The new European insurance regulation will be introduced in 2016 with important consequences for the global financial system. A paper by Avinash Persaud argues that Solvency II introduces an undue bias against assets with high market and liquidity risk, such as equity. Meanwhile it encourages excessive holdings of low-yielding sovereign and high-grade bonds.

Persaud, Avinash (2015), “How Not to Regulate Insurance Markets: The Risks and Dangers of Solvency II”, Peterson Institute for International Economics, Policy Brief 15-5 (April 2015). http://www.iie.com/publications/interstitial.cfm?ResearchID=2777

See also: European Commission, “Solvency II Overview – Frequently asked questions”, EU Press Release database http://europa.eu/rapid/press-release_MEMO-15-3120_en.htm?locale=en

The below are excerpts from the paper (and the EU site). Emphasis and cursive text have been added.

The very basics of Solvency II

“Solvency II is a framework for the regulation and supervision of insurance and reinsurance undertakings in the EU, adopted in 2009, modified in 2014…and due to be applied on 1 January 2016. It…introduces economic risk-based solvency requirements across all EU Member States for the first time.” [European Commission]

“Solvency II was developed at the turn of the 21st century and modeled on the Basel II accord on the supervision of international banks. Both documents reflected faith in the “marketization of finance”—the idea that markets are better than financial firms and individuals at pricing and managing financial risks…Underpinning this conviction were the related beliefs that all assets had one price…and that the short-term volatility of this price captured the asset’s riskiness.”

“Over its 40 years of existence, the ‘Solvency I’ regime showed structural weaknesses. It was not risk-sensitive, and a number of key risks, including market, credit and operational risks were either not captured at all…The Solvency II framework, like the Basel framework for banks, proposes to remedy these shortcomings. It is divided into three ‘pillars’: Pillar 1 sets out quantitative requirements, including the rules to value assets and liabilities to calculate capital requirements and to identify eligible own funds to cover those requirements; Pillar 2 sets out requirements for risk management, governance, as well as the details of the supervisory process with competent authorities…Pillar 3 addresses transparency, reporting to supervisory authorities and disclosure to the public.” [European Commission]

“Solvency II’s solvency capital requirement is made up of a series of capital requirements for the risk of different activities, such as insurance risk, counterparty risk, and investment risk. In the last quantitative impact assessment reported by the European Insurance and Occupational Pension Authority (EIOPA), capital for the market risk of investments constituted the largest component of life insurers’ capital requirements, accounting for more than 60 percent of their total capital requirements for many life insurers. The standard formula for capital with respect to market risk of investments sets the amount of capital required as that which would absorb a one year decline in asset values of a scale that is estimated to take place no more than once every 200 years.”

The scope of impact of Solvency II

“With more than USD50 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 extraterritorial reach of the new directive…is significant, particularly for the United States. US subsidiaries of insurance companies headquartered in the European Union, such as Allianz, Aviva, ING, and MAPFRE, fall within the scope of Solvency II. compliance. The EU subsidiary of a non-EU insurance group like MetLife, Canada Life, Travellers, and Tokio Marine will also have to comply with Solvency II as stand-alone entities.”

“Perhaps because the European Union is the single largest insurance jurisdiction…US state regulators and other non-EU jurisdictions…change their regulations to be more in line with Solvency II.”

“Apart from the Solvency II initiative, the Financial Stability Board (FSB)—the international body of finance ministers, central bankers, and other agencies… s seeking to set up an international standard for the regulation of what it considers to be systemically important insurance companies. The FSB’s list of systemically important insurance companies includes a number of non-European groups, including AIG, MetLife, Prudential Financial, and Ping An Insurance. But given the influence of EU countries on the FSB, the long reach of Solvency II and the dearth of fundamental thinking about the nature of the risks of insurance companies, the standard to which the FSB is holding these firms looks increasingly similar to Solvency II.”

The consequences for asset allocation

“In the case of equities…the standard formula of Solvency II requires that capital be provided for a 39%  fall in prices… Quantitative impact assessments of Solvency II indicate that insurers would need to put up capital worth 23–28% of the value of their equity holdings compared with just 3% of the value of a 10-year A-rated corporate bond… Although equity and property represent only 12%, or USD6 trillion, of their holdings today, these worldwide holdings would account for 37% of life insurers’ capital adequacy requirements under Solvency II if they were to hold on to them.”

“Following a series of quantitative impact assessments…Solvency II will lead to a switch out of public and private equity, infrastructure bonds, property, and low-rated corporate bonds.”

“Anticipation of the impact of Solvency II and other regulatory and accounting pressures has already reduced their holdings of equities, but insurers and pension funds still hold about 15–20 percent of the equities in developed markets (Bank of England 2014). The arrival of Solvency II will accelerate equity disposals, reduce the universe of equity investors.”

The potential systemic flaw in Solvency II

“The capital asset pricing model fails to account for the fact that institutions with different liabilities have different capacities for absorbing different risks… The riskiness of an asset is not independent of what it is used for or who owns it. Private equity funds 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.”

“Life insurers and young pension funds with likely concentration of payouts in 20 years have a natural capacity to take liquidity and market risks and earn the liquidity and market risk premia. They do not have a natural capacity to hold credit risk… Time hedges liquidity risk, but more time in which a shock can arrive and a company can go bust increases credit risk.”

“For life insurers and pension funds, the risk of a shortfall in the return of the asset when they need to sell it is paramount. If they have a liability in 20 years’ time, taking liquidity risk for the first 10 years does not endanger a shortfall, but taking credit risks for that time does. Shortfall risk is different and not well reflected, if at all, in the daily, monthly, or even annual volatility of the price of the asset.”

“Assets with low annual volatility but risks of a loss that rises over time or cannot be reduced over time [such as bonds with negative real yields] may pose greater shortfall risk for a long-term investor than assets that exhibit high annual volatility but whose risks fall over time [such as equity].Regulators are pushing life insurers into bonds when the outlook for long-term bond returns is skewed to the downside. Near-zero interest rates, modest economic growth, post-crash risk aversion, geopolitical uncertainty, and a massive bond-buying program that has just ended in the United States have pinned bond prices to the ceiling…Since 1928 the average cumulative return over discrete 10-year periods was 196%. Returns were positive in every discrete 10-year period except 1928–38. Although this single losing decade included the 1929 crash, the Great Depression, and the 1937 stock market collapse, the loss over 10 years was only 6 percent. Similarly, only 7% of the 76 overlapping 10-year periods since 1928% were negative.”

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