Jakob Wilhelmus lores
Jakob Wilhelmus
Associate Director, International Finance and Macroeconomics Research
Capital Flows and Finance and Regulation and Systemic Risk
Jakob Wilhelmus is an associate director in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows, and investment. Concentrating on market-level information, his work focuses on identifying and analyzing financial data to produce a better understanding of the behavior and underlying structure...
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Solvency II: A Macroprudential Framework for EU Insurers

By: Jakob Wilhelmus
January 29, 2016

Macroprudential policies have moved to center stage of financial and regulatory discussions since the financial crisis. As the regulation of bank activities, especially their risk taking, has mostly been implemented through Basel III, regulators are beginning to look for the next potential breeding ground of systemic risk. One of the major difficulties of macroprudential policies—those meant to contain systemic risk—is the proper definition and identification of “contagion vehicles.” Which market players or activities, if they fail, have the potential to deeply damage other players or sectors? So far, regulators seem to favor size discrimination, as suggested by their focus on systemically important financial institutions (SIFIs). The biggest share of the financial assets other than those held by banks are held by asset managers and insurers, which has put them in regulators’ sights.

What is surprising is the difference in attention and extent of discussion about asset managers compared to insurers. While there is seldom a day in which a regulatory framework for asset managers is not discussed or written about, little attention has been paid to the implementation of Solvency II, the regulatory framework for insurers in the EU that was implemented by the European Parliament on January 1. This prudential framework is similar to Basel III in that it represents an overhaul of the previous regulatory approach. Instead of banks, it is intended to apply to insurers the lessons learned during the financial crisis. Given that insurers are the largest institutional investors in the EU’s financial markets—with around $11 trillion in total assets—the implementation of Solvency II drew surprisingly little media attention. I thought it would be good to describe the key objectives of the new framework.

The starting point of the overhaul is similar to that of Basel III, where the previous iteration of the framework turned out to be inadequate for addressing threats to financial stability. Under Solvency I the capital requirements for insurers were based solely on insurance premiums and claims without a direct relation to the financial-market risk borne by an individual insurer. The objective of the new framework is to provide a homogenous and more precise assessment of insurers’ risk exposure that supersedes existing EU Member State regulations, creating regional consistency.

The main indicators used in the updated regulatory scheme are the seemingly synonymous solvency capital requirements (SCR) and minimum capital requirements (MCR). While these may sound like the same thing—a level of capital on hand below which an insurer should not go to remain able to meet its obligations to policy holders and investors—in fact, they are different, and the difference between them is key to regulators enforcing Solvency II.

SCR represents the minimum, normal level of capital an insurer should have on hand for its day-to-day operations. MCR represents the absolute minimum amount of capital an insurer must have to protect shareholders and beneficiaries. These are meant to be better gauges of the capital required to guarantee an insurer’s solvency in the event of a market crisis. Regulatory scrutiny will be triggered any time an insurer’s capital falls below SCR.

Solvency II specifies how to calculate SCR similar to the methods used in Basel III to gauge a bank’s level of risk, in that it is based on variety of stress tests. The results of the tests are combine into the SCR and take into account the correlation among various risks.[1] In general an insurer will have to hold assets in excess of liabilities equal to the SCR.

Interestingly, regulators offer insurers the opportunity to have lower SCR (and more capital to put to work) if they hold high-quality (lower risk) securities. The promotion of high-quality securities (HQS) is in line with the recognition of the strong performance of such securities over past years. They can be characterized generally as the most senior tranches of securitizations, with underlying exposures to residential, small and medium-size enterprise, auto, or consumer loans that are limited in their complexity and relatively transparent. All of these HQS have significantly lower capital requirements, capped at 3 percent, to incentivize their use by insurers.

Beyond this, Solvency II aims to promote long-term investment in an area the EU needs: infrastructure projects. Estimated to be somewhere between EUR 1.5-2 ($1.6-2.1) trillion, infrastructure needs are a priority for the EU. It is using Solvency II to incentivize insurers and other financial institutions to play a major role in filling the gap by allowing capital requirements that favor a matched maturity of assets and liabilities. This should promote investment into long-term projects such as infrastructure.

As with all regulatory frameworks, there are concerns among regulated institutions about technical implementation: are the regulations understandable, and are efforts to comply likely to be costly? Also, insurers are uncertain whether the regulator-supplied standard approach of risk calculation is adequate. Even though regulators encourage insurers to use models they develop internally and that are subject to regulatory review, most small and medium sized companies will rely on the standard model, due to a lack of needed resources and risk-management know-how for taking an internal approach. The standard model, however, might not distinguish well enough between the tradeoff: the higher a held security’s risk the more return is to be expected. This might lead to an extreme discrimination against volatile assets as even small parts of such assets in the insurer’s portfolio have effects on the SCR.

The problem with this is that volatile assets not only represent potentially profitable opportunities for an insurer but also vibrant sectors of an economy that rely on institutional investment. A further complication: Solvency II allows the use of assets that do not observe high return volatility but have a maturity that is not in line with the insurer’s liabilities. This can cause an increased risk, as assets and liabilities observe different due dates[2]. The risk this poses is not adequately captured through some form of penalization by the SCR. This may lead to insurer portfolios that are riskier than intended by the regulator’s framework.

The principle of proportionality—regulation should have equal impact regardless of an enterprise’s size—is important when it comes to a regulatory framework and its effects, including unintended ones. Proportionality not only includes the added cost and diligence that is introduced by the new regulatory framework, but also any disadvantages that might arise out of the use of proposed standard models of the regulatory policy. Solvency II might already have been implemented, but its crucial phase is about to begin, as regulators monitor the real effects and adjust to deviations from the expected outcome.

[1] For the extensive technicalities see (100mb file will take a long time to download):

[2] This leads to an increase of the weighted duration between assets and liabilities, generally referred to as duration gap.