Prior to the Great North Atlantic Recession, international bank regulators were highly protective of their decade-long development of the new banking accord – Basel II. Warnings of its impending failure were dismissed. However, once the financial crisis made it clear that Basel II had taken a wrong turn, they were quick to introduce amendments. With more than $50 trillion in assets worldwide, investment funds run by the insurance industry and pension system are one of the most systemically important elements of the global financial system.
The crisis presented an opportunity for regulators to take a fresh look at plans for insurance regulation and in particular how the interplay between banking and insurance markets could be incentivised to make the financial system safer. But the regulators didn’t use the opportunity and warnings of the impending failure of the new plans were dismissed.
Solvency II, codifies and harmonizes insurance regulations in Europe, in order to reduce the risk of an insurer defaulting on its obligations and producing dangerous systemic side effects. The regulation tries to achieve these aims primarily by setting capital requirements for the assets of insurers and pension funds based on the annual volatility of the price of these assets. Perhaps because the European Union is the single largest insurance jurisdiction, and EU countries have a significant presence on the Financial Stability Board (FSB)—the international body of finance ministers, central bankers, and other agencies—the direction of travel internationally has been for US state regulators and other non-EU jurisdictions to change their regulations to be more in line with Solvency II.
The extraterritorial reach of the application of Solvency II in Europe has captured most of the attention so far, especially in the United States. However, extra territoriality is not the most important issue for Solvency II and its international variants. The capital requirements of Solvency II, while not particularly onerous at an aggregate level, will impose an asset allocation on life insurers and pension funds that does not serve the interests of consumers, the financial system, or the economy.
The main problem with Solvency II is that the riskiness of the assets of a life insurer or pension fund with liabilities that will not materialize before 10 or sometimes 20 years is not accurately measured by the amount by which prices may fall during the next year.
Solvency II fails to take account of the fact that institutions with divergent liabilities have different capacities for absorbing individual risks and that it is the exploitation of these differences that creates systemic resilience. An alternative approach that is more attuned to the risk that a pension fund or life insurer would fail to meet its obligations when they come due (shortfall risk) and less focused on the short-term volatility of asset prices would correct this problem.
The riskiness of an asset is dependent of what it is used for or who owns it. Private equity funds investing in infrastructure are risky for a casualty insurer and safer for a life insurer with liabilities beyond the redemption period of the fund. To a life insurer, what matters is not the price of an asset or the risk of holding it tomorrow or at the end of the year but the risk at the point of maturity of the policy (shortfall risk).
Better matching the capital requirements of insurers to shortfall risk would allow insurers, consumers, the wider financial system, and the economy to establish a superior risk-return equilibrium. It would provide consumers with cheaper but no less adequate insurance; make the financial system safer, as risksflowed to where they are best spread or diversified; and reduce the cost of long-term capital, boosting investment and economic growth. In its current form, Solvency II will achieve the opposite.
Avinash Persaud is Chairman, Intelligence Capital Limited and Emeritus Professor of Gresham College. He was ranked by a panel of experts for Prospect Magazine as one of the three best public intellectuals in finance in the world.
See, Banks put themselves at risk in Basel, A. Persaud, The Financial Times, October 22, 2003,
See, How Not to Regulate Insurance Markets: The Risks and Dangers of Solvency II, A. Persaud, Policy Brief, PB15-5, Peterson Institute for International Economics, https://piie.com/sites/default/files/publications/pb/pb15-5.pdf
Avinash Persaud is a panelist at our Insurers: investing in an evolving world event.