Solvency II - Equivalence: The cost of regulation to cross-border trading

nick-lowe

The regulatory costs associated with cross-border trading have long been a burden on international insurers, but things may be improving explains Nick Lowe.

Regulation is by a long way the number one issue for the London insurance market right now. That is not to deny that other issues are important too. Market modernisation is vital to the future, for example, and both rates and how to make a profit in continuing soft conditions remain a perennial preoccupation. Yet these are subjects where the outcome can be predicted with reasonable confidence and where, to a large extent, the market is in control of its own destiny.

Regulation is another matter. The industry faces a convergence of developments in the UK, Europe and the rest of the world, that will shape the way business is supervised for years to come. Most of the topics will be familiar enough to readers; the transfer of powers away from the Financial Services Authority, the introduction of Solvency II and the arrangements for 'alien' reinsurers in the US are all of vital importance and have rightly been extensively discussed in the media.

The subject of 'equivalence', by contrast, has received much less attention. Although senior insurance executives instinctively regard regulatory change as burdensome, equivalence could actually make things easier. This assumes — and it is a big caveat — that it is handled correctly by the authorities.

Essence of equivalence
The essence of equivalence is that regulators recognise other jurisdictions as equivalent to their own. Any insurer or reinsurer regulated in one country may then operate in an 'equivalent' regime without going through the lengthy compliance and reporting process that might otherwise be demanded. This is, of course, already the principle behind cross-border regulation within the European Union. As well as reducing the time spent on bureaucracy, it makes it much easier for international companies or groups to act in a uniform way across national borders, instead of having different internal rules from country to country.

The main driving force behind equivalence is provided by the introduction of Solvency II, and it comes as no surprise that Switzerland and Bermuda are at the front of the queue of countries wishing to be equivalent. Europe is a vital market for companies based in Bermuda, so they have no choice but to be Solvency II-compliant. Yet to have to obey two sets of regulatory regimes, as would be the case without equivalence, would be an administrative burden and would cut away at the principles of globalisation. Switzerland, meanwhile, is at the heart of the European insurance and reinsurance market and has been involved in the discussion almost from the outset.

It is equally unsurprising that Guernsey, after flirting with the idea, has decided against equivalence for the time being. The impact of Solvency II on the island is less clear-cut, because its insurance industry is based around the captive sector. Its regulatory resources would have to be substantially ramped up to administer equivalence, and it is by no means clear that it would be worth all the effort.

Other jurisdictions, meanwhile, are waiting in the wings. Most notably, Japan is seeking equivalence for its reinsurers. Informally, other countries are to a lesser or greater degree shadowing Solvency II and introducing the principles of risk-based regulation. Singapore, Australia, South Africa and some Middle East countries are among those that could move in that direction.

The really big prize, of course, would be for North America to become equivalent. Bringing the US on board would be incredibly complex because of the nature of federal regulation, the tendency to move forward at the pace of the slowest and the American view that in many respects it is ahead of Europe in such matters. Nonetheless, both the federal insurance regulators and a number of states have made positive noises, and there is a prospect of temporary equivalence being granted for the next few years on an ad hoc basis.

The International Underwriting Association supports this global trend because a more harmonised regulatory framework would make it easier for its members to trade cross-border. It would reduce reporting requirements and make it easier to operate seamlessly in all operations. The alternative is to have more layers of regulations making it harder and more costly for members to operate and more difficult for regulators to work together effectively.

This enthusiasm, however, comes with an important qualification; it is important to get equivalence right or else it may be counter-productive. It will come as no surprise that the devil is in the detail. While the principle of equivalence is easy to understand, the insurance world is entering uncharted waters in terms of the practical implications.

Taking the lead
There are almost certain to be questions about the ability and resources of individual regulators to shoulder the responsibility of equivalence, especially where group supervision is concerned. This may, in turn, lead to issues about which regulator should take the lead in any particular arrangement. There may also be pressure to make compromises, especially in the case of the US, where regulations will not easily dovetail with Solvency II.

The danger in all this is that, instead of one unified regime covering much of the globe, the market ends up with more rules and reporting requirements than before. In the IUA's view, however, this risk should not deflect from pursuing the benefits of equivalence. No one is pretending that there is going to be a seamless global market, but anything that simplifies the onerous level of reporting requirements will reduce frictional costs for those companies that trade cross-border and make the industry more efficient. The benefits will be felt by customers as well underwriters, and it will make the regulators' job easier.

We expect this subject to loom larger over the coming years.

Nick Lowe is director of government affairs at the International Underwriting Association of London

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