Two Fundamental Flaws of Solvency II

Many people in Europe have worked very hard for many years, attempting to perfect solvency oversight for insurers. The concepts underlying Solvency II are the best thinking about risk regulation that the world has ever seen.

However, there are two fundamental flaws that are drivers of the problems that Solvency II is having in getting to the point of actual implementation.

The first flaw is the targeted level of required capital.  When Solvency II was first imagined, banks seemed to be well run and well regulated.  And under that system banks were reporting returns in the high 20’s.  Insurer returns rarely hit the perennial 15% target.  Banks tended to operate right at their level of regulatory required capital.  Insurers looked at that and suggested that the capital requirement for Solvency II should be at a level that the largest insurers would be comfortable operating at.  There was also a big push for a single set of books.  So with a solvency requirement at the level where a rational insurer would want to operate that would mean that in addition to having only one set of books, there would only be one important capital target.  (for discussion of the flaw in the idea of “one number” management, see Risk and Light.)   But the reason why setting the required capital at that high of a level is that it then leaves no room for error or for disagreement.  (Disagreement is absolutely inevitable.  See Plural Rationalities.) The capital calculation needed to be just right.  A capital requirement that was at say 2/3 of the level a prudent company would want to operate at would leave room for errors and disagreements.  If for some risks the requirements were even 50% higher than what some would feel is the correct number, then companies could in fact live with that.  It would become known in the marketplace that companies that write that risk are likely to have tighter solvency margins, and everyone would be able to go about their business.  But with a target that is so very high, if some risk is set too high, then there would be firms who are forced to hold higher capital than makes sense in their minds for their risks.  That completely destroys the idea of management relying upon a model that is calibrated to what they believe is the wrong result.  It also encourages firms to find ways to get around the rules to only hold what they believe is the right level of capital.  What we are seeing now is the inevitable differences in opinions about riskiness of some activities.  The differences of opinion mean the difference between being in business and not for companies concentrated in those activities.  Or for being in those businesses or not for more diversified groups.  If the Solvency II target was set at, for instance, a 1 in 100 loss level, then there might be room for compromise that would allow that activity to continue for firms willing to run a little tight on solvency margin.

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The second flaw, that surprisingly has only been raised very recently is to total lack of any cost benefit criteria for the process.  If further refinement of Solvency II could prevent one insolvency over a 10 year period, yet would cost other insurers $100 million in expenses and $1 billion in additional capital, is that a good trade-off?  This is the exact sort of thinking that Solvency II REQUIRES of insurers.  EIOPA ought to have a complex model of the insurance industry in Europe so that they can show the risk reward relationship of all of their rules.  What?  You say that is terribly difficult and complicated and would not provide reliable guidance?  EIOPA should  live in the same world that they are requiring of insurers.  Without even a simple minded cost benefit requirement, anything can make it into Solvency II.  The exposure process allows questions to be raised about cost/benefit, but in many cases, that has not happened.  Besides, with no stated criteria for cost benefit, the question is ultimately solved by judgment.  So now we have insurers saying that they will withdraw from parts of the Solvency II process because they are too expensive.  Those insurers have not put forward an objective criteria under which they reached that conclusion either.

It seems unlikely at this point that either of these flaws of Solvency II will be fixed.  A lower standard would seem to too many to be a retreat, a dilution of the power of Solvency II.  Imposing a risk reward or cost benefit rule would result in crazy inconsistencies between decisions made after the rule with those made before or else a very long wait as all of the parts of Solvency II are examined under such a rule.

So it is yet to be seen whether those faults will in the end be fatal.  Solvency II could be tied up in arguments until it is abandoned, it could limp into practice with very mixed support and then be pulled after a few years and enough unanticipated implementation issues, or it could soar for a long run of effective prudential oversight as its designers originally hoped.

I am sure that someone in London can quote you odds.

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One Comment on “Two Fundamental Flaws of Solvency II”

  1. Andrew Howe Says:

    Love the second point. It reminds me of Bill Panning in his paper Managing the Invisible where he seemingly despairs of the claims for the value of risk management accompanied by so little evidence. There does seem to be standards assymmetry here!


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