Smallwood's Shout: Is Solvency II worth it?

Despite an increasingly busy fourth quarter for many in the industry, it is unlikely to have escaped too many people’s notice that the possible impact of the “Solvency II” directive on annuities is already attracting a lot of negative and nervous attention.

The European Union's (EU's) Solvency II Directive claims to provide a ‘comprehensive new framework for insurance supervision and regulation', introducing across the EU a more risk-based approach to supervision and capital assessment, using market-based valuation of assets and liabilities.

The Directive was agreed in May 2009 and the Association of British Insurers (ABI) initially showed its support for the legislation based on its belief it "has the potential to create a stronger single market for insurance across Europe...and to give consumers assurance that firms have the right level of capital, neither too little nor too much." Some reticence however has since emerged, following this.

But with the news from Europe that UK insurers might need to tap investors for more than £50bn in fresh equity due to the new EU legislation - set to be implemented from 2012 - debate on this issue is clearly going to escalate.

We have already seen the FSA managing director of retail markets, Jon Pain, commenting on Solvency II as a "potential time bomb" for the pension market. He, probably, and quite correctly in my opinion, believes the directive poses a significant risk to the pensions market. The nub of the issue being the question of whether the legislation will allow firms to continue to take into account a liquidity premium in capital provisions for annuity business, but if the implementing legislation does not allow for it, annuity providers are likely to have to significantly increase the capital they hold.

Due to the huge over-capitalisation, we should be prepared to see a large fall in investment returns within the insurance arena. And this would undoubtedly lead to companies exiting the market, which in turn will lead to an increase in prices and a reduction in cover. This will also have a dramatic impact on innovation within the sector.

It is absolutely vital then that we ask whether this new legislation, which is supposed to improve capital management and transparency in the insurance industry and create a single capital requirements standard across the EU, is worth the potential damage to our own domestic market. The main worry being that it will have a profound effect on Europe as a whole and our competitiveness worldwide.

As with the majority of rulings brought in to regulate the industry, it is our clients that could feel the most financial burden. And this is after the industry has already had to stump up significant extra capital, which will no doubt have to be directly passed on to clients through a dramatic rise in premiums.

What the outcome will be remains undecided. All we can hope is that in an economy facing such strong and humiliating words of caution from the European Commission about the state of our debt and our inability to meet future spending commitments such as pensions, we will look at different and more sympathetic ways to impose the necessary regulation; without potentially hitting us where it will hurt the most.

Chris Smallwood is chief executive of 2plan Wealth Management