Insurers should prep for questions on pro-cyclicality

Insurers could be forgiven for thinking they are having a bad dream – the one where you are taking an exam, only to find when you turn over the paper that you've studied the wrong subject. In this case, the paper would be marked Solvency II, but examiners would have moved on to asking about insurers and systemic risk.

With timing that has left many in the industry dumbfounded, the European Systemic Risk Board (ESRB) published a report in December – just weeks before the implementation deadline for Europe's new directive – saying insurers contribute to systemic risk through pro-cyclical investment behaviour, and that something should be done about it.

The ESRB's idea is to introduce a counter-cyclical buffer, similar to the measures in place for European banks. The buffer would load additional capital requirements on firms in good markets and release some of the pressure in periods of stress. The ESRB thinks a buffer would stop insurers herding into riskier assets in bull markets and dumping them when prices fall.

The board has no formal power to force its view on the industry. But the report shows how regulators are thinking. It is worth noting the Bank of England has also looked into the question of pro-cyclicality in the past. Beyond whether certain institutions are too big to fail, regulators are starting to ask whether systemic risk arises from groups of smaller institutions acting together.

The irony here is that risk-based regulation is widely seen as contributing to the herding effects that create this worry, incentivising insurers to hold the same types of assets and imposing a short investment horizon on firms that otherwise might take a longer view. In other words, some in the industry think the ESRB is trying to fix a problem that only exists because of Solvency II.

Of course, early drafts of the directive included a counter-cyclical premium, which might have done the job first time round. Instead, that measure became the volatility adjustment, which provides protection from asset-price dips but not the restraint in bull markets that the ESRB would like to see.

It has been suggested to Risk.net, though, that some regulators are still thinking of the volatility adjustment as a counter-cyclical tool. In the UK, the Prudential Regulation Authority (PRA) has said internal model firms cannot model a bigger benefit from the adjustment in a market downturn – a different view from that taken by other regulators.

As a result, UK internal model firms must hold more capital than their continental peers when markets are positive. Meanwhile, because the PRA approves internal model applications, it might have leeway to soften this position firm-by-firm if a slump were on the horizon.

Whatever the PRA's motives, it seems clear where the systemic risk agenda is heading. UK insurers and their peers would be advised to start reading up on the pro-cyclicality syllabus.