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Solvency II can bring benefits to buyers

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As the labyrinthine insurance regulation debate rumbles on remorselessly and gathers pace, both in Europe and in the United States, the potential benefits for insurance buyers becomes clearer by the day.

As U.S. Treasury Secretary Henry Paulson began his review of the U.S. financial regulatory system, and was urged to go for a Federal system for insurance, and as H.R. 1065, the Nonadmitted and Reinsurance Reform Act of 2007 passed the House of Representatives, the European Commission published the Solvency II framework directive.

Save for some admittedly significant technical details that will keep the actuarial and accounting eggheads blissfully awake at night, this directive's direction and implications are now much clearer than they were just six months, or even six weeks, ago.

Overall, it looks like better news for buyers of nonlife insurance in Europe.

This is because the Commission has firmly followed through its oft-stated desire for a proper risk-based economic system that will reward those insurance companies that actively manage their risk and penalize those that do not.

It also seems clear that the European Commission does not want to see its new solvency regime increase the overall level of prudential capital in the system.

It seems to have accepted that, if it all goes according to plan, the sector will be cajoled into making a more efficient use of its capital and thus perhaps require less capital, not more.

It is feasible, therefore, that Solvency II will deliver a more efficient and competitive insurance industry for European buyers.

Ideally, this will in turn deliver more innovative and competitive products for buyers, rather than simply enable the insurers to hand any capital released back to investors.

That is what the insurers say they will do with the cash anyway, so hold them to it.

It also now seems more likely that there could be some kind of trade-off made between the large insurance companies and smaller ones through diversification benefits and the use of mitigation tools.

And, significantly, this could offset the specter of choice—limiting and rapid consolidation that has been raised in this column before.

Logic dictates that the liberal application of diversification benefits will enable bigger insurers to enjoy more capital relief under the new regime than smaller, more specialist players.

This—as has been stated here before—would simply present the big companies with another reason to gobble up lots of smaller companies, and thus restrict—and not broaden—competition.

But if the Commission does its homework on the ever-widening range of mitigation tools available to smaller players to bolster their capital, then this doomsday scenario does not necessarily have to transpire.

Indeed, if handled well and bravely, it is possible that the big boys may decide that it is a better bet for them to avoid another round of risky and expensive mergers and acquisitions, and invest in their smaller peers instead through the provision of mitigation tools.

If this were to occur, then Solvency II would simply have hastened what many in the reinsurance sector say is the already inevitable trend by which smaller, less well-capitalized, local and niche players convert into distribution centers for the big capital warehouses sitting above and behind them.

The main stumbling block for this evolution would probably be lack of trust in the ability of the newer forms of risk dispersion, beyond traditional reinsurance, to deliver the level of policyholder protection demanded by the supervisors.

Banking regulators are already jittery about the potential impact of the U.S. sub-prime mortgage crunch on the massive global credit derivatives market. How much of those losses will wind up in insurance and reinsurance company accounts?

This was compounded a couple of weeks ago when Milan, Italy-based bank Intesa announced it had already incurred collateralized debt obligation losses to roughly half the value of its total €1.5 billion in assets, and presumably counting.

How welcoming to brave new risk mitigation tools will the elected politicians of the European Parliament be, if U.S. credit derivatives destroy a previously run-of-the-mill Italian deposit bank?