Death by Solvency

Another great post by  Maggid.

It seems that Solvency II is perfectly designed to reproduce the conditions that led US banks to believe that they were impervious to risks.  They and the regulators believed that they knew what they were doing with regard to Risks and Risk Management.

In 2004, the US Federal Reserve allowed investment banks to cut their capital levels by 2/3, tripling their potential leverage!  Not to worry, they knew how to manage risk.

European insurers are all being told that they need to have economic capital models to manage risks.  A few firms have had these models for more than five years now.  Those models tell us that those firms can reduce their capital by a third or more.

But everyone leaves out of their thinking two important things that will always happen.

The first is called the Peltzman effect by economists.  John Adams calls it the Risk Thermostat effect.  In both cases, it means that when people feel risk decreasing due to safety measures, they often respond by increasing the riskiness of their behaviors.  So the success of Solvency II will make some firms feel safer and some of them will take additional risks because of that.

The second effect is what I call the Law of Risk and Light.  That says that you will accumulate risks wherever you are not looking out for them.  So anywhere that there is a flaw in the Economic Capital model, the activity that accentuates that flaw will look like the best, most desirable business to be in.

But read Maggid’s post.  He provides some actual analysis to support his argument.

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Explore posts in the same categories: Compliance, Economic Capital, ERM, Regulatory Risk, Risk and Light, Solvency II

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