After over a decade in the making, EU-wide rules are here.

To its fans, it is a beautiful example of harmonisation, a way of protecting customers and investors that also helps to create equitable European conditions. To its opponents, it is an overly complex piece of regulation that will push up prices for consumers and impose an enormous extra administrative burden on companies. Even after more than a decade and a half of planning, discussion and fine tuning, the EU’s Solvency II insurance rules are displaying their potential to divide opinion in the industry. The regime came into force on January 1 and is the biggest change in European insurance regulation since the 1970s. Out goes a patchwork of local systems, in comes a common set of rules across the EU.

Jeff Davies, partner at EY, sees two big differences from previous regimes. “The first is that it is a market value balance sheet, whereas for most of Europe it was a book value balance sheet before. Moving to market values will make balance sheets more volatile,” he says.

The other is a move to what is known as a “risk-based approach” to capital and regulation. Insurers have to ensure that they have enough capital on their balance sheets to withstand a level of stress that is deemed likely to happen only once every 200 years. The risks to assets and liabilities are examined in a far more detailed way than before.

“Risk-based capital is a great thing,” says Omar Ripon, partner at accountants Moore Stephens. “The best firms are looking at using it to improve their returns. If you only look at it from the compliance angle, you won’t get the benefits.” At a very high level, Solvency II shares some features with the equivalent in the banking world, Basel III. It is a three-way approach to supervision: the first is the calculation of capital levels; the second is internal control and supervision by regulators; and the third is supervision by the market, with added reporting requirements so that outsiders can come to their own conclusions.

As with Basel III, there are transitional rules to help companies adapt to the regime. So January 1 was for many insurers part of an evolution from what they used before, rather than a revolution. As with the banks, insurers can use either internally developed models or standardised models produced by regulators to work out their capital requirements. That is where the similarities end. The long process required to create the new system shows how complex it was to create a common set of rules to cover national insurance markets that had evolved in very different ways.

“There was a lot of lobbying and campaigning,” says Mr Davies. “Everyone had their own pieces that they wanted and they had to be traded off against each other.” David Prowse, senior director at Fitch Ratings, notes that work remains to be done on harmonisation. “Different countries have different opt-outs via transitional arrangements. And there are differences in terms of how each regulator interprets the rules.”

For now, the main focus for analysts and investors is the Solvency Capital Ratio or SCR. This is a measurement of the amount of capital that insurers have available as a proportion of the minimum required. The higher the ratio, the more spare funds the insurer has. Regulators and insurers have been at pains to stress that the ratios are not comparable with those that were used before or with those reported by other insurers because of the different ways that the rules have been interpreted.

Nevertheless, early indications suggest a wide divergence between the companies. At the top of the pile, Germany’s Allianz, France’s Axa and NN Group of the Netherlands have all reported ratios of more than 200 per cent. At the other end, Netherlands-based Delta Lloyd has reported a ratio of 131 per cent and wants to raise €650m in a rights issue to strengthen its balance sheet.

The impact of Solvency II stretches beyond a single ratio. Over the long term, it will change the way insurers operate. “It is definitely changing business models because of the effect of the rules on new business,” says Mr Prowse. The biggest impact is expected in the life insurance sector, where Mr Prowse forecasts a shift away from insurers offering long-term investment guarantees, which carry heavy capital requirements under Solvency II.

UK annuity business is also changing. Those insurers still selling annuities are increasingly buying reinsurance for the longevity risks in order to reduce capital requirements. The impact elsewhere will be less severe. “In general, Solvency II has fewer implications for non-life property and casualty business,” says Mr Prowse. “Some products will cost a bit more, but people will carry on buying them, so the main impact will be on the customer.”

Solvency II also influences the asset side of the balance sheet. All insurers hold large investment portfolios to back the promises that they have made to their customers. Returns on these portfolios have traditionally provided a big chunk of their profits. On the general insurance side of the business, where claims are unpredictable, companies tend to hold a lot in liquid assets. In the life insurance industry, however, companies have a lot more flexibility over where to invest. It is here that Solvency II has had the biggest impact as the insurers aim to move away from assets that carry high capital charges under the new rules, but at the same time avoid assets whose returns are either tiny or negative.

In the much larger bond portfolios, those insurers that have offered long-term guarantees have moved towards gilts, but these offer very small returns. Others have therefore moved down the credit curve. Infrastructure debt has been particularly popular. This offers better returns than government bonds and its long-term nature matches many insurers’ liabilities.

However, not everybody has been able to invest. “There are access issues because liquidity and issuance aren’t great,” says Richard Sarsfield, head of European insurance at Morgan Stanley Investment Management. “Smaller insurers are struggling to access the market.” The Solvency II story did not finish on January 1. The transitional rules alone last for 16 years. As insurers get used to Solvency II, it is not only their products and asset portfolios that will change. Many are expected to buy and sell whole businesses as they reassess which ones work well in a Solvency II world, leading to a wave of merger and acquisition activity that started last year.

“It has definitely changed the way we do business,” says Bart De Smet, chief executive of Belgian insurer Ageas. “We’ve divested small entities and we’ve bought some non-life companies.”

The next few years will also see a formal review process. An assessment of some parts of the regime is due in 2018, although already the UK government has called for the review to be sooner and more wide ranging than had been planned.