The return of prudence

She's back! Such is the refrain echoing down the corridors of progressive insurance regulators dotted around the North Sea as they look anxiously southward. 'She' is of course prudence, a word that denotes the traditional but arbitrary safety factors imposed on mathematical reserves and asset allocations used by insurance companies, and currently enshrined in EU law.

With the advent of economic, market-based solvency, the hope was that the traditional system would wither away. In its place would be a new system where assets and liabilities were given a market-consistent value. The solvency margin by which assets should exceed liabilities would be calculated using a risk measure that allowed for diversification, and covered a percentile of downside scenarios, with perhaps an extra amount to cover the capital costs of runoff.

Regulators closely identified with the new system, such as Britain's FSA, have been scathing about prudence. "A recipe of the outdated, the inflexible and the inadequate," is what FSA CEO John Tiner calls it. For such reformers, Solvency II was the great white hope that was supposed to ditch prudence once and for all. Now it turns out that prudence may return via what progressive supervisors thought was an interim measure: to apply a percentile measure to technical reserves, providing what regulators call - wait for it - a 'prudential margin'.

Regulators from more traditional-minded countries such as France, Italy and Spain called for this measure because they distrust market-based valuation. Their case is strongest for non-life business where market consistency is most tenuous, but they have argued it even for the with-profits life business, where the prudential approach is notorious for failing to flag the market risks embedded in guarantees. The distrust extends also to internal risk models, which in some quarters are viewed as an unwelcome import from the banking world, unsuited to the complexities of insurance.

These developments alarm the progressive regulators, and also the larger insurers that already steer their businesses using economic, market-consistent valuation. While we are inclined to support the progressive camp, we retain some sympathy for the traditionalists. Basel II was preceded by a great output of technical research, some of it published in our sister magazine Risk, which did a lot to convince banking regulators of the merits of risk-based capital.

If Solvency II is to be truly market consistent, we need a similar output of research in order to convince the traditionalists of the merits of the progressive case. As the FSA's Paul Sharma suggests in this issue, Life & Pensions has a role to play. Valuable as it may be for industry organisations such as the CRO Forum to produce studies that support the progressive argument, it will not be enough to bring round the sceptics. We need to see more practitioners and regulators willing to submit their arguments to the kind of objective and sometimes critical peer review process that Life & Pensions can provide.

If the intellectual argument can be made in the right way, we believe the sceptics will come round. And the stakes are high. A field test recently conducted by Swiss regulators has identified substantial capital hidden by the current statutory reserve system, capital that could be released to benefit shareholders if fully risk-based solvency requirements were permitted. With the deficit-ridden UK pensions industry crying out for life industry capacity to absorb occupational pension liabilities, there are many stakeholders who could stand to benefit from a risk-based, fungible capital regime.