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Solvency I is dead, long live Solvency II

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Solvency II is one of the most important pieces of regulation to hit the insurance industry for years.

It could—and should—transform the way buyers, sellers and intermediaries of insurance and reinsurance coverage measure and manage their risks.

It should, in short, prompt a revolution in the way business is carried out and drive the market onto a new level of professionalism and sophistication.

Solvency II qualifies as a revolution because it should force the European insurance industry to fundamentally assess the way it measures and manages its core resource-capital.

Revolutions are, of course, usually painful for those involved.

But those involved in this particular regulatory overhaul have one huge advantage: It has happened before and they can learn from others' mistakes.

The global banking sector was forced to rethink the way it manages its capital by the introduction of the Basel II capital adequacy regime by the international banking regulator—the Bank for International Settlements.

At the turn of the century, the banking industry was faced with the same big questions that the insurance industry is currently grappling with.

They too had to decide whether to invest heavily in sophisticated new risk management systems and technologies or rely on standard models, work out how to use risk transfer tools and methodologies such as hedging instruments to make the most of the new system, disclose lots of information that they previously regarded as top secret, share data industry-wide and get to grips with the relatively new concept of operational risk.

Many in the banking sector feared that the new system would penalize smaller and less well-capitalized players that could not afford to develop expensive new company-wide risk management technologies and that the gains provided by the new system would be outweighed by corporate volatility and loss of choice for customers.

Those fears proved to be largely ill-founded.

Yes, the banking sector has consolidated further and the process was partly caused by the introduction of Basel II.

But from a macro perspective this was not such a bad thing because too many banks were taking on risks that they could not manage.

The Basel II system helps the banking sector more effectively manage and distribute its core risks globally.

It has helped fuel the rise of the global risk distribution system under the guise of securitization in its many forms and this is one of the reasons why there is so much liquidity out there currently to invest in new projects and development.

It has also forced banks, asset managers and other financial institutions to focus on what they are good at—marketing, distribution or capital management.

Theoretically, Solvency II should do the same thing for the insurance sector. It should help insureds manage their seemingly ever-rising and widening exposures by offering a more efficient, diverse and robust risk capital market.

It would, therefore, be a mistake for Member states to bow to the fears of certain groups and water down the more challenging aspects of the new regime.

The continent's insurance buyers need the more efficient and innovative risk transfer market offered by Solvency II, not the confusing and capital-inefficient collection of markets currently served by Solvency I.