Friday 8 July 2016 11:54 am

Unintended consequences: Tinkering with Solvency II

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Tinkering with things is in the nature of regulators. Inevitably, however, well-intentioned tinkering often delivers unintended consequences.

Today, the unintended consequences of tinkering are emerging in London’s international specialty insurance market, notably following Solvency II, which specifies the amount of capital that insurance companies must hold to reduce the risk of insolvency.

While the impact of the EU referendum result on London’s insurance market is not yet clear, it is generally accepted that the majority of Solvency II’s provisions will apply in London. Implemented in January, Solvency II lays out the amount of capital which insurance companies must hold, rewarding insurers for increasing the geographical diversity of the risks they cover. Credit rating agencies also reward diversification.

The move makes sense: a big hurricane hitting, say, Florida, could knock over an insurer that has all its exposure there, but the blow would not affect risks in other parts of the world. Geographical risk diversification brings financial strength. 

Read more: UK exit from the EU would damage our insurance market

But an unintended consequence may already defray the benefit for some insurers. In the rush to achieve geographical diversity, and thus to lower their statutory capital requirements, London insurance underwriters have entered into new territories like Latin America, China, India, and the Middle East.

Often they have done so without being able to assimilate data and insights around local risk factors, such as the likely cost of the damage caused by a large hurricane. And the unintended risk-rush has pushed prices down through competition. This combination has the real potential to bite insurers where it hurts – on the balance sheet.

The recent wave of M&A should help insurers somewhat. Making a bigger insurance company can fill expertise gaps and bolster the balance sheet. However, whether the rate of transactions continues depends upon how the markets bounce back against the current uncertainty.

Models can be fed with information about the local risks an insurer has taken onto its balance sheet and flag up dangerous accumulations of risk. Such signals allow insurers to adjust the prices they charge to reflect both the potential benefits (profit and risk diversification) and disadvantages (many claims under policies sold too cheaply).

Read more: What EU insurers need to be more coordinated about

A recent example is the massive explosion at the huge cargo terminal in Tianjin, China. Some companies were unaware that their international offices had insured an extraordinarily large accumulation of containers which all happened to be in the port on the day of the blast.

Fortunately no company was forced into bankruptcy, but it was a costly lesson in exposure management.

The regulators and ratings agencies now insist that insurers understand the potential for accumulations of risk within their portfolio. They require insurers to model their exposures, to gain a better understanding of how large loss events could impact upon their capital.

The ratings agency Standard & Poor’s says the quickest way to bankrupt an insurer is to misunderstand the risks it faces from catastrophes. It is vital then, that the London insurance market does not expose itself to unforeseen risks through its efforts to manage the unintended consequences of the regulators’ well-intentioned tinkering.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.