Is Europe Undermining Its Insurance Companies?

06/04/2015 07:02 pm ET | Updated Jun 04, 2016

Why is the European Commission pressurizing its insurance companies?

As well intended as it could be, the regulator seems to ignore that none of the European insurance companies needed any rescue during the financial crisis and they even contributed to the haircut of Greek debt. Yes, there was AIG, but it was not their insurance businesses that were at stake: they used their AAA to write tens of billions of CDS on mortgage debt. US insurance regulation is weaker in the United States than in Europe. The US Government obliged.

The European insurance sector has approximately 6.8 trillion euros of assets under management. It is the largest European institutional investor. Waves of legislation continue to absorb valuable managerial and financial resources. The fragile economy and the sovereign indebtedness in Southern Europe are tough enough to tackle.

Insurance companies started to liquidate their long term positions to comply with Solvency II. However, the uncertainties surrounding this piece of regulation explains why this trend has not (yet?) been accelerated. This regulation was conceived to heal the AIG's traumatism and guarantee that it would never happen again. The definitive bandage is named Solvency II.

What is Solvency II?

As mentioned in a KPMG paper, Solvency II has a tremendous amount of requirements (It can maybe explain why the European Commission had to meet on this subject more than 20 times since 2009!) and needless to say that insurance companies have already to deal with other difficult regulations.

Solvency II is a set of regulations for the European insurance industry. It has been adopted in 2009, was supposed to start in 2013, was modified in 2014 by Omnibus II and will be implemented in January 2016. The time approaches. Solvency II seeks to harmonize the European insurance market and bring a more dynamic risk-based approach. Thanks to that, the Commission believes that they reduced to 0.5% the probability of failure.

It is divided in three pillars:
• Pillar 1 consists of the quantitative requirements: all solvency ratio valuations done in Europe would have to apply the "prudent person principles" and the mark-to-market valuation.
• Pillar 2 sets out requirements for the governance and risk management of insurers.
• Pillar 3 focuses on disclosure and transparency requirements for supervisors and the public.
But the devil is in the details.

Nobody objects to the need to improve governance, risk management or disclosure and transparency. It will have a beneficial effect on the companies, their policyholders and their shareholders.

Deconstructing the balance sheet

It is the new solvency ratios and balance sheet rules that are at the core of the uneasiness, not only of the industry, but also of the entire financial services industry. Solvency II asks for a complete overhaul of the insurance companies' balance sheet by introducing a series of valuation criteria for individual types of assets and liabilities. The calculation of the necessary capital to meet the requirements is unnecessarily complex.

Besides, the Commission wants a mark-to-market valuation for all assets, independently from the fact that insurance companies keep them to maturity. One keeps wondering why banks can keep at par their bonds if they intend to keep them to maturity (core banking) while insurers, who are less vulnerable, are not allowed to do so. The volatility inherent to the markets will affect the value of the assets and make the balance sheet, at best, inconstant and difficult to manage.
Solvency II will drive insurance companies toward safe assets, mostly short term bonds, restricting the flow of funds to growth areas of the economy. It obliges companies to raise unnecessarily their capital requirements. Forcing insurers to apply a rigorous mark-to-market approach ignores their ability, as long term investors, to ride long term cycles.

Paradoxically, the European Insurance and Occupational Pensions Authority (EIOPA) invites (re)insurance stakeholders and market participants to provide their feedback on the discussion paper on infrastructure investments by insurers. This was launched in May 2015.

Insurance and banks carry different risks

The biggest misunderstanding of Solvency II is clearly the difference of risks between insurance and banking. While often enough banks are carrying short term assets and liabilities, risks in insurance companies are professionally managed with a long term horizon. It is not unusual for insurance companies to analyze risks based on a set of circumstances that are deemed to be possible once in 200 years.

Solvency II seems to consider insurance companies as banks and it confounds the risks. This is particularly true of the liquidity risk. Indeed an Insurance company receives a continuous cash flow from premiums and can be covered by reinsurance and long term financing. This confusion leads to liquidity requirements that are not adapted to insurance. A bank relies on short term deposits as well as the interbank market and therefore, in case of panic, will face a sudden rush of withdrawals. It is not the case of an insurance company.

The Commission should have differentiated the capital adequacy of a bank from the equity of an insurance company. They have been working on a draft of delegated regulation since 2014: it aims to correct the improper design of capital requirements for growth-fostering investments...and the excessive volatility stemming from equity prices.

Insurers as Systemically Important Financial Institutions

By looking at the sheer size of the companies, the Financial Stability Board decided that nine global insurers had to be treated as SIFIs and therefore over capitalized. Currently Met Life is suing its regulators on that point: they consider that there is no justification for this penalization.

It is counterproductive not to recognize the important contribution of insurance companies to global financial stability. It would be a mistake to take measures that will increase their costs and reduce their activities that are essential to the global financial services industry.
Some voices would like the Commission to abandon Solvency II. It might not be wise, and probably impossible since Solvency II has already been delayed. It has to come back to its original objectives and make the necessary corrections to the first pillar. It could be done before January 1, 2016.

Europe needs, more than ever, soundly managed and well capitalized insurance and reinsurance companies. It needs to be harmonious throughout the European Union. The rest is up to the prudent management of those companies and those who monitor them.