Sir, Solvency II, an insurance regulatory initiative, has received many criticisms. Most of them are quite fair, as regulators still do not seem to grasp that insurance companies (unlike banks or hedge funds) do not rely on short-term lending as a funding source. Therefore, during a crisis, insurance companies are more likely to act as shock absorbers than shock propagators.

However, an important shortcoming of Solvency II has gone so far undetected: the way it treats operational risk. Clearly, operational risk (for example, the risk that a trader might key in the wrong number when executing an operation) is uncorrelated with any other risk.

Strangely, Solvency II, when estimating the risk-based capital an insurance company must have, implicitly assumes that there is an extremely high correlation between operational risk and all the other types of risk (market, longevity or credit). In some cases, this figure could be as high as 90 per cent. This is obviously unwarranted.

The reason is the peculiar way Solvency II aggregates the different risks to arrive at the final capital requirement: it combines all the capital requirements based on the different risk factors using the conventional linear aggregation formula, except for one detail: it leaves out of the formula the capital due to operational risk. The capital due to operational risk is then added to the previous amount at the end.

The result? Most insurance companies will see an increase in their risk-based capital that could be as high 15 per cent. This, in turn, will have a negative effect on annuities. Would this create systemic risk?

Dr Arturo Cifuentes

Financial Regulation Center (CREM),

University of Chile,

Santiago, Chile

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