European insurance - CRO Forum rejects calls for pro-cyclical capital margins

The Chief Risk Officers' Forum has rejected the idea that measures to reduce pro-cyclicality should include increasing capital reserves in good periods to mitigate against strains in more troubled economic times.

Both the UK's Turner Report, published in the second quarter this year, and the Rasmussen report commissioned by the European Parliament in the second half of 2008 called for some form of counter-cyclical capital regime to be applied to financial services groups.

However the CRO Forum rejected this approach in its report, Insurance Risk Management Response to the Financial Crisis, which was published in April. It said that, in general, it, "sees the need for measures to address pro-cyclicality but is hesitant to do so by introducing counter-cyclical measures into the solvency margin calculation."

According to Raj Singh, CRO at Zurich-based insurer Swiss Re and a member of the forum, the purpose of Solvency II was to provide an economically based assessment of each company's capital needs, and there was no purpose to adding a prudent capital margin in benign economic periods. "If you introduce it (counter cyclical capital requirements) into the solvency margins you could be drawn in the wrong direction. If, for example, the market was dealing with a purely equity-based problem, it is not clear how having an across-the-board increase in solvency margins would deal with the risk management issues this raises."

Instead Singh argued that the use of market-consistent models was inherently pro-cyclical - "because the principles on which it is based will all have some form of duration". But he said even though Solvency II was based on these principles, the increased harmonisation it prompts should enable more co-ordinated action by regulators in future crises.

The past six months have seen European regulators take a variety of approaches, including adjusting discounting rates, widening the scope of stress tests, and relaxing certain intervention parameters to cope with the effects of the recent market turmoil. Such individual actions will be restricted by the creation of an overarching European regulatory system in Solvency II.

While conceding Solvency II would restrict individual actions, Singh said it would be beneficial. "The implementation measures are not in place, but when they are it will restrict individual actions such as the changes in discount rate recently introduced by some countries - otherwise you end up with unequal treatment by firms in different markets."

But Singh argued this was a positive development for the European insurance sector. "Rather than say Solvency II will constrain individual regulators from taking certain actions, I prefer to say it will provide a great degree of harmonisation that will enable a common response to a serious market event in the future."

The CRO Forum also called for ratings agency reports to have less importance in solvency regulations, arguing that there was a "widely held view in the market that credit ratings agencies are partly responsible for the current crisis". Singh argued that companies should focus on their in-house ratings and how these fed into their internal models.

"This would focus insurers to model credit portfolios based on their own fundamental analysis - there will always be a role for rating agencies in providing an additional source of information, however the CRO Forum doesn't want ratings to be at the head of solvency management".

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