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The improvement in the regulatory environment in Central and Eastern Europe is having a positive impact on the the credit ratings of local insurers despite a number of challengesWhen talking about emerging insurance markets it is important to resist the temptation to generalise, according to Chris Waterman, managing director and head of the Europe, Middle East and Africa (EMEA) insurance practice at Fitch Ratings. The term “emerging markets” is widely used to refer to insurance markets in Asia, Latin America, eastern Europe, the Commonwealth of Independent States (CIS) and, more recently, to insurance markets in sub-Saharan Africa. The relevance for Waterman is Fitch has recently issued a report on emerging European insurance markets, “but here, again, you are talking about a very broad range of countries with insurance industries at different levels of development. There are very different challenges in each of these markets”, he says.
While the Fitch report by no means underplays the challenges facing insurers in central and eastern Europe (CEE) and the CIS, it is very positive about the prospects for insurance markets in the region over the next five years. Indeed, Fitch expects a notable improvement in the credit quality of insurance companies in these markets over that period. According to the report, many emerging European insurance markets are growing at annual rates of 20% or more. This compares with the regional market in western Europe which declined 2% last year.
Although the Fitch report is informed by the rating agency’s presence in other insurance markets in the region, many of its conclusions are based on research and data collected from a sample group of four countries: Belarus, Kazakhstan, Russia and Turkey. Clara Hughes, a senior director in Fitch Ratings’ insurance team and the lead analyst on the market report, says one reason for these markets featuring in the Fitch sample group is these are the countries where Fitch has issued the most insurance sector ratings in the region. However, adopting the most consistent approach possible was an equally important consideration for Hughes and her team. “The varying levels of development in these countries is always an issue. When we started the report, we had another market in the region as part of the sample group. But it was just too much information. That market is not really at the same level of development as the other four. It is lagging behind a little bit,” she says.
But what is it about the insurance market and other developments in these four countries that encourage Fitch’s belief the credit quality of companies in these markets will improve significantly over the next five years – particularly, as the report points out, as these insurance markets are tiny, representing just 2% of world premiums and even the biggest companies in the market are deemed small by Western standards? Hughes cites insurance penetration – premiums as a proportion of GDP – as a major indicator of growth potential. Penetration, she says, is as low as 1% in these markets, compared with up to 13% in developed markets. This, she says, represents huge opportunities for local insurers in terms of increasing their business volume on the back of the vibrant economic growth in some of these countries.
But there are challenges, according to Hughes. “I think education is an important issue in terms of people understanding and valuing the benefits of insurance. Also, there is the issue of a lack of disposable income in these countries, so even though you might see extremely fast GDP growth, that doesn’t necessarily translate into a higher disposable income among the general population.”
For Waterman, expanding the channels through which insurance products are distributed would also help to increase insurance penetration. “There is a need for alternative distribution channels to better cover the population. This, coupled with increased wealth distribution, should theoretically improve the growth potential of insurance markets in the region, which is what all the forecasts are indicating. This is why we are seeing many foreign insurance groups looking to invest.”
Another challenge for insurers in the region is the way the insurance sector is perceived by the general public. In some markets in the region, Hughes says, insurers’ behaviour has fallen well short of what the public expected of them. “For example, credit insurance policies in some markets during the financial crisis did not pay out and the way some of those policies had been structured, they were not intended to pay out. There have been a number of such examples, including incidents involving savings products in Russia, so a huge issue for the market is convincing people they will actually be compensated in line with their loss. If insurance is not perceived as actually functioning as insurance, people are not particularly encouraged to take out cover unless they really have to.”
For Hughes, an important development in terms of addressing the issue of trust between consumers and the insurance sector is the changing regulatory frameworks in the region. “These are intended to improve regulation, transparency and to introduce higher solvency requirements. Public trust is not necessarily something insurance companies can address themselves. But I think it is really important there is a supervisory framework in place that ensures insurance is really functioning as insurance.”
Taking Russia as an example, she says the regulatory responsibility for the insurance sector has recently shifted to the Bank of Russia, although the previous regulator, the Ministry of Finance, had introduced a number of measures to support the development and liberalisation of the insurance market as part of a list of specific commitments made by Russia when it joined the World Trade Organisation in August 2012. These included increasing the capital requirements for insurers, which reduced the number of companies in the market from 600 to fewer than 400. Hughes expects the Bank of Russia (which, in addition to regulating the banks, also assumed responsibility for insurers, insurance brokers, private pension funds, asset managers, investment funds and investment brokers in September) will be stricter than the previous regulator. In Russia, the level of supervision in the banking sector is widely judged to be higher than in any sector of financial services.
However, it is not all positive in terms of regulatory developments in the region. Occasionally, there are what Hughes refers to as “hiccups”. “In Ukraine, where quite a number of insurance companies have set their business models up around compulsory insurance products such as third-party motor liability, the government is in the process of taking a new insurance law through parliament which, if it is passed, will create a new state company to write to these compulsory insurances.”
From a credit perspective, according to Waterman, the improvement in the regulatory environment impacts Fitch’s ratings in several ways. “For example, it can manifest itself in better capitalisation. In many of the markets we cover in eastern Europe and the CIS region, capital requirements are going up, which places insurers in a better position to write business. On the back of that trend, we are also seeing an improvement in corporate governance, which historically has been quite a weakness in the region. In addition, regulators are also focusing on reserve requirements, reinsurance criteria and so on.
All of those developments help to improve the credit profiles of insurers in the countries we cover. Over time, that process of improved regulation will enhance many of the metrics we take into account from a rating perspective. The consolidation we are seeing results in larger companies, increased scale, better efficiencies and improved profitability. All those things go together. Factors like size, scale and capitalisation matter when it comes to developing ratings,” he says.
However, there are a number of factors that limit the ratings that can be issued to companies in these markets. “Typically, we don’t rate insurance companies above the sovereign for the country. This indicates the ability of governments to meet their obligations. So ratings on companies can be significantly constrained because of our view of the economic environment and other challenges faced by the government. Other factors which limit ratings are the level of corporate governance, the opacity of ownership structures, management controls and so on. Profitability is an issue in these markets, which are very competitive. Making money is a challenge for insurers and is an important driver in terms of ratings. So a number of factors such as the sovereign rating, profitability, capitalisation, reinsurance programmes and reserving can act as constraints. These, I think, will over time improve but at the moment they mean the ratings we have on companies in the market are relatively low compared to our ratings in developed markets. In some cases, they are significantly lower,” Waterman says.
Other emerging markets
Fitch expects insurance market growth to outpace the global average, with emerging European insurance market premium income reaching a 5% share of the global market by 2020. But one of the central findings of the report is while growth in emerging European insurance markets will exceed that of developed markets, it will continue to lag behind that of other emerging markets, particularly those in Asia. In terms of accounting for this finding, Hughes points to differences in the comparative rates of GDP growth between countries in south-east Asia and countries in central and eastern Europe (CEE). “GDP growth in emerging markets in Asia is considerably higher than in emerging European markets. That is partly down to the drag of the eurozone crisis. In eastern Europe, you have got things like unemployment and issues with asset values. In Ukraine, for example, where there was a huge boom in the sale of credit insurance products on the back of mortgages, that has almost completely dried up now because people are not buying houses any more.”
Research by Fitch suggests a definite correlation between GDP growth and an increase in insurance penetration, according to Hughes. “As the rate of GDP growth increases insurance penetration typically grows faster, so there is this compound impact. That is why you see much higher insurance penetration in Asian countries. With regards to people’s behaviour, historically in eastern Europe the general public have been exposed to very high inflation rates and that has produced a spending rather than a savings culture, which tends to be the case in south-east Asia. If you look at the split in insurance product lines in Asia compared with emerging markets elsewhere, you will often see a larger percentage of savings products in Asian markets. I think that is partly cultural and reflects a greater public trust in financial services institutions than you find in eastern and central Europe,” she says.
Waterman also points to the relative differences between the population numbers in countries in Asia and in the CEE region. “This is quite important if you are looking at single markets that are likely to become dominant forces. For example, in China you can see the ongoing process of urbanisation and huge growth in the size of the middle class. For China, the sheer size of the population is a huge factor in terms of future growth prospects for its insurance sector. By 2023, China is likely to account for 15% of the global insurance market.”
But the overall trend in the region is decidedly positive and Hughes points to other indicators which suggest the growing maturity of some of the markets in the region. “One thing we have started to see recently has been debt issuance on the part of insurance companies. These transactions have mostly been private issues or loans with banks but that indicates the counterparties have enough information on these companies and enough confidence in their business models actually to loan them money. They are willing to invest their money in debt capital markets, often in savings products and pension funds. We think as the market develops these companies will start to borrow money in the open market, which will lead to more transparency and disclosure. With disclosure comes scrutiny, which further strengthens companies’ operating structures.”
Indeed, for those companies in the region going through the rating process, this usually involves a significant learning curve. “They learn different things about what we are looking for in terms of transparency, data and the presentation of information. Going through the rating process gives companies a different way of looking at things and can affect the way they look at their businesses,” Hughes says.
The ratings are used for various reasons in the emerging European insurance markets. One reason, Waterman says, is peer comparison. “It enables users of the ratings to identify which we view as the strongest and weakest companies in a particular market. But companies also find having a rating is useful for things like buying reinsurance in the international markets. There are local reinsurance markets, but a portion of the business is typically placed in the international reinsurance markets. International reinsurers will do their own assessment of the credit quality of the ceding companies but they will also look at the ratings that have been assigned to companies.”
While there are still considerable challenges, it is increasingly easier for rating agencies to operate in the region. However, it remains difficult to make an assessment of a company’s creditworthiness based solely on information in the public domain. “We are looking at a region that is significantly less sophisticated and where access to market data is much more limited than in the West. For example, companies’ ownership structures are very difficult to identify unless you are actually sitting down with the insurer and asking direct questions,” Waterman says.
In Russia, for example, companies now have to issue their financial report in accordance with International Financial Reporting Standards (IFRS). “That has been in place for two years now and the quality of information in terms of the performance of companies has improved considerably because it is on a more realistic basis than local GAAP [Generally Accepted Accounting Principles] reporting. But there is only so much information you can get out of published IFRS statements. So, definitely at this point in time, when we do ratings in that type of environment, we would sit down with a company and discuss their results, their reserving standards, how they price, the quality of their data and their reinsurance programme and how it performed over previous years. Without that extra information, I don’t think it is really possible to produce a rating,” Hughes says.
But here too the trend is positive, according to Waterman. “Historically the regulatory structures in many emerging markets have been very basic. There have been some simple capital requirements and other metrics around reserve adequacy and reinsurance. In Europe, through the introduction of Solvency II, developed countries have moved to, or are moving towards risk-based regulatory regimes. This is a trend we are seeing across the world. It is a move from a Solvency I-type world to a Solvency II-type world and that is what is happening, albeit somewhat delayed in emerging Europe. Certainly, the expectation over time is these emerging countries will move to a more sophisticated risk-based regulatory framework. The reason for that is not because they are necessarily copying what is happening elsewhere but because it is simply a better framework and is more predictive of insolvencies. Consequently, it is better for the market as a whole.”
Chris Waterman CV
Chris Waterman is a managing director within the insurance division of Fitch Ratings London. He joined Fitch in 2001 and is responsible for overseeing a team of analysts covering a broad geographical range of life and non-life insurers and reinsurers. Before joining Fitch, he was senior managing financial analyst at AM Best Europe. He joined A.M. Best Europe in 1997 as one of the founding members of this start-up operation.
Waterman began his career in 1983 as a directors’ and officers’ liability broker with Willis Faber & Dumas. In 1987, he joined Jardine Insurance Brokers as group security officer, responsible for managing the group’s market security department. In 1995, he took a new role as executive director within the market security department of global broker Minet.
Waterman has a BA honours degree in insurance, banking and finance from the University College of North Wales.
Clara Hughes is a senior director in the insurance department of Fitch Ratings. She leads Fitch’s ratings analysis of several global life insurance groups and projects including initiating insurance coverage in various European emerging markets, EMEA insurance’s capital modelling and Fitch’s Solvency II research.
Hughes is a qualified actuary and previously worked at the Wesleyan Assurance Society and Friends Provident specialising in capital modelling.