Solvency II's biggest unintended consequences

Published in: Risk, Risk management, Capital management, Solvency II, Investment risk - strategy, UK, Rest of Europe, People, Brexit, Climate change and sustainability

In part two of a Q&A to accompany the launch of his book on Solvency II, Karel Van Hulle discusses the impact of directive, and how the insurance sector should prepare for sustainability, Brexit and new technologies

Karel Van HulleLast week, InsuranceERM published the first part of a Q&A with Karel Van Hulle, to coincide with the publication of his book, Solvency Requirements for EU Insurers: Solvency II is good for you.

Van Hulle was head of the European Commission's insurance and pensions unit during the development of Solvency II, and few can claim to be as well-informed about the directive.

In part two of the Q&A, he expands on the unintended consequences of Solvency II and discusses some of the European industry's future challenges: responding the climate change and sustainability; Brexit; and the impact of new technologies on the insurance business.

What are the biggest unintended consequences from Solvency II?

As I explain in my book, Solvency II is not perfect and was never meant to be. That is the reason why the Framework Directive provides for the possibility of regular updates. They should help to improve the regime based upon experience in practice.

There are however a number of unintended consequences. I will mention three:

(1) The complexity of the regulatory regime. Solvency II was designed as a principles-based regime. It still is, but the implementation is too complex.

Insurance undertakings and insurance supervisors seem to have difficulties to work with a principles-based regime. They have both contributed to making the regime very complex.

My experience is that the introduction of more rules does not necessarily lead to a better application of the regulatory regime. It takes the mind away from the principles and leads to a tick-the-box attitude.

"More rules does not necessarily lead to a better application of the regulatory regime"

The 2021 review of Solvency II should make all parties concerned reflect on where the system can be made more flexible.

(2) The lack of a proper treatment of long-term insurance business. The requirements for the valuation of technical provisions and for the treatment of the matching long-term investments should be improved, so that insurers can continue to offer long-term guarantees and can fully play their role as institutional investors.

This means we need to have another look at the present requirements. This should be part of the 2021 review.

(3) A too heavy investment by insurers in government bonds. As there is no capital charge for such investments, there is too much focus by insurers on investment in government bonds to the detriment of other investments.

This is not in line with a risk based approach and might have macro-prudential consequences. It will not be easy to resolve this issue as it also requires changes in the capital adequacy rules for banks and may have budgetary impacts. The European Central Bank has already indicated that changing the rules in this area must be carried out with caution.

Has Solvency II had the influence you expected on the development of insurance regulation in other jurisdictions?

Solvency II has had a great impact on regulatory developments in other parts of the world. Many countries are in the process of reviewing their solvency regime. They may not copy Solvency II but they clearly look at Solvency II for guidance.

"Solvency II offers a wealth of experience for other countries that want to improve their solvency regime"

The basic principles underlying Solvency II are easy to explain and are convincing for anybody who wants to introduce a risk-based solvency regime. It may, however, not be possible or desirable to take over the whole framework.

The insurance market may not be as developed or the risks may have to be calibrated differently. It might be more sensible to introduce a risk-based solvency regime in stages. Solvency II does, however, offer a wealth of experience for other countries that want to improve their solvency regime.

You say "the debate on sustainable finance will profoundly affect the insurance sector". If you were running an insurance company today, how would you be preparing for the change?

I am convinced that we will not be able to resolve the important challenges that we face, such as climate change, longevity, pensions or long-term care without an active contribution from the insurance sector.

Contributing to sustainability is no longer a luxury but a necessity. This means that insurers must be more forward looking, developing products that can contribute to a more sustainable society and offering protection to consumers and businesses for risks which they cannot master on their own.

"Contributing to sustainability is no longer a luxury but a necessity"

If I were running an insurance company, I would focus my business model on those issues and I would make sure that my company promotes sustainability as an insurer, an investor, an employer and indeed as a corporate citizen. This is more likely to bring consumer satisfaction.

Insurers should be seen as a help and not as a source of contention.

I would also want to send a clear message to the market that my investment policy is clearly focused on sustainable investments and that I am not interested in providing protection for activities or actions that are not contributing to a more sustainable society.

I believe the world will change more rapidly than many people expect and that insurers that are now taking the lead in this area are more likely to succeed.

You suggest when – or if – Britain leaves the EU, it may require some risks to be recalibrated. Is that the only thing that needs to change in Solvency II, in the event of Brexit?

I am not in favour of Brexit and I firmly believe Brexit is not in the interest of the EU nor in the interest of the UK. If it happens, I hope that it will happen as smoothly as possible.

From a technical point of view, if the UK leaves the EU, a number of risks may need to be recalibrated to the extent the calibration of those risks (such as real estate) is primarily or largely based on UK data.

"Most supervisory authorities in the EU would want to continue their good cooperation with the PRA and FCA"

As I explain in my book, the UK has greatly contributed to Solvency II and I see no reason why the many contributions the UK made (for instance the Orsa [own risk and solvency assessment]) should now be reversed.

An important change that will follow from the departure of the UK from the EU is the UK will become a third country and the relationship between EU member states and the UK will have to be reformulated.

I understand most supervisory authorities in the EU would want to continue their good cooperation with the Prudential Regulation Authority and with the Financial Conduct Authority. Much will of course depend on how the UK will conduct itself after having left the EU.

Is there anything in insurance legislation that might need to change in light of the growing digitalisation of insurance, and more widespread use of big data analytics and predictive modelling?

I indicate in my book the approach that is presently followed by Eiopa and by the European Commission is right. Rather than to intervene now with detailed rules in an area that is still very much evolving, it is better to wait and see what regulatory action might be needed.

There are a number of issues that need to be followed up very closely such as the supervision of insurtech companies that are, technically speaking, not providing insurance nor insurance mediation services; the use of big data and the impact this might have on data protection and the pooling of risk; the use of artificial intelligence; and the protection against cyber-security attacks.

On this last issue, the logic of Solvency II implies insurance undertakings have a clear policy for the treatment of this risk as part of their risk management and they mitigate that risk, for instance by buying insurance for cyber-security risk.