How Not to Regulate Insurance Markets: The Risks and Dangers of Solvency II

Abstract

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. In March 2014, following the global and euro area financial and economic crises, the European Parliament adopted a new directive, Solvency II, which 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. Solvency II 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. The extraterritorial reach of the new directive, which is scheduled to take effect January 1, 2016, is significant, particularly for the United States. This Policy Brief argues that 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. Under Solvency II, 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 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 different liabilities have different capacities for absorbing different risks and that it is the exploitation of these differences that creates systemic resilience. An alternative approach, set out in this paper, 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.