Coming soon to a theater near you: “CEIOPs S2”! Sound scary? 

Some in the insurance industry think so, and it has U.S. regulators afraid of what’s behind the door. Actually, CEIOPS S2 is short for the Committee of European Insurance and Occupational Pensions Supervisors and its spawn, the Solvency II project.

After years of study, Solvency II was officially adopted by the European Union in 2007. Its aim: to create a comprehensive and far-reaching reform package that would remove obstacles to an efficiently functioning insurance and reinsurance market while improving supervision and oversight of risk. In announcing the project, the EU said it would close the huge gap between how insurers manage risk and how they are regulated, and would serve as a model for worldwide supervision of the industry.

Solvency II introduces risk-based solvency requirements across all EU members. The total balance sheet approach takes into consideration both asset-side risks and liability-side risks. It extends the definition of risk to include market risk, credit risk and operational risk as, well as insurance risk. Insurers will be required to hold capital against all of these risks.

On the upside, the EU says there are competitive advantages to the insurer. The better a company manages its risks and the more diversified it is, the less capital it may have to put up.

The financial crisis, however, was a game changer. It’s unlikely that insurers will see their capital lowered. Last year, a CEIOPS proposal called for a 70% increase in capital levels over what was recommended in an earlier study. Although it’s expected that the next impact study will recommend capital requirements lower than that, the levels are likely to be much higher than initially assumed.

Clara Hughes of Fitch Ratings says a likely outcome of higher capital levels will be consolidation in the European market among smaller insurers struggling with the cost of compliance and raising the capital needed to meet the higher solvency requirements. Also, higher capital levels could result in insurers hedging assets and liability risks—potentially buying more reinsurance—and changing their business mix in favor of less capital-intensive lines of business. 

Risk managers are concerned that higher capital requirements would significantly raise the cost of insurance. FERMA—the Federation of European Risk Management Association—also worries that it will reduce the availability of insurance, particularly for volatile lines.

Despite the concerns and continuing “study” of the impact, Solvency II is scheduled to go viral on December 31, 2012. All European insurers and reinsurers will be subject to the new rules. 

But Solvency II’s reach goes far beyond the EU, which raises competitive worries outside the EU community. The requirements also apply to any U.S. or other foreign insurer with European subsidiaries—meaning that U.S. parents with subsidiaries in Europe most likely will have to put up more capital, implement new internal controls, report on internal risk issues and carry out risk and solvency assessments at a group level. 

Solvency II also includes an “equivalency” provision, which allows the European Commission to anoint other supervisory authorities outside the EU as having regulatory schemes that meet the EU standards. Unfortunately, the U.S. is not among the first group of countries to be assessed for equivalency, according to CEIOPS. Bermuda and Switzerland are. 

Excuse us, but the U.S. is the largest insurance market in the world. Not to include it in the first round of assessments is a serious slight and puts U.S. insurers at a competitive disadvantage.   CEIOPS’s rationale is that the U.S.’s state-based system of regulation hampers assessment. Even though the NAIC develops model acts for the states to adopt, CEIOPS still has to deal with more than 50 regulators. It says it simply doesn’t have the resources to do the assessment.

No one understands better than the U.S. insurance industry the limitations of our regulatory scheme. The Council, along with many of our insurer brethren, has fought long and hard for uniformity in the laws and regulations governing us. Complying with multi-state requirements is costly and inefficient.

Certainly, we understand CEIOP’s reluctance to assess the state regulatory schemes. But at a fundamental level, the U.S. is well regulated for solvency. Can it be more uniform? Of course. But the insolvency rate is low, and when an insurer does fail, companies are unwound in a way that least harms the policyholder—a major goal of solvency regulation.

No doubt Solvency II will have a major impact on how we regulate in the states, particularly if it becomes the de facto global regulatory scheme.

However, I have to ask if there are political motives behind the decision to bypass the U.S. Without equivalency, EU insurers will have a competitive advantage over U.S. insurers. CEIOPS needs to revisit the U.S. assessment questions, find the resources and, in the meantime, grant the U.S. temporary equivalence.