Scrap 'misconceived' Solvency II regulations

In 2008 the United Kingdom's Treasury department, writing about the potential 'benefits' of Solvency II, said: "Solvency II is based on a three-pillar approach used in the Basel II banking accord." This was at the height of the banking crisis and came without any apparent recognition of the failure of regulation in that crisis. This is hardly the best recommendation for Solvency II.

More recently in a leaked letter Andrew Bailey, head of the Prudential Regulatory Authority, criticised Solvency II, the complex set of rules being developed by the European Union to regulate all insurers in the bloc in a uniform way. He was right to do so. Everything about Solvency II is misconceived. It is estimated that it will cost EU insurers £3bn. The new regulations are still at least three years from implementation after delay upon delay. And they attempt to fine-tune the capital requirements of every insurance company in the EU, as if a regulator can decide exactly how much capital companies need in order to have a precise probability of insolvency.

Solvency II is likely to incentivise investment in government bonds with a poor credit rating while raising the cost of capital to private companies, because it will make investment in corporate bonds more expensive for insurers than investment in government bonds. Just as international banking regulation distorted the behaviour of banks and made them do more complex and risky things, Solvency II will do exactly the same to insurers.

Yet Solvency II is simply not necessary. We do not need to centralise regulation at EU level in order to ensure the free movement of financial services around Europe. In fact, currently, very little cross border trade in financial services happens through branches whereby insurance sold in, say, a branch in France is regulated by the regulator in, for example, the UK where the head office might be located. Most trade in insurance services – certainly at the retail level – happens through subsidiaries which are regulated in the country in which they are established allowing different countries to regulate their insurance industries in the way that is appropriate given their history and structure. It is perfectly feasible to have free trade without uniformity of regulation.

However, Andrew Bailey's motivations for criticising Solvency II were themselves misguided. He implied that Solvency II would not be tough enough on insurers. After the regulatory debacle surrounding Equitable Life when antiquated actuarial techniques, encouraged by the regulator, proved inadequate to manage modern risks it seems that regulators want to ensure that British insurers are so safe they never fail.

The most successful period in the insurance industry's history was arguably the century or so from 1870. During most of this period there were no specific solvency rules for insurers. Insurance companies had to publish balance sheets and the basis upon which they were compiled. Different funds designed for different purposes had to be separated. The Board of Trade could take action to wind up insurers using a special resolution mechanism if necessary. There was the odd failure in the non-life insurance sector but, despite two world wars, exchange controls, a great depression and then the post-war slump in the value of money the life insurance sector never had a failure that affected policyholders.

There is a lesson here. Both the EU and the UK financial regulators are, in a sense, trying – as TS Elliott put it in a different context – to design a system so perfect that nobody needs to be good. Indeed, worse than that, attempts to over-regulate financial markets undermine those crucial checks on behaviour that develop within markets themselves.

Furthermore, complex regulation allows the regulatory process to be captured by a few firms who make money from expensive models and who know how to exploit and game the regulatory system. Yes, Solvency II should be scrapped. But we should think again about our regulatory system in the UK too. Perhaps it is time to wind back the clock – not to 2000 when the Equitable failed, but further back to an era when a regulatory system known as 'freedom with publicity' went hand-in-hand with security for policyholders.

This article originally appeared on Public Service Europe.

Not just Solvency II but its banking counterpart Basel II and III are just about as ridiculous though wearing the garb of highly mathematical, highly esoteric. These regulations have so many faults that it would necessitate a lengthy dissertation but a few lines to provoke a lay reader: 1. Highly opaque rules that a large part of management pretends to understamd but actually does not. 2. Very, very difficult for a lay shareholder to understand. 3. Rather than leave risk-reward equation (and consequently success - failure) to shareholders and directors to solve, it transfers a large part of that onus to bureaucratic rule writers and public servants. 4. It does not look upon capital rules as a 'minimum qualifying requirement' but seeks to calibrate optimality and sufficiency which should be the domain of not the bureaucrat but the risk-taker / shareholder. 5. The rules seek to undermine the importance of failure to a free market, tyranny free society. We should be actively seeking to delegitimise these rules on moral grounds and civilisational tenets, not on the basis of book-keeping.
brilliant summary, abhay
"Arguably the only way to get to the point of a more logical system will be for Solvency II to collapse under the weight of its own shortcomings – a result that still whilst still unlikely looks increasingly possible." From http://blog.willis.com/2013/03/capital-modelling-in-solvency-ii-where-di... Highly recommended reading.

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