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.