Solvency II and the shifting risk to consumers


Gideon BenariEurope is introducing Solvency II at a time when other global accounting and regulatory standards are being implemented. In this article, Gideon Benari, editor of Solvency II Wire, asks: Could Solvency II and the other regulatory and accounting changes harm the very consumers they are trying to protect? The changing landscape The regulation of Europe’s insurance industry needs to be reformed. Of that there is no question. The current framework – Solvency I – was put in place in 2002, but its roots are based as far back as the 1950s. Technological developments and market liberalisation have created a more dynamic and innovative financial landscape. We need to create a regulatory framework that is adequate for the 21st century and the prevailing economic conditions, and is in keeping with a harmonised European market. But, at the same time, we must make sure it delivers the right outcomes and does not hurt those it aims to protect. Observable trends: risk-shifting and transfers The changes in markets and economies over the past quarter of a century have led to an observable trend of gradual risk-shifting away from traditional insurance and government institutions towards markets and individuals. The continued low yield environment that prevailed for the past decade or so and the downturns of 1999 and 2008 have further accelerated this trend: hurting the balance sheets of many insurers and reducing profitability as they struggle to honour commitments made in more prosperous times. Evidence of this shift can be seen in the falling share of policy holders of defined benefit pensions and guaranteed return insurance products. At the same time there has been an accelerated trend of risk transfer to financial markets through increasing use of reinsurance, securitisation and derivatives to compensate for the fall in asset prices and low yields. It is in this context that the Committee on the Global Financial System (CGFS) established a Working Group to explore the potential effects on markets and consumers of a number of upcoming regulatory and accounting standards, such as IFRS and Solvency II. Effects on markets and consumers In July the working group published a report, Fixed income strategies of insurance companies and pension funds, in which it said that the system-wide effects of these new regulation and accounting standards are under-explored and it identified a number of areas that may well accelerate the trends outlined above. The report also recognised that of all these upcoming changes, Solvency II will have a profound effect on the insurance industry. In this context Solvency II raises a number of dilemmas that are worth exploring. The report noted that, “Overall, it seems likely that capital requirements under Solvency II will, in aggregate, lead to a risk reduction in the asset allocation of the insurance sector as a whole.” However, Peter Praet, Member of the Executive Board of the ECB, who chaired the CGFS Working Group, told Solvency II Wire in an interview, “While this risk reduction is welcomed, Solvency II may accelerate a number of trends that have a less positive effect. These include, continued risk-shifting to policy holders through increasing exposure to financial fluctuations; increased risk taking in search of yield should low interest rates persist; risk transfer to financial markets through increase use of derivatives and hedges; and reallocation of assets away from equity and illiquid assets, partly to reduce interconnectedness, away from bank bonds.” Furthermore, a shift of a portion of the risk to households could result in inefficient risk-sharing, which in turn could have a negative wealth effect that could reinforce a downturn. Mitigating factors The impact of Solvency II is far from certain. As Mr Praet noted, “Our assessment of the effects of Solvency II is preliminary. We recognise that a number of factors may counterbalance the risks I outlined above, so it remains to be seen what the full effect of Solvency II will be.” For example, the report noted that it was likely that the use of an internal model, rather than the standard formula, will result in lower capital requirements that match a firm’s line of business, freeing up substantial capital for investment. In addition, the transitional periods for the full implementation of Solvency II may well allow other market participants, such as hedgefunds to move into those asset classes abandoned by insurance firms. Solvency II, conflicting outcomes The potential detrimental effects of Solvency II to households and the economy require some exploration. The report reminds us of the importance of collective risk sharing. “The raison d’être of insurance companies is to take a large number of individual, independent and largely homogeneous risks and diversify them directly or indirectly (via reinsurance and securitisation), thereby helping consumers to smooth consumption over their lifetimes.” If the regulation put in place will accelerate contrary trends, we must ask ourselves, and the industry, some difficult questions. It is clear we cannot ignore the growing problem of the capital gap confronting the insurance industry. And surely any regulatory system we put in place must allow firms to exploit the full range of market instruments to deliver their obligations and maintain profitability. But as the authorities and the industry set out to reform the regulatory system they cannot consider the insurance industry in isolation. They must strike a balance between the needs of individuals, industry and society. — The views expressed are the author’s own.