From Professors Jon Danielsson, Ralph S J Koijen, Roger J A Laeven and Enrico C Perotti.
Sir, The European legislation on prudential rules for insurers (Solvency II) is set for a final decision. This legislation is of fundamental importance, as it dictates capital regulation for insurers.
Solvency II is a major step forwards, introducing risk-based regulation. After a long process over many years, there has, however, been a final rush to address important outstanding issues.
A key challenge arises in recessions, when asset prices and interest rates are low, in part due to variation in risk premiums, resulting in high reserves required. As insurance companies are long-term investors, it may not be optimal to fully respond to cyclical fluctuations in asset prices. An efficient way to address this is a countercyclical buffer building up in good times and drawn down in bad times.
Instead, the proposals address this by discounting liabilities at a rate higher than the risk-free in all periods. This might lead to reduced solvency and wrong incentives to insurers. We therefore stipulate three essential principles the legislation should have to meet.
The proposals are expected to define a precise formula to compute the spread to add to the risk-free discount rate, embedding forbearance in all stages of the financial cycle while requiring no extra prudential reserve building in good times. At the least, the level of forbearance should be disclosed.
Second, one should commit to a broad review of Solvency II within three years. Designing new regulation often comes with unintended consequences that can be addressed during this review.
Third, prudential authorities should be empowered to intervene across the cycle. It is undesirable to commit in advance to forbearance, without powers to correct rules when profits may be overstated in good times or understated in bad.
Jon Danielsson, London School of Economics
Ralph Koijen, London Business School
Roger Laeven, University of Amsterdam
Enrico Perotti, University of Amsterdam