Wednesday, 27 November 2013

The Potential Impact of Solvency 2 Regulation on Competition

One of the challenges about financial regulation is identifying the impacts so that costs can be kept to a minimum and benefits maximised.  Targeting regulation to address identified ‘market failures’ helps but it also require an analysis of the costs and benefits.  

Some impacts can easily be measured, like the cost of changes to IT systems.  Others are not so easily measured like the impact on how firms compete in the market place.  For example, regulation can create barriers to entry that can undermine the efficiency of competition. 

The potentially negative impact on competition because of market consolidation was one of the concerns at the time of the publication of the Solvency 2 directive.  There were two aspects to this concern:

(i) reducing capital requirements by taking into account the pooling of un-correlated risks could benefit disproportionally large and well-diversified insurers.

(ii) the fixed costs of risk management and compliance aspects of Solvency 2 could bear more heavily on small and medium insurers.

Relevant extracts from the Commission’s impact assessment of the Solvency 2 directive published in 2007 are below:

"The recognition of diversification effects implies that well diversified entities, or those which are part of an insurance group will, in practice have lower capital requirements than single solo entities which are less well diversified. Although this is fully in line with the basic economic principles underpinning the proposal, and does not entail lower protection for policyholders, it may nevertheless act as a catalyst to the already existing trend of consolidation in the EU insurance market and increase already existing competitive pressures on small and medium-sized insurers. This however does not mean that small and medium sized insurers would be expected to quit the market in a disorderly way following the introduction of Solvency II, but rather that they would be incentivised to look for new partnerships and alliances. Moreover, many small and medium sized insurers are specialised insurers that carefully monitor and manage their risks, and benefit greatly from being close to their customers. Where this is the case, these natural competitive advantages will be fully recognised and will result in lower capital requirements for those companies." (Commission’s Impact Analysis of the Solvency 2 directive, page 49)

"Insurers may also have incentives to consolidate further, as the implementation of Solvency II could require substantial investment in data collection, IT and risk management systems and expertise. Similarly, strengthening risk management will give rise to fixed compliance costs which are likely to fall more heavily on small firms. While this effect should be smoothed by applying the roportionality principle (limited reporting requirements for small firms), the higher weight of compliance costs for small firms could be a further driver of consolidation.  Moreover, the use of relatively sophisticated internal models for risk management could ensure lower regulatory capital requirements - and a consequent pricing advantage – for bigger insurers."  
(DG ECFIN Report - Section 3.4.1)

As noted in the assessment, an important point to bear in mind is that the underlying effects mentioned above exist anyway.  So the question is really about the extent to which Solvency 2 exacerbates these trends significantly.

A few years have now gone through and I would be keen to hear your thoughts about a number of aspects of the impact of Solvency 2 on competition:
  • You may have observed negative effects on competition in the product space as a result of Solvency 2.  If so, could you share details about your observations?
  • If you have not observed a negative effect on competition, do you believe that it’s just a matter of time until we do?  For example, you could take the view that the reason we have not observed a negative impact is that Solvency 2 has not yet been implemented.  
  • You may take the view that the absence of negative effects on competition is the result of changes in the industry landscape.  For example, a recent CSFI survey ‘Insurance Banana Skins 2013’ suggests that there is a significant amount of capital in the insurance industry (‘capital availability’ goes from the second highest concern in 2012 to number 16 in the 2013 survey).  If so, do you believe that the increased availability of capital has muted the potential impact on competition?  Are there any other relevant changes in the industry landscape that have a similar effect? 
  • Finally, you may take the view that we are unlikely to see a negative effect on competition.  This could be because regulation’s marginal impact on existing trends is unlikely to be material.
I would be grateful for your thoughts.  If you want to share your thoughts privately, email me at isaacalfonblog "at" gmail.com.  

This is not intended to be a scientific poll but if there are sufficient answers I will summarise the emerging views (without attribution) in a future post. 

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