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"Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice" - Adam Smith

Solvency 2 – a step towards statism

Written by Jan Iwanik | Wednesday 22 June 2011

European insurance companies are busy preparing the implementation of the European Solvency 2 Directive. This law increases the degree of governmental control of the already strongly regulated industry.

State interference at present

Britain has one of the least regulated insurance markets in Europe but, despite this and even before Solvency 2, the state is heavily involved in running insurance businesses. Firstly of all, to set up an insurance company, an authorisation from the Financial Services Authority (FSA) is needed. From this moment on, the insurer must use government-approved accounting, reporting and actuarial standards. This means that basic tools of processing financial information are imposed by the political process.

The FSA also decides who can do the most important jobs in an insurance company. It is not the owner or the shareholders who have the final say on who will be the sales, risk or finance director, but a government agency approves individuals to perform such functions.

On top of that, all important meetings in an insurance organisation must be minuted and the FSA can review the minutes, check who said what and question them about it. This stifles internal discussions and challenge process because people are less willing to say what they really think when an FSA auditor can later be questioning them about this.

The regulator also approves every insurer’s principles of customer service. Under the “Treating Customers Fairly” regulation, insurance companies cannot freely change their claims handling processes, call centre procedures or complaints handling. Significant changes to those may require FSA approval.

Pricing of insurance services is at least partly regulated too. The recent decision of the Office of Fair Trading limits the use of some market information for pricing and underwriting. Similarly, the European Court of Justice prohibits (PDF) the use of an important risk factor – gender – in pricing. The Transport Committee Enquiry may well result in additional government interventions.

The FSA also decides how insurance should be distributed. The FSA’s Retail Distribution Review will be a massive change to the way life insurance is distributed in the UK.

As if this was not already too much, in the near future, the FSA wants to regulate the terms and conditions of insurance contracts and be directly involved in product design and development.

State interference under Solvency 2

Solvency 2 comes into force in 2013, but it is already affecting insurance companies today. It introduces new requirements for management data collection and reporting. Even today, although the implementation of Solvency 2 is still in progress, large insurance companies send every day half a dozen e-mails to the FSA with data and information on the strategy, risks, governance and financial results.

Solvency 2 introduces new ”controlled functions” in insurance businesses. Those include (PDF): the actuary, chief risk officer, and a new audit function. As a result the government is increasing its control over the senior management and governance of insurers.

Under Solvency 2 the FSA approves individual insurers’ internal risk management models. These models must then be used in all strategic decisions such as mergers, spin-offs, entering a new market, distribution strategies or investment and reinsurance programs. By deciding which internal models to approve and which to reject, the FSA gains additional influence over all strategic decisions of insurance enterprises.

Private ownership, mixed control

Watching the European insurance regulatory expansion feels like reading Schumpeter’s “Capitalism, Socialism and Democracy” again. The ownership of insurance enterprises remains in private hands but their decision making processes and operations are to a significant extent controlled by the state. With Solvency 2, Europe and the UK take another step towards statism.

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The European Gender Directive insurance judgment is unjust

Written by Jan Iwanik | Friday 11 March 2011

driverA free society uses the pricing system to send signals between people who do not know each other personally. A society without a pricing system is like an organism with malfunctioning nervous system. Every attempt to tamper with the nervous system of a society will weaken some social activity.

The European Court of Justice has recently ruled that insurers will not be allowed to use gender as a factor in pricing risk. This ruling is based on an European principle that “equality between women and men must be ensured in all areas”. The ruling violates the freedom of individuals to set the terms of contracts between them and as such is unjust. 

Because the ruling also distorts the spontaneously emerged pricing system in the market for risks, it will have detrimental effects to the quality and quantity of risk management performed in the society.

People using services of insurance companies should on average expect slightly deteriorating service or increasing costs of insurance. The best way to respond is to review your risky activities, like driving or traveling, and check if it makes sense to do more of less of them as the cost of insurance changes. For example young inexperienced male drivers, especially under 18, might want to drive more and young inexperienced female drivers might want to drive less.

People working for insurance companies should expect reduced enjoyment from work as some natural and spontaneous activities are replaced with directives. Their organizations are a part of the society’s nervous system and they will be weakened. Employees should take extra care for their organisations and not let them catch some other virus in the process. The way to do this is to be extra careful when starting new projects and making other changes. 

Insurance consultants should charge more. The way to do it is to scare insurers about the Directive and then to offer new services to review compliance. 

People interested in why this is happening should read John Galt’s speech

Everyone else should watch out for more inexperienced male drivers under 18 when crossing the streets.

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Think piece: Market pricing information and competition

Written by Jan Iwanik | Saturday 05 February 2011

carsUK motor insurance companies have been using detailed market pricing information to help set insurance rates for many years. Insurers have been able to check how much their competitors have been quoting for different types of vehicles and different groups of drivers. Available information has been very precise and has allowed predicting prices for individual quotes and up to one month ahead.

The Office of Fair Trading (OFT) is claiming that using such market information limits competition. OFT is threatening the largest UK insurers with a continued investigation to make them commit to restricting the use of market pricing information. This commitment will be applicable to all UK insurers, including smaller ones who are not signatories.

There is no valid economic case for restricting access to market pricing information. As a consequence the commitments offered, or any other regulatory action, will not be addressing an identifiable competition concern.

[Continue reading]

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Europe's pension seizures

Written by Jan Iwanik | Thursday 23 December 2010

flagsPeople’s retirement savings are a convenient source of revenue for governments that don’t want to reduce spending or make privatizations. As most pension schemes in Europe are organised by the state, European ministers of finance have a facilitated access to the savings accumulated there, and it is only logical that they try to get a hold of this money for their own ends. In recent weeks I have noted five such attempts: Three situations concern private personal savings; two others refer to national funds.

The most striking example is Hungary, where last month the government made the citizens an offer they could not refuse. They could either remit their individual retirement savings to the state, or lose the right to the basic state pension (but still have an obligation to pay contributions for it). In this extortionate way, the government wants to gain control over $14bn of individual retirement savings.

The Bulgarian government has come up with a similar idea. $300m of private early retirement savings was supposed to be transferred to the state pension scheme. The government gave way after trade unions protested and finally only about 20% of the original plans were implemented.

A slightly less drastic situation is developing in Poland. The government wants to transfer of 1/3 of future contributions from individual retirement accounts to the state-run social security system. Since this system does not back its liabilities with stocks or even bonds, the money taken away from the savers will go directly to the state treasury and savers will lose about $2.3bn a year. The Polish government is more generous than the Hungarian one, but only because it wants to seize just 1/3 of the future savings and also allows the citizens to keep the money accumulated so far.

The fourth example is Ireland. In 2001, the National Pension Reserve Fund was brought into existence for the purpose of supporting pensions of the Irish people in the years 2025-2050. The scheme was also supposed to provide for the pensions of some public sector employees (mainly university staff). However, in March 2009, the Irish government earmarked €4bn from this fund for rescuing banks. In November 2010, the remaining savings of €2.5bn was seized to support the bailout of the rest of the country.

The final example is France. In November, the French parliament decided to earmark €33bn from the national reserve pension fund FRR to reduce the short-term pension scheme deficit. In this way, the retirement savings intended for the years 2020-2040 will be used earlier, that is in the years 2011-2024, and the government will spend the saved up resources on other purposes.

It looks like although the governments are able to enforce general participation in pension schemes, they do not seem to be the best guardians of the money accumulated there. 

The table below is a summary of the discussed fiscal-retirement situations (source):



*These figures do not include the costs of higher taxes, price inflation and low interest rates, which additionally devaluate retirement savings.

[This article was originally posted at]

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Solvency II: The seen and the unseen

Written by Jan Iwanik | Wednesday 10 November 2010

Several days ago I read That which is seen and that which is not seen by Frederic Bastiat. This reading gave me a new perspective on the European risk management regulation known as ‘Solvency II’.

That which is seen: The aim of Solvency II is to create a ”common European insurance market”. For Brussels, it means that all European insurers will be subject to similar regulations. The uniformity of regulations may facilitate the export of insurance services across European borders and, if this is successful, it will be a visible success of the reform.

Additionally, Solvency II introduces sophisticated European capital requirements. European insurers will be able to determine their capital requirements based on individual risk exposure rather than a set of simplistic one-size-fits-all ratios. Providing all European insurers with such sophisticated systems appears to be a visible improvement.

That which is not seen: Because the analytical resources of insurance companies are limited, the implementation of Solvency II creates a distraction from traditional risk management and detailed underwriting. In this way, the basic social function of insurance companies is neglected.

The insurance market is constantly changing as new phenomena keep appearing. For instance, recent increased involvement of personal injury lawyers means that some groups of drivers in some parts of the country will receive higher compensations and will commit some types of insurance frauds more frequently. Good risk management requires deep understanding of this phenomenon and development of defensive strategies.

Unfortunately the best insurance analysts are busy with Solvency II at the moment. The understanding of the complexity of Solvency 2 models: economic scenarios, distribution of random variables, estimations of correlations and structure of copulas in the internal models requires a lot of time from an insurance analyst. At the same time, the analyst cannot deal with real risk management problems.

Management’s and boards’ attention are also a scarce good. Time devoted to keeping a close eye on Solvency II projects cannot be used to supervise the traditional risk management and detailed underwriting.

Solvency II requires a lot of effort from the FSA as well. The FSA imposed a tax of £16m on insurers earlier this year to hire one hundred Solvency II analysts in total. This money is being used to drawn experienced analysts away from insurance companies and reallocate these scarce resources to the FSA. These experts will not be able to devote their precious time to traditional risk management and underwriting.

While introducing the new European risk management system Solvency 2 also weakens the proven, common sense mechanisms of risk management and underwriting. The second effect is harder to notice but a good economist takes into account both the effect that can be seen and those effects that must be foreseen.

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Solvency II

Written by Jan Iwanik | Tuesday 30 March 2010

From 2012 all European insurance business will be subject to new regulation called Solvency II. Initially, the main objective of Solvency II was to create a single European risk based capital requirements regime and hence to increase trans border competition in the European insurance market. We are yet to see if this outcome will be achieved. In the meanwhile other aspects of Solvency II already became apparent.

The FSA’s “Path to Solvency II” explains that, under the new regime, insurance capital supervision is not just about ensuring that sufficient capital is held by insurers. Instead FSA endorses the very broad approach to risk supervision designed in Brussels. The regulator may now be interested in insurers’ internal risk models, business model, governance, decision making processes, content of board meetings, capital raising, dividend decisions, pricing, strategy and even employee remuneration.

In numerous industry meetings, the FSA representatives usually make clear their preference for the broad interpretation of their new role. Unsurprisingly, FSA’s prefers a “proactive” approach to risk management supervision. But since insurance businesses are all about risk management, a holistic approach gives FSA a mandate to be involved in all decisions insurers make.

This is a dangerous role for any regulator to undertake. It is not clear if FSA’s mission creep is more likely to increase or reduce the number of future insurer’s insolvencies. Finally, it is not a small task. This is why in the next months the FSA will recruit 460 new regulators to run the national insurance industry. As Hector Sants, FSA’s boss, puts it: “if society wants a more proactive approach it must accept that it will have a larger and more expensive regulator”.

In the most recent Z/Yen ranking of global insurance centres London dropped from the first to the third position. The London’s unique insurance business model (globally recognised as “The London Market”) withstood centuries of business cycles, natural catastrophes and political cataclysms. Let’s just hope it will survive the upcoming decades of “proactive” regulation.

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