Executive’s Guide to Solvency II. David Buckham, Jason Wahl, and Stuart Rose. John Wiley & Sons 2011, pp.194, $95.00

In the United States, the states, rather than the federal government, are primarily responsible for regulating the insurance industry and the business of insurance. This is due to both longstanding custom and, most significantly, to Congress’ passage of the McCarren-Ferguson Act in 1945. McCarren-Ferguson established a regulatory system in which, unless Congress specifically indicated otherwise, the states were to be the primary regulators of insurance companies. This is why, to this day, each state and territory has its own insurance commissioner; unfortunately, there is no federal insurance regulatory agency in Washington D.C. to oversee and to regulate a national insurance market. Indeed, for a modern economy with a large financial services industry, the American insurance market is quite decentralized.

By way of contrast, the European Union (EU) is in the process of harmonizing its system of insurance regulation to prepare for the challenges of the 21st-century economy. Beginning January 1, 2013, the EU will implement Solvency II, an initiative designed to replace the Solvency I, a reform that the European Commission and European Council agreed to in 2002. In Executive’s Guide to Solvency II, the authors argue that those cynical about this new phase in EU insurance regulation are wrong and that “Solvency II is a well-thought out directive, painstakingly developed over many years by collaboration between the European Commission, member states, and the insurance industry.” Buckham and Wahl, of Monocle Solutions, and Rose, of SAS Institute, have written a comprehensive overview of the Solvency II Directive in a book that will most likely be a standard reference guide for years to come.

The authors begin their work with a cursory introduction to the role that insurance fills in mitigating and transferring risk. For those unfamiliar with the historical development of insurance and its importance in market economies, Chapter 1 is particularly worth reading. The authors rightly note that “the optimal goal” of Solvency II and similar regulations “is to promote a socially optimal balance between the profit motive of organizations and individuals’ rights” and cite Article 27 of the Solvency II Directive which emphasizes that “[t]he main objective of (re)insurance regulation and supervision is adequate policyholder protection.” In Chapter 3, the authors argue, “the important role that insurance companies play in the financial system today makes it imperative that the industry should be regulated.”

As with any regulatory system for financial products, the question is where to strike the appropriate balance between consumer protection, managing systemic risk, and allowing companies to compete and to innovate. (Indeed, the ongoing debate over the how best to write and to implement regulations for the recently enacted Dodd-Frank reform legislation highlights this tension). Significantly, the authors state with clarity “that the production cycle in insurance is inverted; that is, insurers receive a premium up front but are obliged to pay out only if the risk materializes at some future date.” Because an insurer bankruptcy would expose both policyholders and the beneficiaries of insurance contracts to losses, insurance regulation focuses on solvency. That said, according to the authors, insurer insolvency is not very frequent.

For those readers most interested in the nuts and bolts of Solvency II, Chapter 5 provides a useful overview of the Directive. The authors point out that Solvency II, like the Basel II banking regulations, has a three-pillar structure and that its “primary objective is the protection of policyholders and beneficiaries.” What makes Solvency II unique is that it is principles-based, rather than rules-based, and that “it explicitly states that capital is not the only (or necessarily the best) way to mitigate failure.” In the United States, by way of contrast, the states utilize a rules-based system for financial regulation, in which insurers have specific regulations with which they have to comply. Within the Solvency II framework, EU (and Norwegian, Liechtensteinian, and Icelandic) insurance companies “will be required to meet regulatory principles rather than rules.” Under the Solvency II regulations, good governance of insurance companies is emphasized and insurers are given wide latitude to develop internal modeling systems. The new rules “will inevitably shift business attitude from a compliance-based culture to a risk management culture.” What will be interesting to watch is how competitive EU insurance companies will likely be under this principles-based system.

Should Solvency II prove to be a successful regulatory framework for EU insurers, it would likely further expose the weaknesses of America’s current rules-based, compliance-oriented insurance regulation. For those policymakers and legislative staffers interested in modernizing insurance regulation in the United States, Solvency II, as noted by insurance regulation scholars, Martin F. Grace and Robert W. Klein, “could be used as a template, but U.S. regulators need not mimic any particular system to create the best possible system.” That said, for those interested in harmonizing and streamlining insurance regulation in the United States so as to make American insurers more competitive, the Solvency II Directive is worth ample consideration.

In conclusion, Executive’s Guide to Solvency II is not for the general reader, nor is it for readers without a serious interest in the economic and policy aspects of insurance regulation. For individuals working in the EU insurance industry, this book will be invaluable; for Americans interested in bold thinking about how the United States might want to restructure insurance regulation after Dodd-Frank, as well as for those interested in an Optional Federal Charter, this book — and Chapter 5, in particular — is worth reading. It may very well come to pass that by the end of 2013 EU insurers will be far more competitive globally than American insurers.
Jon Lewis © 2011