tohelp organizations make sense of this rapidly evolvingenvironment and to support our clients whateverthe future may hold. We’ve formed a new integratedspecialty team with members who work closelytogether across the world to serve this market better.We recognize that a more global approach is requiredto provide truly world-class services.We hope the articles in this publication provide youwith some helpful insights.

In this issue ...02Meeting the challenge of changeWhat’s next for specialty insurers lookingto achieve growth? We examine the mainfactors influencing strategy and driving thespecialty sector to seek growth.06Lloyd’s remains as attractive as everThe flurry of transaction activity in thespecialty market is set to continue, withseveral insurance vehicles remainingattractive acquisition targets.08Financial services ITEM clubeconomic forecastThere is welcome news for specialty insurerskeen to optimize opportunities in the Londonmarkets as the latest ITEM forecast forfinancial services sees a return to growth forthe UK economy.12Investing in the finance function as aprerequisite for achieving growthWe examine why it’s important to invest inthe finance operating model and identifywhat companies need to do to realize growthopportunities.18The Swiss Solvency Test versusSolvency IIWe shine a spotlight on the similarities anddifferences between these two regimesand consider how Swiss companies aresuccessfully working within this framework.22Tax leakage: more than a drop in theoceanBetter management of the withholding taxcost on cross-border investment incomecould be a quick win to driving improvedperformance.26The benchmarkOur survey uncovers substantialopportunities for specialty companies toreduce their costs by transforming theiroperating models and provides valuableinsight for those being challenged to drivemargins in a sustained soft market.31Key contacts14My five most courageous decisionsRobert Hiscox reveals in his own words someof the key decisions that helped to makehis business so successful and also outlineswhere he sees the future of the industry.

WelcomeWelcome to Specialty— our new twice yearlypublication for specialtyinsurers and reinsurers.Clients often ask me, “Howcan I grow my business in asustained soft market?” AsI travel around many of thespecialty locations, I hearthis more and more, particularly as new capitaland price competition further exacerbate thecycle.The tragic events of tropical storm Sandy, whichcaused so much death and destruction in theCaribbean and Northeast seaboard, highlightthe key role insurance plays in paying claims tohelp neighborhoods, families and businessesget back to normal. However, although somemarket participants expect staggering losses ofUS$20b and beyond, this does not appear tobe significant enough to cause hardening of themarket and a spur to growth.There are many differing views on the waysto achieve growth in these market conditions;however, most CEOs I speak with predict severalcommon avenues. As you will read, expansionto Asian markets remains a strong opportunity:Hong Kong and Singapore offer excellentpotential for new capital and new business,though the infrastructure requirements andrisk management considerations are very much“front of mind” for those with eastern expansionplans. While a change in location footprintis an option, regulatory challenges affect allspecialty locations, albeit in differing ways. Forexample, while Europe continues to secondguesswhen — or even if — Solvency II will comeinto force, Hong Kong is trying to anticipatethe Financial Services Authority’s decision onfund management rebates and the impact on itseconomic and operating models.Given the high priority placed on growth by seniorexecutives, our first issue concentrates on thistheme. What are the best options for growth?Which markets are the most attractive? Whatchanges should be made to operating modelsto facilitate growth? How might companiesinnovate? In the series of articles that follow, weseek to address these questions and more. Wealso speak with one of the industry’s prominentfigures who has grown his business substantiallyin the years he has been at the helm — RobertHiscox. Robert tells us about the most courageousbusiness decisions he has made as leader of hisinternationally successful business and also wherehe sees the future of the market.And finally, on a slightly different note, I’d liketo share my excitement about the creation ofour new global specialty team. We’ve created anintegrated team across a number of locationswhose remit is to focus solely on the businessneeds of specialty (re)insurers — companies willbenefit from our more unified global view ofthis market as we bring the full weight of ourknowledge to create options for the most complexof business issues.We hope that this publication will providesome food for thought as to how players in thespecialty (re)insurance markets can differentiatethemselves and succeed in the uncertain timesthat lie ahead.Shaun CrawfordGlobal Head of Insurance, Ernst & YoungIssue 1 — December 2012 Specialty 1

Article / Growth: future outlookMeeting the challengeof changeWhat’s next for specialty insurers looking toachieve sustainable business growth?Having spoken to a number ofCEOs operating in the specialtyinsurance and reinsurancemarket, we found that themajority believe the industry is atan inflection point.The 2012 half-year results of listed specialtyinsurers revealed robust earnings and astrong performance, despite a challengingbackdrop of lower global GDP growth,anemic investment yields and the nearrecordcatastrophe losses of 2011. Althoughthe market has generated strong profits sofar in 2012, growth is proving a significantchallenge. The developed economies of thewestern hemisphere are largely stagnatingor are in low-growth mode and will be forthe foreseeable future, which is severelyrestricting the ability of insurance carriersto grow with their existing footprint. Bycontrast, expanding emerging economiesoffer tantalizing opportunities for thespecialty market.So what are the main factors influencingstrategy and driving the specialty sectorto seek growth? In this article, we outlineour views on likely developments for thespecialty market in the next five years.The pressure to growProfitability from existinglines is not sufficient to beatmarket expectationsAt the half year, the specialty marketdelivered a strong set of results andgenerated a better return on investmentthan other insurance sectors. Theseresults could largely be explained by prioryear reserve releases and a benign claimsenvironment. Clearly, the second half ofthe year will be affected by tropical stormSandy with initial indications showing thatUS primary carriers will be particularly badlyhit: losses are estimated to be US$20b andbeyond although this is likely to impactearnings and not capital. The half-yearresults announcements 1 show that averageearnings were better in 2012 than prioryears and that the price-to-book multipleshave increased to 1.35x compared with1.15x 2 at the start of 2012. In addition, theaverage price-to- earnings ratio of specialtyinsurers comes in at 9.8x, compared with7.7x 2 for the remaining insurance sector.These figures tally with the views of themajority of market practitioners, withCEOs prioritizing increased underwriting1 Specialty insurers listed on the LSE.2 Deutsche Bank Markets Research, 8 August 2012.profitability over growth. The commonthemes identified from our discussionswere a focus on disciplined and selectiveunderwriting and appropriate pricing forrisks being written.Despite this positive picture, mostinvestment analysts we speak to recommendholding specialty shares rather than buying.Investors are being urged to show caution,as delivering improved returns from existinglines of business is exceptionally challengingin an environment where rates are notexpected to increase significantly, GDPgrowth is minimal and future prior-yearreserve releases are drying up.Regulation favors largercross-border firmsThe current and proposed regulatoryenvironment is creating a drive for growththat may not be in the best interests of thespecialty market overall.Firstly, smaller carriers aredisproportionately hurt by regulations,which are the same whether a carrier writesUS$1b of premiums or US$100m. Smallercompanies typically lack the scale to absorbthe additional costs that regulation createsand generally have insufficient in-housecapability to implement a plethora ofchanges. We have seen expense ratios riseacross the sector (especially among the2 Specialty Issue 1 — December 2012

smaller players) as a result of both the softmarket and the costs of implementing newregulation. We envision that these smallercarriers will be at a cost disadvantage as wellas a capital disadvantage from a regulatorystandpoint compared with the larger insurers,which will have lower expense ratios as wellas more resources to implement regulatorychange (such as better internal models).Secondly, most regulatory requirementsare effectively discouraging a narrow focuson fewer lines. The ratings agencies turnedbearish on monoline carriers after 2004and 2005, when losses from hurricaneshurt a number of pure-play propertycatastrophe (re)insurers. In addition, from acapital perspective, the Solvency II regimegives significant credit to (re)insurerswith diversified businesses. We have seena number of carriers pursue growth in“uncorrelated” lines of business to providethem with the diversification credit. However,returns have been diluted as the carrier maylack the underwriting expertise in the newareas, or the risk association with these newlines may not have been fully understood —e.g., international property treaty and thelosses arising from the Thai floods of 2011.Recovery and resolution planning is anoteable exception. These changesencourage firms to focus on fewer lines andsimplify their corporate structures.Larger firms can negotiatemore favorable terms frombrokersSpecialty insurers, including Lloyd’s, haverecognized the challenge posed by thelargest brokers’ dominance. 3 The largestthree brokers (Aon, Marsh and Willis) haveplaced just over half of the business acrossall lines, and in reinsurance they control75%. 4Several of the CEOs who we spoke tohighlighted their dependency on the“big three” brokers and said that theconcentration of power with these playersleaves them vulnerable. While larger carriersmay have significant market share in certainlines, which they can leverage to resistthe negotiating powers of brokers, smallerplayers are particularly vulnerable and lackthe might to prevent their underwritingmargins from being eroded. The implicationof this is that the smaller carriers will need topursue scale to counteract the might of thelarge brokers.3 Lloyd’s 2011 Annual Report and Accounts underStrategic Review.4 Insider 16 July 2012, The biggest 10 brokers place justover three-quarters of business across all lines; inreinsurance they control 95.7%.5 Aon Benfield, 2012 June and July Renewals Update.6 Aon Benfield, 2012 June and July Renewals Update— Between 2010 and Q1 2012, the reinsurance capacityhas remained unchanged at US$470b, and the insurancecapacity has increased by 5%.The underwriting cycle mayflattenBetween 2008 and 2010, reinsurancecapacity increased by 35% from US$342b toUS$470b and insurance capacity increasedby 46%. 5 Given the severity of the majorlosses of 2010 and 2011, we would expectsome of this capacity to have been depleted.However, it has remained stable during thisperiod. 6 The increase in it from 2008 to2010 and the effect of the financial crisisof 2008 is not a coincidence. Capacityentered at the start of the crisis as investors,including large pension funds and privateequity (PE) firms, sought alternate waysto boost yields amid volatile markets andanemic global growth. These investors wereattracted by the fact that the insurance cycleis uncorrelated to the general economiccycle.The way this new capacity has been deployedshows a changing dynamic in the(re)insurance market. The major losses ofthe last two years did not result in a “class of2010-2011” like in 2001 and 2005. Instead,much of this capacity is being channeledthrough sidecars, cat bonds and investmentlinkedsecurities, as evidenced by the factthat the Bermuda Monetary Authoritylicensed 23 special purpose insurers in 2011.Never before has there been such flexibilityin getting capital to the market and oneconsequence of this might be the flatteningIssue 1 — December 2012 Specialty 3

Meeting the challenge of changeof the rating cycle. As a result, it may be difficult to rely on thestrategy of capitalizing on the cycle and gearing up in a hard marketand may mean that being smaller and more nimble is no longer asadvantageous.Scale can offset downward pricing pressureIn the current market, with surplus capacity and supply outstrippingdemand, price pressure will continue. Unless a meaningful amount ofcapacity exits the market, underwriting margins will continue to beunder pressure and management will turn its attention to loweringthe expense ratio to boost returns. We have already seen a number ofcarriers implement cost reduction programs, while several others arelooking to grow and gain scale to defray their fixed costs over a largepolicy base.The options for achieving growthTaking market share through M&A is a wellwornpathOne option available to carriers to achieve scale is through M&A. Inrecent months, there has been significant speculation concerningthe prospect of M&A activity in the specialty markets. Severaltransactions have already been completed, and we understand thatothers are close to completion. 7Further activity is rumored, particularly in London and Bermuda,and unlisted privately owned companies also present interestingopportunities. In addition, the significant cash funds available to PEplayers means further PE buyouts are a credible possibility. Meanwhile,insurers from the US and Asia are facing similar challenges, includinglack of organic growth in their home countries, and as a result areincreasingly showing an interest in access to the Lloyd’s platform.But getting it right is a challengeAlthough most CEOs would consider inorganic growth strategies,numerous acquisitions or mergers have not delivered value for allstakeholders. In our experience, common challenges include:► Insufficient knowledge and understanding of the underlying bookof business (and corresponding reserves) being purchased► Estimating correctly the economies of scale that can be achievedby combining two specialty businesses► Execution of post-integration plans and a good understanding ofthe cultural differences between organizations. The importance ofthis cannot be underestimated; many a transaction has destroyedvalue as a result of management failing to find a way to meld thebest of both the acquirer and acquired businesses’ cultures andworking practices.► Differences in internal IT systems, control environment andgovernance frameworks — for example, when managingexpectations of dominant individuals.Therefore, a good alternative avenue to achieve growth couldbe to pursue the sale and purchase of specific lines of businessor to acquire a team of people. Key differences will still need tobe addressed: the team should be integrated into the business,cultural differences identified and harmonised, and degrees offreedom communicated to the new team. It appears that there areopportunities to pursue this alternative avenue, especially withincreasing private equity (PE) involvement with the Specialty sector.PE players pride themselves in being innovative with the businessesthey own, and this could result in rationalization of books of businessor the splitting or combining of businesses with a view to releasingthe “trapped” value in a company.A new product development strategy is oftenoverlookedTaking new products to market is a viable option for growth, but onethat does not appear to be on the agenda for most specialty firms.While notable exceptions exist, such as successes around cyber liability,in general it appears that companies lack the appetite to invest time,money and resources in developing new or non-traditional products toserve new industries. A number of CEOs who we spoke to agreed thatinnovation (particularly product innovation) was not a key strength ofthe specialty market. At the same time, the constantly changing natureof the world’s economy provides a wealth of demand for new riskmanagement products.Moving into emerging markets is attractive …It is well publicized that GDP growth in emerging markets hassignificantly outpaced that of developed economies in recent years,and we have seen the specialty market take advantage of this. Forinstance, when capacity entered the market between 2007 and 2011,Lloyd’s saw a 5% increase in its business written in Central Asia andAsia Pacific. By contrast, during the same period, UK business writtenat Lloyd’s decreased by 6%. 8However, the decrease of the UK segment is not a result of lowerpremium volumes — on the contrary, premiums have grown year onyear, albeit less than in emerging markets. Indeed, the volume ofbusiness written within countries in Latin and Central America, CentralAsia and Asia Pacific has grown by 105% over the last five years,compared with growth of 31% within the US, Canada, UK and Europe.7 Recent transactions completed or near completion include: Chaucer & Hanover Group (April2011), Omega and Canopius (April 2012), Hardy & CNA (July 2012), Sea Bright Enstar(August 2012), Flagstone Re Validus (August 2012).8 Society of Lloyd’s segment analysis — 2007-119 Semiannual report, World Bank.4 Specialty Issue 1 — December 2012

Article / Growth: future outlook… and the best opportunities are in the tigereconomiesLloyd’s has been vocal and proactive about its intentions to grow inLatin America and Asia by strengthening its distribution channels inthese areas. The change in the composition of its book supports thisto some extent. In addition, the series of natural catastrophes in Asiahas helped to raise risk awareness and prompt corporations to seekincreased insurance.Most CEOs recognize that the emerging economies present a greatopportunity, although this will not be an option for everyone. In ourview:► Great opportunities exist to create hubs in the “tigereconomies” in the Far East. This area is an increasingly excitingplace to be, with access to a number of countries. We have seensome specialty players open offices, recruit local talent and investin building and strengthening distribution channels in the region.This has enabled access to new business and, with more andmore players increasing their presence, it will provide the abilityto compete with existing large insurers in that region by writingrisks on a subscription basis. Over time, the view that a largeproportion of specialty business comes to London will diminish,and we believe these hubs will attract business from across Asia.► Brazil presents another great opportunity and providesgood access to the rest of Latin America. Brazil is one ofthe fast-growth emerging economies, and the entire region ofLatin America is predicted to grow by 3.8%–4% 9 in 2013. Lloyd’shas opened a franchise in Brazil and plans to strengthen itsdistribution channels. The 2016 Olympic Games in Rio de Janeiropresents some short-term opportunities, and is Brazil’s (and LatinAmerica’s) opportunity to take center stage and showcase to theworld the investment opportunities available.► India and China also present enormous growth opportunities,but the political, regulatory, legal, social and culturaldynamics are extremely challenging. For example, legislationprevents full control of a company, and a local partner is required— a particularly delicate balancing act for carriers that wish toensure their intellectual property is protected. We believe thatboth substantial investment and a long time frame is neededfor a new entrant to the Chinese and Indian specialty insurancemarkets to take full advantage of the opportunities available.Expanding into new markets in emerging economies offers clearattractions but is not without risk. Indeed, several CEO’s in themarket have avoided the emerging economies and instead arefocusing on developed economies with very large, mature insurancemarkets. In many ways, doubling their market share from 0.5% to1% of a developed economies’ insurance market can be easier as thecompetition, ways of doing business, legal system, and culture are allknown and familiar.Our view is that carriers should simplify their business models andfocus on fewer, narrower lines and fewer locations. A focus onsimplification would enable carriers to concentrate on their corestrengths and free management from being distracted by peripheralclasses of business which are “nearly breaking even” or “just aboutto take off on a growth spurt”. Operating in fewer locations wouldalso bring lower costs with less people issues, and systems should bemore easily aligned with business processes.Specialty in the futureWe see this as an exciting yet challenging time for specialty insurersas they enter new markets and pursue new strategies. We predict:► London, Bermuda, Switzerland and the US will continue to bethe most prominent locations in this market, however we see theemergence of a competitive and sizeable local hub in Asia.► Winners in the market will be those pursuing a strategy of growthby taking market share in developed economies or increasingmarket penetration in emerging economies. The complexity oftrying to achieve both will be too difficult.► The concentration of power and dominance of the brokers willcontinue, with further consolidation increasing the market shareof the largest brokers.► The race for talent, in a market where most CEOs recognizethere is a shortage, will result in wage inflation, especially forspecialized skills. This, along with the costs of compliance, placesmore pressure on the expense ratio.► Building a brand new franchise will be more challenging. Withsignificant barriers to entry, regulatory costs and concentrationof brokers in distribution, significant scale will be required todeliver the returns demanded by the market.► Building the franchises of today from scratch will no longer bepossible. With significant barriers of entry, regulatory costs andscale required to deliver returns, the spirit of entrepreneurship,which is what built this market, will be lost.AuthorsPaul Cooper (pcooper@uk.ey.com) is a Partner with Ernst & Young LLP (UK)who works on a range of audit, advisory and transactions projects for specialtyinsurance clients in London, Bermuda and New York.Richard Battersby (rbattersby@uk.ey.com) is a Partner working across thesame locations in transaction advisory services, and Shubhendra Bobby Swarup(sswarup@uk.ey.com) is a Senior Manager in the London-based audit team.Issue 1 — December 2012 Specialty 5

Article / Growth: M&A activityFour transactions across 2011 and 2012 (upto October 2012) related to the acquisitionsof Lloyd’s platforms by overseas insurerswhere the respective acquirers werewilling to pay a significant premium for therespective platforms. The Lloyd’s platform,which includes access to underwritinglicenses in over 75 jurisdictions, is anattractive proposition to many buyers,particularly those who haven’t achievedorganic growth in the current ratingenvironment. CNA Financial’s Chairman andCEO, Tom Motamed, noted in reference to itsacquisition of Hardy, “With its access to theUS$35 billion Lloyd’s marketplace, Hardy willprovide a solid platform for profitable growthand an attractive opportunity for CNA todeploy capital.”Lloyd’s operations have proved popular inrecent years, with the number of LondonStock Exchange-listed Lloyd’s insurersfalling to five following Apollo and CVCprivate equity’s acquisition of Brit, TheHanover Group’s acquisition of Chaucer,CNA’s acquisition of Hardy and Canopius’stie-up with Omega. Since 2007, a majorityof Lloyd’s listed vehicles, including Atrium,Kiln, Heritage, Brit and Chaucer, havebeen acquired. Novae, the smallest of theremaining listed Lloyd’s businesses by marketcapitalization, and once a suitor in the racesto acquire Chaucer and Omega, remains anoften-discussed potential takeover target inthe trade press.As a market, Lloyd’s has been managingits capacity carefully, with the number ofsyndicate start-ups approved by Lloyd’sfalling from nine in both 2008 and 2009 tothree in 2010 and 2011. This has effectivelyrestricted new entrants from gaining accessto the market through acquisitions or viaa slower process of establishing a turnkeyoperation.Following acquisitions of a number oflisted players since 2007, some privatelyowned Lloyd’s insurance vehicles havebeen discussed in the trade press recentlyas either acquirers or targets. There are anumber of potential transactions in process,and we expect some of them to be completedin the next 12–24 months.Looking further afield, Bermuda has seenan influx of additional capital over the last18 months, with substantial investmentsbeing made in side cars, hedge fund backedvehicles and other insurance-linked assets.This capital looks set to benefit from apositive return in 2012 albeit, with theimpact of Sandy yet to be determined.It will be interesting to see what happensto some of this capital if rates softensignificantly, if substantial cat losses areincurred, if markets improve and generatealternative investment opportunities forhedge funds, or if a combination of thesefactors occurs.Market conditions remain conducive tofurther transaction activity in the Lloyd’smarket, and several insurance vehiclesremain attractive acquisition targets for thepurposes of gaining access to the Lloyd’splatform.6 Specialty Issue 1 — December 2012

Lloyd’s remainsas attractive as ever …We have seen a flurry of transaction activity in the specialtymarket since the early part of 2011. Market conditions havebeen conducive for M&A activity, given the capital availablewithin insurers and private investors, continued softness inrates and low investment yields.An overview of recent activityDate Buyer Target ConsiderationUS$mNTA multipleAugust 2012 Validus Flagstone Re 623 0.7xAugust 2012 Enstar SeaBright 252 0.7xAugust 2012 Tower Canopius Bermuda 240-290 1.0xJuly 2012 CNA Hardy 255 1.5xMay 2012 Tokio Marine Delphi 2,700 1.5xApril 2012 QBE Brit UK 63 n/aApril 2012 ANV Flagstone Re at Lloyd’s 210 1.3xApril 2012 Canopius Omega 255 0.9xMarch 2012 Alleghany Transatlantic Re 3,400 0.8xMarch 2012 Goldman Sachs Ariel Re n/a n/aMarch 2012 Arch Ariel Credit and Surety n/a n/aJanuary 2012 Tawa/Paraline/Skuld Whittington n/a n/aSeptember 2011 Ryan Specialty Jubilee 57 3.0xMay 2011 Apollo/CVC Brit 1,423 1.0xApril 2011 The Hanover Group Chaucer 510 1.3xSource: Ernst & YoungAuthorJames Aldridge (jaldridge@uk.ey.com) is a Directorwith Ernst & Young LLP (UK) and works in the Londonbasedtransaction advisory services team.Issue 1 — December 2012 Specialty 7

Article / Growth: UK economyAutumn 2012Financial servicesITEM club economicforecastThere is welcome news for specialty insurers keen to optimize opportunities in the London markets as thelatest ITEM forecast for financial services sees a return to growth for the UK economy in the second half of2012. GDP is down only 0.2% on the year as a whole. Growth then picks up to 1.2% next year and to 2.4% in2014 and 2015. The forecast includes a mild recovery in consumption, thanks to falling inflation and risingemployment. CPI inflation is expected to ease back into line with its target over the winter. In this article,we summarize the latest findings and how they affect general insurance (property and casualty) companies.After falling 0.9% in 2011, consumer spending is expected to grow by0.6% in 2012 and by 0.8% in 2013. Although this is an improvement,it is still weak by historical standards. The housing market will benefitfrom rising real incomes and consumer confidence, as well as theeasing of funding pressures on the mortgage market. We expecthousing transactions to fall to their lowest levels this autumn beforestarting to recover in 2013, with house prices set to follow. Therecovery will be slow, however, with transactions at the end of 2016still 39% below the levels reached in 2007. The gradual turn in thehousing market will be assisted by a modest improvement in theavailability of mortgages. UK banks have reduced their borrowingfrom overseas banks and the Bank of England and can now usegrowing savings deposits to boost lending to the private sector. TheFunding for Lending Scheme and revival of the securities market willprovide further support.However, the improved outlook for the consumer is offset by aworsening outlook for exports. Short-term prospects remain fragile,with the Eurozone likely to slip further into recession and signs of aslowdown in the US and emerging markets like China and India. Butwe are more optimistic about prospects further out, given the USFederal Reserve’s announcement of additional quantitative easingand the European Central Bank’s announcement of a new bondbuyingprogram. The willingness of Saudi Arabia to turn on thetaps, too, should prevent higher oil prices from holding back growth.Providing that the Eurozone remains intact and the US negotiates its“fiscal cliff” successfully, world trade and exports should pick up againnext year. Business investment is unlikely to pick up until domesticand overseas demand recovers more convincingly, however. Sparecapacity and risk aversion are holding back investment, despite verystrong cash flows enjoyed by UK plc. We are forecasting increasesof 2.3% in 2012 and 3.9% in 2013– very modest by the standards ofprevious recoveries.The economic environment remains extremely risky. Policy-makersin the Eurozone have vowed to do what it takes to hold the systemtogether, but further fiscal austerity is still planned and progresstoward a banking union is slow. The US fiscal cliff is looming, andemerging markets are slowing more than previously expected.Moreover, this summer saw yet another example of extreme weatheraffecting food and other world markets. Nevertheless, some upsiderisks are now emerging. The world’s largest central banks haveproved adept at dealing with tail risk, and their latest moves are verysupportive. In the UK, there is a chance that the credit famine mightbe nearing its end, at least in the mortgage market, which couldresult in a much stronger bounce in the housing market and the highstreet than we currently envision. Similarly, our forecasts for exportsand investment would need to be revised upward if the uncertaintyabout the Eurozone was convincingly resolved.Table 1: forecasts of theUK economyAnnual percentage changes unless specified2011 2012 2013 2014 2015 2016GDP 0.9 –0.2 1.2 2.4 2.4 2.4Consumer prices 4.5 2.8 2.1 2.0 2.0 2.0Average earnings 2.6 2.0 2.8 3.2 3.9 4.0Unemployment rate (%) 4.7 4.8 4.9 4.5 4.1 3.8Government net borrowing (% of GDP) 8.2 6.7 6.7 5.0 3.5 1.9Three-month interbank rate (%) 0.9 0.9 0.8 1.6 2.5 3.5Effective exchange rate 79.9 83.2 84.2 83.6 81.8 79.4Source: ITEM8 Specialty Issue 1 — December 2012

Key summary for general insurersChart 1.1: UK insurance industry profitsThe combination of low interest rates, higher hedging costs, lowerbusiness volumes and more onerous capital requirements is provingto be a challenging environment for uk insurance companies. Inresponse, management remains focused on cost cutting and processre-engineering. M&A activity will continue, with the aim of reducingcapacity and improving topline growth. Property and casualtyinsurance prices need to rise and annuity rates need to fall in order torebuild profitability. The benefits of restructuring are already visiblein a rise in profit margins from a low of -0.3% in 2009 to 3.2% inQ2 2012.Although margins are now back above their historical average of2.7%, they are still around one percentage point below the levelprevailing before the financial crisis. Improved margins will helpthe contraction in profits slow to 9.5% in 2012 from 31% in 2011.We then expect profits to start recovering in 2013 as nominal GDPgrowth doubles to 4.1%, boosting business volumes and making pricerises easier to achieve. The expected 7.1% rise in equity prices willalso support investment returns. Even allowing for expected growthof almost 19% in 2013, profits will remain about 25% below the£7.8b peak hit in 2010 and are not expected to exceed it until 2017(Chart 1.1).b9.08.07.06.05.04.03.02.01.00.0–1.01981Source: ITEM19861991199620012006Forecast20112016Issue 1 — December 2012 Specialty 9

FS ITEM Club economic outlook for financial services — autumn 2012In the near term, the UK non-life-insurance business will be affectedby weakness in both the housing market and new car sales (Chart1.2). Slow household income growth and credit constraints mean thatwe expect house prices to decline by 0.7% in 2012 and then rise byjust 2.3% in 2013. The same factors mean that we expect new carregistrations to decline by 1.2% in 2012 and then rise by just 0.5% in2013. As a result, we expect non-life premium growth of just 1.4%in 2012. Corporate business should be a source of support, with thenumber of companies expected to grow by 9% in 2012 and 10% in2013. After that, as the economic recovery strengthens, premiumgrowth should rise to 3%–6% between 2013 and 2016.Chart 1.2: car registrations and property transactions3000ForecastThousands2500Car registrations200015001000Property transactions50001990 1993 1996 1999 2002 2005 2008 2011 2014Source: ITEM/Haver AnalyticsTable 2: insurance 2011 2012 2013 2014 2015 2016Non-life gross premium (£b) 73 74 77 80 85 89% year 5.9 1.4 3.6 4.7 5.5 5.5Non-life gross claims payments (£b) 36 37 38 38 39 40Paid claims ratio (%) 49 50 50 50 50 50Net profit (£b) 5.4 4.9 5.8 6.7 7.3 7.7Source: ITEM10 Specialty Issue 1 — December 2012

Article / Growth: UK economyTable 3: forecast for the UK economy2011 2012 2013 2014 2015 2016Macro variablesNominal GDP growth (%) 3.6 2.2 4.1 5.4 5.0 5.8Real GDP growth (%) 0.9 –0.2 1.2 2.4 2.4 2.4CPI (% yoy) 4.5 2.8 2.1 2.0 2.0 2.0Labor marketTotal employment (thousands) 29,166 29,493 29,779 30,059 30,374 30,709Employment in manufacturing (thousands) 2,524 2,507 2,485 2,465 2,442 2,422Employment in non-manufacturing (thousands) 23,540 23,765 24,050 24,429 24,844 25,270Unemployment (thousands) 2,564 2,604 2,646 2,532 2,390 2,253DemographicsPopulation (thousands) 63,005 63,479 63,923 64,342 64,753 65,159Population of working age (thousands) 39,188 39,488 39,774 40,042 40,301 40,546Population, 65+ (thousands) 12,072 12,143 12,189 12,215 12,228 12,234ConsumersNominal personal disposable income (% yoy) 3.1 3.9 3.9 3.9 4.7 4.4Gross household financial wealth (£b) 4,284 4,516 4,693 4,872 5,063 5,206Personal loans outstanding (£b) 151 152 155 159 166 174Credit card lending outstanding (£b) 56 54 54 56 59 64Personal insolvencies (thousands) 142 134 129 118 100 84MotoringCar registrations (thousands) 1,941 1,918 1,927 1,969 2,114 2,259Housing marketHouse prices (% yoy) –2.6 –0.7 2.3 4.5 5.7 5.5Number of households (thousands) 26,204 26,386 26,569 26,754 26,940 27,127Property transactions (thousands) 883 916 926 994 1,073 1,147Mortgage marketGross mortgage lending (£b) 141 144 143 166 199 238Net mortgage advances (£b) 10 8 3 18 35 48Number of mortgages approved 593,143 592,604 596,771 640,755 700,028 763,600Total number of mortgages (thousands) 11,260 11,265 11,329 11,409 11,501 11,603Corporate sectorNew companies (% active companies) 0.19 0.24 0.25 0.21 0.19 0.20Insolvencies (% active companies) 0.0079 0.0079 0.0078 0.0078 0.0077 0.0077Total number of companies 2,375,315 2,590,540 2,846,484 3,008,628 3,101,237 3,194,717Company profits (£b) 323 318 334 353 367 374Financial variables3-month interbank rate (%) 0.9 0.9 0.8 1.6 2.5 3.520-year government bond yields (%) 3.1 1.9 2.1 2.9 3.7 4.2FTSE All-Share (% yoy) 2.6 2.0 7.1 13.6 10.2 7.8Source: ITEMThe ITEM Club Outlook for Financial Services is a companion tothe main ITEM Club forecast launched to examine in more detailthe implications of the ITEM Club’s economic projections for thehealth of the UK financial sector.Ernst & Young is the sole sponsor of the ITEM Club, which isthe only non-governmental economic forecasting group to usethe HM Treasury model of the UK economy. Its forecasts areindependent of any political, economic or business bias.Issue 1 — December 2012 Specialty 11

Article / Growth: finance systemsInvesting in the financefunction as a prerequisite forachieving growthMany specialty (re)insurers take great pride in being highly entrepreneurial and able torespond quickly to emerging opportunities. Companies pursuing growth do so either bymergers and acquisition or by expanding the business through new products, offices,locations and teams.Management, not unreasonably, expectsintegrating a new business operation intoexisting finance processes and systems tobe as easy as “plug and play.” However,regardless of the strategy pursued, theexperience of many specialty (re)insurers isthat growth just adds cost and complexitywithout realizing the desired back-office costsynergies and economies of scale.For example, as organizations groworganically over time, local financeteams customize processes and bolt oncustom-made applications to meet localrequirements. Existing corporate systemsthat were appropriate for a smaller financeorganization become a limiting factor forlarger ones — an inability to provide granularanalysis and reporting or to support internalrestructuring are key issues. Internationalexpansion brings the additional challengesof operating in multiple currencies, requiringseamless translation and revaluationprocesses as well as intercompany servicecharges and allocations.Organizations that grow through mergersand acquisitions experience a different set ofissues. Many firms choose not to integrateacquisitions operationally. The acquiredcompany continues to operate its existingprocesses and systems, mapping financialresults to the new parent’s chart of accountsfor external reporting and retaining theirinternal management information. Evenwhere a corporate general ledger is deployedacross the business, the existence of multiplelegacy underwriting platforms can result innumerous challenges. The most prominentissues relate to the quality, completenessand consistency of underwriting data takenfrom multiple sources, which can resultin considerable excess work to normalizedata for reporting or to analyze to the levelrequired for management reporting.Successful growth requires efficient andeffective, streamlined support functions thathave the flexibility to respond to businesschange. The majority of the industry needsto make a real step change in order to realizegrowth opportunities. However, we are awareof a number of companies that are launchingmajor process improvement initiatives andlarge-scale IT implementations to addressthese challenges.What does good look like?An effective, flexible and scalable financefunction has the following characteristics:► Processes should be standardized andstreamlined and procedures supportedby common policies and strong financialcontrols. Process standardization candeliver significant efficiencies andfacilitate centralization of transactional12 Specialty Issue 1 — December 2012

processes in shared services, deliveringfurther economies of scale.► There should be a high degree ofstraight-through processing andautomation of period-end adjustmentsand reporting with a correspondingreduction in the number of criticalspreadsheets used in the process.► There should be common global financetransaction and reporting systems,including a flexible and scalable generalledger to ensure emerging businessrequirements can be met. A singlegeneral ledger instance provides acommon control environment, facilitatesreporting from one source of the truthand can deliver significant savings in thecost of finance systems ownership.The increasing volume, complexity,frequency and speed of reporting requiredunder Solvency II and IFRS 4 Phase II isshining a spotlight on these issues as thelack of globally standardized processes andcommon systems limits the ability to definecorporate solutions, driving up the cost andcomplexity of implementation projects.How can you achieve this?We would recommend companies startby thinking about conducting a rapidassessment to uncover all the issueswith current processes and systems, andsetting out what can be done to addressthe challenges, as well as articulating thebusiness case for change. From this, wewould then recommend devising a highimpactshort-to-medium-term plan toidentify where the greatest benefits couldbe achieved. This is something where thereare a whole range of opportunities tailoredto suit varying budgets and appetites forchange, from pragmatic and tactical processinitiatives to longer-term changes to financesystems.Companies that successfully build flexibleand scalable operations have typicallyinvested significantly in systems andprocesses over a number of years to ensuretheir finance functions deliver the benefitsdescribed above; however, in our experience,an effectively designed program of changecan deliver significant improvementswithin just 6 to 18 months. Companies thatproactively do this, rather than being forcedto change in response to a transaction orother event, are able to design a solutionthat is better optimized for the long term andcan be implemented at a lower cost.What outcomes can beexpected?In addition to the growth benefits previouslyoutlined, creating a more efficient andeffective finance function can deliversignificant cost reduction as well as a rangeof qualitative benefits, which all contributeto the business case for change. Typicalbenefits include► Lower costs due to the “leaner” natureof the operating model — resultingfrom business process streamliningand simplification, adoption of leadingpractices and economies of scalethrough increased global centralization.Finance cost savings in excess of 20% aretypical.► Better control and a reduced risk ofgenerating incorrect information forregulatory reporting and managementinformation — greater automation,cutting out the human element andreducing the reliance on spreadsheetsdecreases the risk of error and thecomplexity involved in generatinginformation. A single global generalledger provides a common controlenvironment and facilitates reportingfrom one source of the truth.► Better, faster and more reliablemanagement information — resultingfrom accelerated processes, datagovernance and data quality. Commongroup-wide finance systems and a globalchart of accounts can accommodatethe management reporting dimensionsand analysis required by more complexorganizations.Ian Stewart (istewart@uk.ey.com) is a Londonbaseddirector in the financial services performanceimprovement practice of Ernst & Young LLP (UK) andhas extensive experience of implementing changewithin insurance company finance functions.Issue 1 — December 2012 Specialty 13

Growth: the interviewMymost courageousdecisionsby Robert HiscoxHe is the man who wasinstrumental in introducingcorporate capital at Lloyd’s,was one of the first at LimeStreet to take his companypublic, and raised morethan a few eyebrows in themarket with the hire of a31-year-old as his CEO. Yethe claims never to havemade a courageous decisionin his life because they justseemed logical at the time.Nonetheless, says RobertHiscox of the companyof which he is Chairman,“We have courage as ourleading value.” Sometimescontroversial but alwaysthought-provoking, Roberttalks us through his biggest(bravest) decisions during aremarkable 47-year career.1Taking control at theage of 27 on the deathof his father“The sheer joy ofbeing in charge”“We were a partnership of sevenrunning two small Lloyd’s syndicatesand had lost money for five years.I had a 5% share and my father had 20%(which was extinguished on his death).On his death in 1970, I managed bypersuasion and force to make four ofthe partners resign, and the remainingpartner and I had 50% each. I will neverforget, while on my way in to work theday after we had succeeded in gettingLloyd’s to agree, having a mental moanabout some decision that needed tobe made then realizing with a surge ofsheer joy that it was now entirely mydecision. The buck now stopped withme. No more moaning.”“We inventedcorporate capital and ina stroke raised£900 million …”2Introducing corporatecapital into Lloyd’s“I became Deputy Chairman of Lloyd’sin 1993 as Lloyd’s was in crisis. DavidRowland, the Chairman, asked meto find capital as the “Names” wereresigning in droves, capacity of themarket had dropped to £5 billion andsome Names were refusing to pay theirlosses. The worldwide media was writingLloyd’s off. I knew nothing about thecapital markets but with Freshfields andJ.P.Morgan we seized an opportunity,adapted the by-laws and obtained allthe regulatory permissions needed,essentially in every state in the US.Limited liability corporate membershipwas invented, and we raised £900million. The Names who were runningfor the door thought that if sophisticatedcapital wanted in, they should stay,so Lloyd’s was well capitalized again.“Strong regulation was put in place, andby the time of the tragic events of theWorld Trade Center in 2001 (which couldhave been totally catastrophic for Lloyd’sin previous times), the market couldabsorb that enormous loss. The marketthen rode 10 years of great profits. But Inever thought that bringing in corporatecapital was a brave decision; it was purenecessity.”14 Specialty Issue 1 — December 2012

3Floating on AIM in1995“We were an agentbeing handsomelyrewarded with nocapital … then we did sixcapital raisings”“At the moment of signing to raiseour first capital to become principals,after nearly 100 years of being anagent with no real risk in the business,we had a considerable wobble. Therewas a hesitation when we thought toourselves, “Why are we doing this?”We were an agent being handsomelyrewarded with no capital in thebusiness. Then we did six rights issues,which did seem brave at the time.We were the first company to form acorporate vehicle to support a spread ofsyndicates, and then the only companyin 1993 to raise a corporate vehicle tosupport solely our own syndicates. Andour final rights issue was the last toraise money at a modest 10% discountto the share price when all others bythen were going at deep discounts ofaround 45%. I dislike deep discountsas they make it dead easy for theinvestment bankers and penalize thesmall investor.”I have found being a public companyrelatively easy, as we have to explainour business to professional, intelligentinvestors who have actually put moneyinto the company, whereas under theold system of Names, we were dealingwith emotional individuals and theiragents (of differing quality!) who hadonly pledged their capital, which theycould withdraw at any time.”“The investmentbanker advised againstand thought we werebetting the bank”4Purchasing EconomicInsurance in 1996“I decided that we had to have aninsurance company to underwriteoutside the Lloyd’s market. Lloyd’s hasa limit of 15% for any business insideLloyd’s, so I had known since I arrivedin the market that we would have togo outside. Prior to the introductionof corporate capital, no one in Lloyd’swas allowed to underwrite outside theLloyd’s umbrella, but I managed tochange that rule in the restructuringof the market. We bid to buy EconomicInsurance for £30 million in 1996against the advice of the investmentbanker, who said we were betting thebank. Considering it had £24 millioncapital, it seems amazing that that wassuch a brave move such a short timeago. Mind you, it was making losses atthe time but we just wanted the shell,so we got rid of 80% of the business.Under the ridiculous Department ofTrade and Industry rules of the time,we had to keep the management inplace for a year as Bronek Masojadadidn’t qualify to run the company ashe was South African, and I didn’t as Ihad only Lloyd’s experience. A difficultyear for us and them.”“Peoplecongratulate you if youbuy a business, but notif you start one up”5Serious expansion inthe United States in2006Hiscox, in tandem with most of theLloyd’s market, has sold insurance toUS businesses through its Lloyd’s ofLondon syndicates forever. In 2006,however, it took the bold decision toestablish offices across the countryand is now licensed to operate in allUS states and the District of Columbia.“We have grown organically at a prettyrapid rate. We did pay a lot of moneyto attract a very good underwriter, butwe would rather do that than buy asmall company with all the problemsthat go with it. We have also startedthe first business to business internetbusiness in the US, which is frighteningas we usually don’t pioneer, we shootpioneers in the back. Let the firstguy in make all the mistakes. (EvenRockefeller said ‘pioneering don’t pay’.)But we have the knowledge and skill, aswe had a successful similar business inthe UK, so it seemed logical, if brave. Iam delighted to say that it is going verywell indeed.”Issue 1 — December 2012 Specialty 15

Growth: the interviewAndRuminations16 Specialty Issue 1 — December 2012

next?on the future …The age of the supersyndicates?“Lloyd’s is a great incubator, but it won’tlet you become more than 15% of theoverall business. As an ambitious youngman driving my motorbike to work, I wouldlook at the great Guardian Royal Exchangebuilding and think that one day we wouldbe a big insurance company and couldn’tstay entirely in Lloyd’s. So this 15% rule isquite interesting as it means that if peoplelike Catlin and us grow successfully, wehave to move out. Do they really wantthat?”Dialogue with DowningStreet“I was having lunch the other day, andthis man (needless to say a banker) saidthat we have lost the right to explain thesuccess of the general insurance industryto politicians. I think he is entirely wrong,but the lack of lobbying is appalling. TheAssociation of British Insurers (ABI) isfocused on corporate governance andlife insurance, with us coming a poorthird. The general insurance parts of theChartered Insurance Institute and theABI should join together with Lloyd’s, andperhaps the broker associations, to forma powerful general insurance associationwith real clout. We do a vital job every bitas important as banks and need our ownlobby. But who’s going to do it?”Heading east“I want us to head east. We look east thewhole time but China is very difficult.You show me someone making moneythere and I will write a quota share.Nobody seems to be making any money inSingapore, and Lloyd’s Japan has similarlybeen tough financially. But we are lookingat the east very closely — it’s all about theright way to do it. In general, in so-calledemerging markets, we are often fightingwith one hand tied behind our backbecause of our tight regulation, whereasthe Africans, Indians, South Americans,Chinese, Russians and others don’t seem tohave the same problem.”The Apple test: becomingmore savvy“How we sell insurance better is crucial.Lloyd’s has a nasty habit of sitting andwaiting for it and, in general, we tend (apartfrom our internet business) to sell the sameproducts in the same old way as we did 40years ago. The question I ask myself is: “Dowe do enough research and development?”I’ve just looked at our household policy andasked, ‘Is it as good as an Apple product?’I don’t fear other insurers; I fear Apple,Google and Amazon. If they start sellinginsurance, we are in trouble.”Issue 1 — December 2012 Specialty 17

Article / Growth: regulatory focusThe SwissSolvencySeen by many as a direct comparator to Solvency II (SII), theSwiss Solvency Test (SST), in force since 1 January 2011, isa mandatory risk-based economic solvency regime for Swissdomiciledcompanies and groups. Here we shine a spotlight onthe similarities and differences between the two regimes andexamine the strategic implications for insurers that are lookingto grow in Switzerland and other locations.18 Specialty Issue 1 — December 2012

Test versus Solvency IIThe SST defines how much capital is required onaverage at the beginning of the year for insurers tocover their liabilities at the end of the year, even inan adverse situation — i.e., to have enough capital tocover the average of the 1% worst situations Havingadopted this framework, Swiss-based(re)insurers will have an advantage when EuropeanInsurance and Occupational Pensions Authority(EIOPA) meets expectations to grant “equivalence”status to SST. They are already prepared and usedto working within a similar environment based onexperience with the SST. However, this would alsomean that the requirements around Pillar 2 andPillar 3 topics will increase. For companies lookingto domicile in Switzerland, or indeed acquire a Swisscompany, the SST raises some interesting issues.The SST framework and the keydifferences with SIIWhile Solvency II is still in development, and a level ofuncertainty remains around the final requirements,SST provides useful insight on what’s to comefor European insurers. The underlying principlesof Solvency II and the SST capital calculation arebroadly similar. Companies use the SST to managerisk, to define the reinsurance structure andexposure steering, and to increase awareness of aportfolio’s risk. Even though the underlying principlesof the two solvency regimes are similar, there aresignificant differences.The standard model for SST differs from thestandard formula of SII. There is a relativelysophisticated SST standard model available fromthe Swiss Financial Market Supervisory Authority(FINMA), covering all risks on an analytical andstochastic basis. The standard model still requirescompanies to derive their own input parameters(e.g., around reserve risk). In this way, a fulldistribution function is derived for each risk type.Issue 1 — December 2012 Specialty 19

The Swiss Solvency test versus Solvency IIThe SII standard model is very much factorbasedand does not derive a full distributionfunction.Internal SST models are mandatory forsome companies, which is not the case inSII. SST internal models are mandatory for:► Insurance groups and conglomerates► Reinsurance companies► All other insurance companies for whichthe standard model is not appropriateCompanies are relatively free to choose anddevelop their internal model, because theSST is principle-based. It has to reflect therisk of the business appropriately and needsto be documented in detail. Internal modelscan be full or partial. Partial internal modelscan use components of the standard modelif these are deemed to reflect the risk of thecompany appropriately.The internal model has to pass a “use test”;the company has to demonstrate that themodel is integrated into the company’score processes and that its outcomes areconsidered in business decision-making.The model has to be fully documented forthe model approval process. In addition,the complete SST report for transferredportfolios of new companies is required.If the model and the report meet certainminimum standards, FINMA typically givesa temporary approval of the internal SSTmodel within the normal license applicationprocess period; a more rigorous modelinvestigation is usually initiated after thelicense has been granted. Currently, FINMAhas approved few models unconditionally(approval can be unconditional, conditional,provisional or declined).There are special rules for reinsurancecompanies. The difference in treatment islegally justified by the different nature ofthe policyholders (undertakings, not naturalpersons). Reinsurers shall develop an internalmodel based on the principles of the SSTwith (few) exceptions that can be allowed byFINMA. However, the internal model can, toa large extent, be identical to the standardmodel, for components where this is deemedappropriate.SST considers additional scenarios.Of particular relevance within the SST is thedescription and evaluation of prescribedand company-specific scenarios. Scenariosreflect the monetary consequences of(loss) events the company is exposed to,but are not reflected within the modelingof the other risk types. They are expectedto play an important role in the company’srisk management framework. Scenarios areconsidered as a fundamental element ofquantifying the required SST solvency capitaland allow FINMA to assess systematic risksin the industry and to appraise the quality ofthe company’s risk management.The solvency capital calculation schemesvary considerably between SST and SII.As a consequence, the solvency capitalrequirements in the two solvency regimescan be quite different; the disparity mightdepend on the products underwritten.SII is based on a more comprehensive andintegrated risk management framework.Apart from the pure solvency capitalcalculation (Pillar 1), the framework alsoincludes extensive risk governance (Pillar 2)as well as public and regulatory disclosurerequirements (Pillar 3). So far, the SSThas primarily focused on Pillar 1, while theother two are not yet developed to the sameextent.The SST quantifies insurance risk,financial risk and credit risk but notoperational risk, in contrast to SII.Operational risks are considered from aqualitative point of view only. Requiredcapital is calculated over a one-year timeframe.SST equivalence with SIISST is deemed to be nearly equivalent toSII, according to EIOPA. Under Solvency II,the European Commission may determinewhether the solvency regime of a countryoutside the EU (third country), such asSwitzerland, is equivalent to the one laiddown in SII in relation to three areas of focus(i.e., Articles 172, 227, 260). The respectivedecision of the European Commission isbased on EIOPA’s final advice, which itselfis based on an equivalence assessmentregarding a preset catalog of differentcriteria.Although the European Commission has notmade a definitive decision on recognizingthe equivalence of the Swiss (re)insurancesupervision system (including the SSTregime) with SII, it is very likely that it will bepositive, due to the fact that:► Possible caveats are related only togovernance and disclosure requirements► Switzerland has declared it will addressthese points20 Specialty Issue 1 — December 2012

Article / Growth: regulatory focusThe benefits experienced from SSTThe introduction of the SST has proven its value in terms of allowingfirms to demonstrate their reliability internationally in a more robustway. While challenges still remain we believe some of the mainbenefits are as follows:► From a market and regulatory perspective— The regulator gets a comparable measure for the solvency ofthe insurance market.— Adjustments can be made, especially to the standard model,if this is deemed to not adequately reflect the economicenvironment anymore (e.g., around market risks).— This protects the customer by ensuring sufficient availablecapital.► From a risk management perspective— This provides an overview of the capitalization of one’s owncompany.— The SST is a tool to identify risks in the business and withinthe company and can support the company to steer the risksof its portfolio.Key considerations for companies pursuinggrowthFor companies that are looking to redomicile, open or acquire newentities in Switzerland, there are a number of key considerations:► For reinsurance companies looking to relocate or open a newentity in Switzerland, an internal model needs to be developed.Existing models (e.g., SII, ICA) can be leveraged. But, based onthe differences laid out in this article, the capital requirementsmight be different, and adjustments to any existing models mayneed to be made.► The development of an internal model should not beunderestimated (from a time and an effort perspective). Thisincludes the development of the model itself, but also thedocumentation of the model and the methodology. Externalsupport can be used.► The capital requirements under SST differ from other regimes.There is no general rule if these are higher or lower.► Future changes to the SST regime should be followed closely,especially Pillar 2 and Pillar 3 changes, which are expected soon.► A detailed plan should be developed early, taking into accountthat the regulator would need to review internal modelapplications before granting a license.AuthorsHans-Jürgen Wolter(hans-juergen.wolter@ch.ey.com) is a Partner, andFlorian Liebe (florian.liebe@ch.ey.com) is a SeniorManager. They both work in Ernst & Young Ltd’sactuarial team in Switzerland.Issue 1 — December 2012 Specialty 21

Article / Growth: preventing tax leakageTax leakage:more than a dropin the oceanAs the sluggish world economy continues to place increasing pressure on investment returns,firms are looking for every possible opportunity to improve their performance.While companies can try to maximize investment returns in a range of ways, includingentering new markets and new asset classes, we think firms need to take a hard look at howto improve their management of the withholding tax cost on cross-border investment income.In short, they need to prevent tax leakage as a quick win to drive improved performance.Tax leakage in this context relates to crossborderinvestments where double tax treatybenefits or claims under domestic lawhave not been applied. A recent EuropeanCommission study identified that the amountof foregone withholding tax relief within theEuropean Union could be as high as €5.47bannually 1 across all sectors. We know ofone global insurance group that reclaimedaround US$90m of withholding and othertaxes after a review.In our experience, many organizations areunderstandably confused about who ownsthe withholding tax process. It is oftendifficult to be sufficiently aware aboutwhat they should be receiving in terms ofpost-tax investment return from the variouscountries they invest in. As each countryhas its own rates, regulations and tax forms,there will always be a level of complexityaround getting this right and receiving theoptimum cash return. However, it is relativelysimple to perform a diagnostic exerciseand identify areas of tax leakage acrossmultiple jurisdictions. We would urge seniorexecutives to focus on this as it does notinvolve complex or aggressive tax planning,but rather involves better controls andprocesses to ensure taxes that are due to bepaid are paid — but nothing more.Understanding the contextCross-border investments are becomingincreasingly important in terms of assetallocation. For example, statistics compiledby the Association of British Insurers showthat the proportion of long-term and generalinsurance investment assets that areinvested in overseas securities has increasedas a percentage of the total of both UK andoverseas securities from 38% in 2005 to 56%in 2010. However, cross-border investorsmay suffer withholding tax on investmentincome arising from holding cross-borderassets, and these withholding taxes need tobe managed to ensure the optimum positionis achieved.The insurance company will generallyhold these portfolio debt and equityinvestments through a global custodian.The custodian’s role is in the post-tradespace, but of relevance here is its role inassisting its clients with securing accessto lower rates of withholding tax pursuantto a double tax treaty or source country’sdomestic law. Accordingly, the custodian’stax services in this context focuses on the1 http://ec.europa.eu/internal_market/financial-markets/docs/compliance/booklet-simplified_en.pdf.collecting and filing of tax documentationto enable investors to make such claims.To claim the benefit of a treaty, some formof documentation is generally required toprove entitlement. Such documentation mayinclude a certificate of tax residence, a treatyclaim form or income payment information.When opening an account, a typical globalcustodian will ask the client to providecertain documentation to determine theappropriate tax service. Often, this will takethe form of a number of representationssuch as:► A representation as to the legal form ofthe entity► Whether the entity is as a general mattertreaty-entitled► Whether the entity is the beneficialowner of the incomeFurthermore, the custodian may askfor a power of attorney to allow it tocomplete certain tax forms and requestdocumentation, etc., on behalf of the client.22 Specialty Issue 1 — December 2012

AInvestorA The global custodian will collect any necessary documentationfrom its clients in order to support its tax servicing proposition.Global custodian bankB The global custodian will in turn pass this documentation,if needed, to the local sub-custodian, which may in turn berequired to pass it up through the chain.BLocal subcustodian(country A)Central securitiesdepositoryLocal subcustodian(country A)Central securitiesdepositoryLocal subcustodian(country A)Central securitiesdepositoryGiven the complexity of the process and the number of potentialmarkets to invest in, mistakes are common. Some of the headlineshere would include: incorrect withholding tax rates, failure to claimtreaty benefits and failure to comply with local source countryobligations. With the increased focus on maximizing returns andgeneral tax authority scrutiny, organizations must have robustoperational processes to manage withholding taxes.Paying agent Paying agent Paying agentIssuing company Issuing company Issuing companyIssue 1 — December 2012 Specialty 23

Tax leakage: more than a drop in the oceanWho watches the custodian?In order for the custodian to provide a tax service — such as filingtax reclaims and collecting tax documentation — a number ofrequirements need to be fulfilled.Firstly, and this may seem self-evident, the custodian needs to beable and willing to offer a tax service in an investment market. This isnot always the case for a number of reasons, stretching from a lackof client demand to unclear processes and procedures. This may bemore of an issue in emerging markets where treaty claim processesare not always clear or defined. Secondly, the lack of a serviceoffering may not always be that apparent to the client, as custodiansare unlikely to publicize any service limitation. While it is common forcustodians to provide tax services in markets with clear regulationsand procedures, they may not necessarily include it within theiroffering where they have little demand for such a service or theprocess is either unclear or costly. As a practical matter, this maymean that an investor potentially entitled to a treaty is effectivelyleaving money on the table.What is the answer? Understanding who is responsible for the taxposition is key — is it the company, is it the custodian, or is it both?Insurers should perform a regular periodic review to identify wheretreaty claims are not being filed and learn why. Where withholding taxclaims are material, it may be worthwhile to either ask the custodianbank to consider filing such claims or appoint a third-party advisorto assist. Potential claims should be considered on a rolling basis toensure that any possible statutes of limitations are managed.Where do the errors typically occur?A custodian tax service is generally predicated on the client takingappropriate action when required. Thus, a custodian will typicallyinform clients through a market information news service updatewhen there is a change in process and a need for new documentationor additional representations to be made, etc. If the client fails torespond, the custodian may take no further action, and a potentialbenefit is lost. The flipside to lack of investor action is that thecustodian may, through poor processes, miss a change or incorrectlyset up a client. Unless such errors are identified, reduced withholdingtax rates could be missed. It can be extremely hard or impossible toreclaim such tax relief in some markets if it isn’t obtained at point ofpayment.Accounts that are set up incorrectly are a real area of concern,anecdotal evidence shows. Insurers should periodically review thecustodian bank’s rates and check against what’s theoretically possible.Discrepancies should be pursued when identified.Another common problem is a lack of general understandingregarding the appropriate investor analysis. This means that certaincategories of investor — e.g., pension schemes arranged throughinsurance companies — may be entitled to an exemption fromwithholding tax in the source country. In addition, global groups maybe missing opportunities to manage exposure to withholding taxesthrough careful management of which entities invest in which assets.Where a group is able to manage its investment portfolio globally, itcan ensure that as many investments fall within the protection oftreaties as possible. However, if the custodian is not sophisticatedenough to ask the right questions at the time of onboarding the client,and the client is not sufficiently aware of such potential benefits, theopportunities can be lost.i) Impact of European Union lawInsurers should consider the potentially positive impact of recentEuropean Court of Justice decisions that relate to cross-borderwithholding tax on dividend payments. A non-resident portfolioinvestor receiving dividend payments cannot be treated in a lessfavorable manner than a comparable domestic investor. Where suchdiscrimination is held to exist, there may be a claim to be made byreference to the principles set out in the EU Treaty. This is relevantin a portfolio investment scenario where a local insurer may havesuffered a lesser withholding tax rate than a comparable foreigninsurer. The amounts of tax involved are substantial, with billions ofdollars at stake.ii) Tax authority scrutinyMany governments are presently under acute fiscal pressure.This poses a further challenge for cross-border investors. As ageneral trend, withholding tax rates are creeping up — e.g., recentchanges in Portugal. Countries are also introducing more onerousdocumentation, Korea and Indonesia being two recent well-publicizedexamples. This is in part designed to repair fiscal shortfalls but isalso a product of tax authorities trying to clamp down on perceivedabuses of process. These new forms often attempt to collate detailedbeneficiary information to help tax authorities determine whether theclaimant is treaty-entitled. From a general compliance perspective,it is therefore important to understand what representations have24 Specialty Issue 1 — December 2012

Article / Growth: preventing tax leakagebeen made and what tax claims are beingsubmitted on your behalf. The cash tax risk(i.e., the tax exposure) of getting a claimwrong is one issue, but the potential damageto reputation and associated franchise riskis greater.iii) Assessing market changesTax laws are notorious for regular change,and, given where we are in terms of thegeneral fiscal cycle, it seems that suchchanges are becoming more frequent. Fromthe perspective of a non-resident investor,changes in withholding tax rules — or, say, aninterpretation regarding treaty eligibility —can require a material change in investmentstrategy. Organizational best practice is tohave a defined process with clear lines ofownership to deal with such changes. This isoften the missing piece on the investor side.Investors generally have a good new product,investment, market or due diligence processin place, but the ongoing maintenance isoften put to one side.Final thoughtsForward-thinking insurers concerned withensuring that they maximize total investmentreturns must scrutinize their withholdingtax position. By running regular reviewexercises and involving the tax functionmore in the investment process, they canoften identify areas where claims have notbeen made. This can be for a variety ofreasons, ranging from complexity of processto missed opportunities. This review shouldbe married up with a fundamental reviewof the governance and control processessurrounding operational taxes to ensure thatthe correct level of tax is being paid.It is not clear when the market will turn andpremium rates will rise to a level to allowthe pressure to be taken off the investmentreturn. In the meantime, the pressurewill remain on the investment function todrive ever-greater returns and to supportthe profitability of the business. With thechallenges in the wider economy showingno sign of easing, managing tax paid oninvestments is one simple way to drive abetter return.Key questions to ask1. Is responsibility for operationaltaxes clearly defined within yourorganization? Where does it lie?2. Who is responsible for the taxrelationship with your custodianbank(s)?3. How comfortable are you that yourorganization is not suffering anyunnecessary withholding tax beingpaid in relation to your investmentassets or investment return?4. Do you have a robust process tomonitor operational tax changesand consider any impact?AuthorsPaul Radcliffe (pradcliffe@uk.ey.com) is a Directorwithin the tax practice of Ernst & Young LLP (UK)with experience of operational taxes.Jeff Soar (jsoar@uk.ey.com) is a Partner within theEMEIA tax practice of Ernst & Young LLP (UK).Issue 1 — December 2012 Specialty 25

Article / Growth: operational transformationThebenchmarkThe results of Ernst & Young’s benchmarking survey — the first focusing onlyon the specialty market — show substantial opportunities for global specialty(re)insurers to reduce costs by transforming their operating models andsimplifying their businesses. For those firms that are challenged to drivemargins in a sustained soft market, we’ve identified a number of ways toimprove efficiency.The 2012 Ernst & Young costbenchmarking survey was designed toidentify key operational transformationopportunities for specialty (re)insurers.Participants of the survey include 16(re)insurers, mostly headquartered inBermuda with offices in a range of countries,including the US and UK. Participants rangedfrom some of the smallest companies inthe market to the largest: Gross WrittenPremiums ranged from US$500m toover US$3b and FTE (full time equivalent)employees from under 100 to over 3,000.Participants were asked to provide details ofthe cost and FTE breakdown by function andby cost type to allow detailed comparisonsbetween peers.Significant savings can beachieved in underwriting,finance and ITThe underwriting function was the largestand most costly function for the majority ofour survey participants. However, the rangeof results was very wide and indicated variedapproaches to balancing ‘front office’ and‘back office’ costs. The majority of insurershad some form of underwriting supportin place, but this was often in higher costlocations or segmented by line of businesswhich reduces the cost efficiency of theseactivities. Compared with the benchmark,this may indicate that some underwritingactivities could be moved to operational orsupport functions.Underwriting cost as a % of total costErnst & Youngbenchmark range17% 38% 60%AverageFinance functions also varied widely insize and cost — the finance functions forall participants were significantly largerand more costly than their equivalents incommercial or retail insurers. These largerand more expensive finance functionsindicate complexity and inefficiency inunderlying processes. This may be causedby role duplication, manual processesand system inefficiencies resulting fromfront-office versus back-office investmentprioritization. They may also be attributed tothe complexity of the legal entity structure.Finance FTE as a % of total FTEErnst & Youngbenchmark range11% 16% 24%AverageThe size of IT functions depended on projectactivity taking place within the organizationsconcerned and also the amount of offshoringand outsourcing that has taken place; thecost of this function can indicate the scale ofoperational transformation. Significant ITinvestment did not appear to be widespread;while the IT spend per FTE ranged fromUS$9k–US$120k, the average was US$38k.However, many participants told us theywere considering investment in claims, policyand finance system replacement, as well assimplifying the overall IT landscape.IT cost as a % of total costErnst & Youngbenchmark range8% 12% 28%AverageClaims, risk and actuarial arealso important areas for costreductionOrganizations with a composite book ofinsurance and reinsurance tended to havelarger and more costly claims functions;in comparison, organizations with smalleror less costly claims functions may haveoutsourced claims or may handle lowervolumes.Market trends showed that claims systemreplacements are being put in place toincrease efficiency and control, such as theuse of Guidewire and claims leakage reviewsto identify ongoing opportunities to reducethe claims ratio.26 Specialty Issue 1 — December 2012

“ Few specialty(re)insurers havefocused onsimplifying theirbusiness modelsand in my view will miss outon substantial cost savingsas they increase in sizeunless they prioritize this.”Ben Reid, Director, Ernst & Young LLP (UK)Risk costs were high, reflecting a recentfocus on Solvency II and other complianceactivities. This increased the amount ofrisk-based capital required and also seniormanagement accountability, putting pressureon compliance and risk departments.Our results indicated that there was somedisparity between the size of the actuarialfunction; we discussed opportunities forsynergies between finance and actuarial,where there are common support functions.Also, there is potential for co-location ofpricing actuaries with underwriting teams aswell as actuarial function rationalization.Some specialty (re)insurersare already implementingopportunities to reduce cost,and many more need to befast followersGlobally, a number of (re)insurers areimplementing operational transformation orcost reduction programs, with a particularfocus on underwriting, finance and ITefficiencies in these complex areas of thecost base.Those organizations that have implementedcost reduction showed smaller or lesscostly functions than those that have not.For example, the finance functions of twoorganizations that had implemented financeeffectiveness initiatives were 9% and 13%of the total cost compared with the averagebenchmark of 15%.“ In my view,trends such asthis have reallygenerated a lot ofinterest in costreduction. With the excess ofcapital in the market,providing reasonable returnsto shareholders must includea focus on efficiencies in allback-office functions.”Philip Burrill, Partner, Ernst & Young Ltd(Bermuda)Issue 1 — December 2012 Specialty 27

The benchmarkIn order to achieve a substantial reduction in costs, underwritingshould be a key focus area for any expense initiative. A typicalobjective is to move routine activities from underwriters tooperational or support roles, which can release up to 30% ofunderwriters’ time to be used on increased trading, or released as acost saving.Concerns about high-cost locations and personnel costs haveincreased activity focused on offshoring processing and outsourcingin the IT function. Some (re)insurers have a fully insourced modelin high-cost locations, whereas others are beginning the process ofoutsourcing infrastructure and application development to lower-costlocations.“ This is a trend we are seeing — whether ornot companies actually make the decisionto move resources to other locations, it issomething that most players have at leastcontemplated. The locations consideredare also not restricted to ‘offshore’locations such as India, but could includelocations that are back ‘onshore’ as well,if the economics make sense.”Philip Burrill, Partner, Ernst & Young Ltd (Bermuda)There are a series of “get rights” to achievingcost reduction, notably executive sponsorship,clear objectives and robust ROIInitially, a powerful guiding coalition and clear objectives need to beput in place to establish a clear definition of success and to provideownership and accountability for individual business units and a coregroup of influential stakeholders.Secondly, a sense of urgency is required to drive the program forward,establish a sense of executive sponsorship and aim for measurablewins.This is complemented by a balance between analysis and action,which will drive pace and delivery focus; in addition, utilizingbenchmarks such as those from our survey will stretch conventionalthinking.“ This tallies with what I’mseeing in the market — costreduction programs with clearleadership from the CEO andCFO are more successful for anumber of reasons: accountability issharper and delivery is more successfulas benefits are tracked and measuredregularly against targets set by the teamand the sponsors. It’s vital to have clearcommitment and leadership.”Paul Cooper, Partner, Ernst & Young LLP (UK)AuthorsBen Reid (breid@uk.ey.com), Philip Burrill (philip.burrill@bm.ey.com) and Carolyn Myers(carolyn.myers@bm.ey.com) are currently working with a number of specialty companies to help deliverexpense reduction, including finance transformation by improving process efficiency, reducing duplicationand consolidating financial systems. Please contact them for more information about the survey.28 Specialty Issue 1 — December 2012

Article / Growth: operational transformationIssue 1 — December 2012 Specialty 29

Key contactsPlease get in touch with the people below or your usualErnst & Young contact, should you have any questions.AmericasUnited KingdomEdward Majkowski+ 1 212 773 2086edward.majkowski@ey.comPaul Cooper+ 44 207 951 6102pcooper@uk.ey.comBermudaSwitzerlandPhilip Burrill+ 1 44 1294 5317philip.burrill@bm.ey.comRolf Bächler+ 41 58 286 4495rolf.baechler@ch.ey.comAsia PacificPaul Clark+ 61 282 956 967+ 61 408 465 303paul.clark@au.ey.com30 Specialty Issue 1 — December 2012

Contact for subscriptionsgpage@uk.ey.comCommentsIf you’d like to pass on anycomments or suggestions toour editorial team, please emailpcooper@uk.ey.comErnst & YoungAssurance | Tax | Transactions | AdvisoryAbout Ernst & YoungErnst & Young is a global leader in assurance, tax,transaction and advisory services. Worldwide,our 167,000 people are united by our sharedvalues and an unwavering commitment to quality.We make a difference by helping our people, ourclients and our wider communities achieve theirpotential.Ernst & Young refers to the global organizationof member firms of Ernst & Young Global Limited,each of which is a separate legal entity.Ernst & Young Global Limited, a UK companylimited by guarantee, does not provide servicesto clients. For more information about ourorganization, please visit www.ey.com.About Ernst & Young — a leading advisor tospecialty insurance and reinsurance firmsgloballyErnst & Young has an integrated specialty teamwho are committed to providing world classservice. Our seasoned practitioners have deepspecialty (re)insurance market knowledge andexperience — we operate as one team in order toprovide companies with global solutions to theirglobal challenges. This focus means we are ableto bring customized business solutions, valuablemarket insights and leading practices to businessesregardless of their location.This publication contains information insummary form and is therefore intended forgeneral guidance only. It is not intended tobe a substitute for detailed research or theexercise of professional judgment. NeitherEYGM Limited nor any other member of theglobal Ernst & Young organization can acceptany responsibility for loss occasioned to anyperson acting or refraining from action asa result of any material in this publication.On any specific matter, reference should bemade to the appropriate advisor.The views of third parties set out in thispublication are not necessarily the views ofthe global Ernst & Young organization or itsmember firms. Moreover, the views shouldbe seen in the context of the time they wereexpressed.ED NoneEMEIA MAS. E106.0812© 2012 EYGM Limited.All Rights Reserved.EYG No. EG0098In line with Ernst & Young’s commitment to minimizeits impact on the environment, this document has beenprinted on paper with a high recycled content.Issue 1 — December 2012 Specialty 31

What aretoday’s highperformersdoing differentlyto succeed?conditions by taking innovative approaches.Find out more in Growing Beyond: howhigh performers are accelerating ahead atey.com/growingbeyond.See More | Growth© 2012 EYGM Limited. All Rights Reserved. ED None.