08 October 2012

Investment Europe: Solvency II in focus - Unintended consequences and how regulation encourages short-term thinking in insurance

This article will argue that the combination of the desire for financial stability occasioned by the financial crisis, together with a primacy of the solvency objective among regulators, and the value that accounting standards place on the market value of many insurance investments, have all encouraged short-term thinking within the profession. It will argue that such short-term thinking is in no one's long term interest.

Even within regulation, competing objectives exist: solvency, policyholder protection as well as conduct of business regulation that ensures consumers are being sold appropriate products that will perform as promised.

One consequence of the European Union's Solvency II Directive in particular has been a sharp adjustment in firms' investment strategies, including reduced incentives to hold non-sovereign debt and certain long-term investments. While not directly within the mandate of regulators, the risk this creates for long-term growth, long-term infrastructure development and more generally the mobilisation of the single largest pool of investable funds has raised concerns among some public policymakers, as evidenced in the Summer 2011 report of the Committee on Global Financial Systems.

The unintended consequences of complying with Solvency II may actually be a less than optimal use of the insurance industry's funds in the interest of longer term European prosperity.

When these regulatory constraints are added to other, natural tendencies to privilege short-term decision-making by industry, politicians, and consumers, the combined effect on saving and investment can be dramatic. Efforts to restart growth through low real interest rates and quantitative easing can have dramatic effects on savers' and insurers' return on investment.

Prioritising the long-term over the short-term is a classic collective action problem. If society wants to mobilise its savings efficiently, this requires a conscious decision, one that is in everyone's collective interest.

It would be inappropriate to blame the regulators for the inbuilt conservatism of their mandates. Market participants and policymakers need to develop a coherent and comprehensive vision for financial regulation. If society wants regulators to help industry, consumers and markets to privilege the long term interests of savings, growth and investment in a society, such a view must be clearly articulated.

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