Risk and the law

What happens when a legalistic interpretation of capital runs up against a risk-based framework? I thought about this question during a recent trip to Germany, where as an observer at the GDV Solvency II conference in Berlin, I witnessed a vigorous defence of the country's traditional life insurance system.

Put simply, the debate goes like this. Like all other EU countries, Germany accepts the need for insurers to hold solvency capital against their market-consistent liabilities. But it refuses to accept the idea that unallocated bonus reserves - the so-called free RfB - should be treated as a realistic liability. Instead, Germany wants RfB to count as available capital.

It's easy to see why this position attracts strong feelings in Berlin. If RfB was counted as a liability, then about 80% of available capital for German life firms would disappear overnight. A Solvency II-compliant supervisor would expect such firms to either quickly find new capital or stop writing business. Not even the most hard-line Anglo-Saxon regulator seriously expects this to happen.

But the question remains of how the apples of UK realistic liabilities can be compared with the oranges of RfB within Solvency II. German insurance practitioners patiently explain that the country's supervisory law permits RfB to be withheld from policyholders and used to cover losses in an emergency. Legally speaking, they are quite right. But the question arises, would they really be able to do that?

Back in the 1990s, many UK insurers also were convinced that reserves above the statutory liability could be withdrawn from policyholders at the stroke of a chief actuary's pen. The House of Lords' judgement against Equitable Life changed this view forever, and the realistic balance sheet came into being.

Maybe the German legal system is fundamentally different to the UK, but given the terrible reputational hit taken by their cousins across the North Sea, how sure of this are German practitioners? Are they 99.5% sure? The next Quantitative Impact Study (QIS) may test this thesis, but as always when legal niceties collide with risk management, finding a definitive answer may be tricky.

Yet this debate is a modest hors d'oeuvre before the main course of legal and risk management conflict in Solvency II. Like the 'funniest joke in the world' in the classic British television show Monty Python's Flying Circus, the issue has become so charged that conference speeches increasingly skirt round it without tackling it head-on.

The issue is, of course, groups, and more specifically the transferability of capital support from groups that compute their own solvency capital requirement (SCR) under the new directive. Our Regulator Q&A series has highlighted how strong the feelings are that the latter will only be possible once the former has been sorted out.

Spare a thought for the commissioners of deepest Brussels who are tackling this conundrum - and that's just for the 27 EU nations that will be signing up to the directive. We save the best conundrum for last. What happens when a non-EU based multinational wants to compute a group SCR in order to compete within the EU but its host regulator balks at changing national law to ensure capital transferability? Here the questions of risk management and the law become intensely political, and it will be fun to watch the outcome.