Solvency sequel set to take Cannes by storm

Later this year, probably in July, the European Commission will publish one of its most important and most eagerly awaited financial services draft directives.

The Solvency II proposal will aim to establish, theoretically by 2010, but in all probability not until 2012, a new regulatory regime for Europe’s insurance industry.

This will deal with complex issues such as the levels of technical reserves an EU insurance company will have to put aside against the risk that, say, an owner of one of its motor insurance policies will drive off the edge of a cliff or a hurricane sweeps through Cannes.

Insurance companies will be required to put aside enough capital to cover their risks not on some semi-arbitrary basis, such as levels of premium income, but based on the danger that the event might happen. This means, for example, that the relationship between the regulators and the regulated will have to change dramatically. It also means that the EU’s national insurance regulators are going to have to come to common understandings on what is the scale of the risks that the companies are running in a particular line of business? Otherwise we will not see the emergence of the single EU insurance market, which is one of the main policy goals.

Since one of the objectives of the new risk-based regulation is to give the financial markets a bigger disciplinary role (as is also the case with the capital requirements directive for banks), comparable methods of assessing risks and comparable regulations for public disclosure will be essential.

As in banking greater co-operation and convergence across the EU in the way national regulators operate will be needed for the purposes of financial stability and policyholder protection.

It may be true that there is less of a danger at present that the failure of an insurance company could trigger a systemic financial crisis compared with the risk from a big bank failure.

But insurance companies are moving into the same world of complex financial derivatives investment as banks. So the danger of a systemic crisis arising from an insurance failure is growing. The Solvency II regime is likely to assume that there is a 1 to 200 chance of an insurance company collaping. So with bank/insurance conglomerates the potential for systemic risk from the collapse of a single large company could well be amplified, not least through contagion.

That the EU, with Solvency II, is on the verge of transforming insurance company regulation reflects in part the recognition that the current systems of regulation are not only incompatible and in danger of operating against the creation of a single market, they do not do a good enough job promoting economic efficiency and growth.

The UK treasury, a staunch advocate of Solvency II in spite of Finance Minister Gordon Brown’s jaundiced view of the EU’s reform potential, has cited improving capital allocation, competition and innovation as three of the spin-offs it expects from the new regime.

As with international accounting standards, with Solvency II the EU sees itself as leading the way in setting new global standards and so seizing a competitive advantage. Unlike the capital requirements directive/Basel II for banking, Solvency II is not based on an international standard already being implemented in other important financial markets. Indeed, according to one private sector expert, the US, where every state has its own insurance regulator, is currently "in the stone age", in terms of its regulatory regimes for insurance companies.

The next big test for Solvency II will come when the draft directive is published. Only when politicians, incipient protectionists and consumer advocates have pored over the details will Brussels begin to get a clearer idea of whether the package which the industry, regulators and expert policymakers have drawn up, is broadly acceptable.

Later this year, probably in July, the European Commission will publish one of its most important and most eagerly awaited financial services draft directives.