Danielsson, J.

Koijen, R.S.J.

Laeven, R.

Perotti, E.

English

Europe is set to finally approve new insurance regulation, Solvency II. This column argues that the final text should respect three fundamental principles to ensure solvency

International Migration, Integration and Social Cohesion online publications

UvA-DARE is a service provided by the library of the University of Amsterdam (https://dare.uva.nl)UvA-DARE (Digital Academic Repository)Solvency II: Three principles to respectDanielsson, J.; Koijen, R.S.J.; Laeven, R.; Perotti, E.Publication date2013Document VersionFinal published versionLink to publicationCitation for published version (APA):Danielsson, J. (Author), Koijen, R. S. J. (Author), Laeven, R. (Author), & Perotti, E. (Author).(2013). Solvency II: Three principles to respect. Web publication or website, VoxEU.org.http://www.voxeu.org/article/solvency-ii-three-principles-respectGeneral rightsIt is not permitted to download or to forward/distribute the text or part of it without the consent of the author(s)and/or copyright holder(s), other than for strictly personal, individual use, unless the work is under an opencontent license (like Creative Commons).Disclaimer/Complaints regulationsIf you believe that digital publication of certain material infringes any of your rights or (privacy) interests, pleaselet the Library know, stating your reasons. In case of a legitimate complaint, the Library will make the materialinaccessible and/or remove it from the website. Please Ask the Library: https://uba.uva.nl/en/contact, or a letterto: Library of the University of Amsterdam, Secretariat, Singel 425, 1012 WP Amsterdam, The Netherlands. Youwill be contacted as soon as possible.Download date:10 Mar 2023Solvency II: Three principles to respectJon Danielsson, Ralph S.J. Koijen, Roger Laeven, Enrico Perotti 21 October 2013Europe is set to finally approve new insurance regulation, Solvency II. This column argues that the final text should respectthree fundamental principles to ensure solvency.aARelatedCountercyclical regulation in Solvency II: Merits and flawsJon Danielsson, Roger Laeven, Enrico Perotti, Mario Wüthrich, Rym Ayadi, Antoon PelsserA prudential regulatory issue at the heart of Solvency IIEnrico Perotti, Jon Danielsson, Frank de Jong, Christian Laux, Roger Laeven, Mario WüthrichAfter a long, drawn out process, the European legislation on prudential rules for insurance companies (Solvency II) is set for afinal decision. The main text is expected to be approved early this week, following negotiations between the EuropeanCommission, European ministries of finance, and the European Parliament. This legislation will be of fundamental importanceas it will dictate capital regulation for insurers.From inertia to rushWhile Solvency II is analogous to the ‘Capital Requirements Directive IV’ for bank capital, it has received less public scrutiny.This is unfortunate as parts of the proposals are still quite controversial. While the controversy slowed down the processinitially, there has been a rush to address important outstanding issues in the span of only a few weeks. We fear that importantaspects of the necessary conditions for effective insurance regulations have been left out in the rush to complete. For thisreason, we wish to propose a short list of essential principles the adopted Solvency II rules should have to meet.What is the issue?The business of insurance companies is to collect premiums from the general public and companies in exchange for futurepromises. Insurance companies are subject to stringent regulations ensuring they hold adequate reserves so they will be ablemeet their obligations. These reserves are similar in nature to bank capital. Any regulatory regime needs to keep up withtechnical advances, and Solvency II is a major step forwards, moving to uniformed risk-based rather than volume-basedsolvency rules for (re) insurance companies.What is the problem?A major challenge for insurance companies and regulators arises from the low interest rates that followed the crisis. UnderSolvency II, insurance companies are meant to use fair market valuations. As a consequence, the post-crisis present value ofliabilities are higher than they would have been had the pre-crisis (higher) interest rates prevailed. This, in turn, demands higherreserves. The effect is significant given the typically long-term nature of insurance liabilities. While this may be an anomaly –stemming from a temporary, low-interest environment and thus having a short-term disproportionate impact on long-termliabilities – no certainty exists on future evolution of interest rates. Thus the low interest rates may continue to cause problemsfor insurance companies for some time.What is a fair solution?Because of the relatively higher cyclicality of asset prices and rates compared to liabilities, one might employ smoothing of thereserve levels to facilitate carrying long-term promises. For example, some of us have called for a countercyclical buffer thatallows a gradual adjustment, in the expectation that the gap between assets and liabilities may be partially self-correcting,particularly with long-term liabilities. Of course, if such forbearance is allowed in difficult times, its opposite should happen ingood times to avoid the problem of insurance companies becoming too thinly capitalized to absorb future shocks. Firms shouldbuild up of additional buffers when interest rates rise and risk premia fall. Earlier proposals of European Insurance andOccupational Pensions Authority endorsed this view, but only recommended weakening reserve requirements in bad timeswithout requiring buffering in good times.What is the proposed regulation?Current proposals would reduce all insurer liabilities by discounting them at a higher rate than the risk free rate, and thencomputing the required capital buffers. This is a flawed approach, likely to lead to undercapitalization and distorted incentivesfor insurance companies, as shown by Koijen and Yogo (2012) for the US, where regulatory discount rates currently increaseduring periods of financial distress, and insurance companies were induced to sell underpriced insurance policies.As we argued in our earlier Vox columns (2011, 2012), it is not economically logical to discount unconditional promises with arisk premium. In a more narrowly defined application for specific stable long-term liabilities, dedicated and ring-fenced insurer-specific portfolios can be tolerated as a short cut with limited risks. But this tolerance should not extend to validate insurancepromises at some risk premium as a fundamental valuation procedure.To summarise:We agree that some smoothing of reserve requirements is justifiable as market values and rates may be too variable forprudential purposes.We disagree with the generalized discounting approach, as it manipulates liability value rather than highlighting theirexcess volatility.This may lead to reduce resilience and weakened solvency.Three concernsThe first concern is disclosureIt can make sense to grant time to insurers to adjust reserves in the present environment of ultra-low interest rates. Unlike frombanks, insurers’ liabilities can be of a very long-term nature. This provides more time to recover and thus justifies a morelenient treatment; see Laeven (2012) for the full rationale. The proposed legislation, however, is expected to define a precise formula to compute the spread to be added to the risklessdiscount rate. It will embed forbearance in all stages of the financial cycle by design, while requiring no extra prudential reservebuilding in good times.At a minimum, the degree of temporary forbearance (the difference between required capital under fair market value and underadjusted liabilities) should be disclosed and tracked for prudential purposes.The second concern is prudential interventionAs the Solvency II legislation will directly set capital requirements with embedded forbearance, the national prudentialauthorities should be empowered to intervene, certainly if the timing of the review is set as late as four or five years. Thedeparture from fair value implied by the discounting rule chosen needs to be monitored, to ensure it is commensurate to futurecircumstances and not undermining solvency.Earlier proposals already introduced discretion in bad times, allowing prudential authorities to extend the time horizon overwhich required reserves may be restored. However, they did not allow in general prudential adjustments to capital buffers infavourable times, when rates rise and risk premia fall and the automatic discounting increases the reported reserves from a fairvalue measure. It is quite dangerous for regulators to commit in advance to forbearance in hard times, without any powers tocorrect rules at times when profits may be overstated in good times or understated in bad times.The third is timely reviewThe Solvency II proposal that may be approved this week will directly become law in all EU countries. All national prudentialregulators, such as the Bank of England for the UK, ACPR in France and BaFin in Germany, will be bound to enforce a verynovel, embedded-forbearance rule without any chance to adjust it until the proposals are reviewed.ConclusionAt the critical junction of the closure of Solvency II, we identify three simple prudential principles that should be respected.First, since the rules will create a partially justifiable but opaque departure from fair value accounting, they must ensuredisclosure of this adjustment.Second, the European Commission and the European Insurance and Occupational Pensions Authority should commit to abroad review within three years.Third, regulatory authorities should retain some discretion to intervene, if prudential concerns arise with the automaticforbearance rule.ReferencesAyadi, Rym, Jon Danielsson, Roger J. A. Laeven, Antoon A. J. Pelsser, Enrico C. Perotti & Mario V. Wüthrich (2012),"Countercyclical regulation in Solvency II: Merits and flaws", VoxEU.org.Danielsson, Jon, Frank C. J. M. de Jong, Roger J. A. Laeven, Christian Laux, Enrico C. Perotti & Mario V. Wüthrich (2011),"A prudential regulatory issue at the heart of Solvency II", VoxEU.org.Koijen, Ralph S. J. & Motohiro Yogo (2012). The cost of financial frictions for life insurers, Mimeo, London Business School.Laeven, Roger J. A. (2012). Contagion: Challenges in Risk and Insurance, Amsterdam: Vossiuspers.aA

Solvency II: Three principles to respect

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Solvency II: Three principles to respect

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