The Complexity Risk of Regulation: an Article on the Complexity of Solvency II

No. 55 , February 2015 The Complexity Risk of Regulat ion: an Article on the Complexity of Solvency II By Martin Eling+ Increasing complexity of regulation The complexity of the financial system is undoubtedly increasing , and increasingly complex regulations has been the political response to this development . Beyond this background, in recent years a controversial discussion has emerged on the intensity, number and complexity of regulations in the insurance industry. Is the growing number and complexity of regulations the optimal answer to the financial world ’s increasing complexity? Many opinions argue that this is not necessarily true, and these opinions are not only provided by the industry. For example, Pottier and Sommer (2002) demonstrated that the equity -to -assets ratio is an equally good or even better indicator of financial distress than the much more complex U. S. risk -based capital (RBC ) standards. Given these results, one might argue that an easy and clear regulation is the better model for handling the complexity of the real world. Regarding the complexity of regulations, particularly the new EU insurance regulations, Solvency II has been the subject of much debate. The main goals of Solvency II are to protect policyholders and create a safe and sound industry. However, given the inherent complexity, it might be questionable as to whether Solvency II achieves its goals. The aim of this article is to outline why Solvency II might fail to achieve its goals and what the unintended consequences of the complexity of the new Solvency II regulations might be . Will Solvency II be a black box? Due to such complexity, one might argue that Solvency II is less comprehensible, less transparent and , thus , less effective. The model started with the first Quantitative Impact Study (QIS 1) with a technical description of only 8 pages ; by QIS 5, it comprised 330 pages (not including the annexes). Only a few experts will be able to review the model completely. The risk is that, at the end of the day, Solvency II is a black box that only a few people will understand. Anoth er layer of complexity is added by the use of different models in insurance companies (such as local GAAP, Solvency I, Solvency II, ratings , international financial reporting standards (IFRS) , market consistent embedded value ( MCEV)), which respond very di fferently under economic scenarios. This is of special concern as regulators want the managers of insurance companies to base their decisions on these models. What type of decisions will be made with the Solvency II model? Solvency II gives ineffective inc entives, which are heavily influenced by political decisions. Ineffective investment incentives Market participants have already noticed that the new market -consistent valuation rules are having a significant impact on asset allocation. Solvency II encourages companies to hold a relatively undiversified portfolio of government bonds , as the required capital for these bonds is very low. This would counteract any macroprudential instruments with the goal to avoid risk. Basel III also favours sovereign debt, so interconnectedness and aligned + Professor of Insurance Management and Director of the Institute of Insurance Economics at the University of St. Gallen.