Solvency II is so safe it's stifling

One definition of insanity may well be doing the same thing and expecting to get a different result, but that has not stopped the European Union as part of its programme to create a single market in financial services from producing Solvency II for the insurance industry.

And the fear is that by making all insurance companies think in the same way, prepare for risks in the same way, approach profitability in the same way, rely on models in the same way and invest their capital in the same way, the new rules will make the system more, rather than less, vulnerable to sudden external shocks - because when some crisis occurs, the companies, inevitably, will all have to react in the same way.

If the banking pattern is repeated in detail, we will then find the companies have been hollowed out by irresponsible management behaviour. The danger in seeking to apply scientific precision to what is still an art, is that it will encourage insurance executives to take advantage of gaps in the regulation to do silly things in pursuit of large bonuses. That after all is what the bankers did.

That is not what is intended, of course. The good intention behind Solvency II - like Basel II for banking - is to make the entire European insurance industry move to a new system of regulation that will make companies comparable, transparent and safer for investors and customers alike. It will do this by making the industry work out its risks and potential liabilities in detail by product line and then set capital aside specifically to cover those risks.

It means that, perhaps for the first time, insurance companies will know in detail which of their activities make money and which do not. This has to be a good thing.

The idea is that this information will guide management decision-making so that insurance will be more accurately priced, unprofitable lines will be dropped and the whole system will become more robust and efficient. Some favoured products, such as pet insurance and annuities, are likely to cost much more, others may simply disappear, as might a large number of niche insurance companies - up to a quarter across Europe on some estimates.

We shall see, though it is always worth remembering that all the above benefits only happen if the models work, and the models are only as good as the assumptions. Auditors will check those assumptions but given their record in banking, that might not be considered a great comfort.

That, however, is only half the story.The insurance industry does not just pay claims, it is one of the great investment machines in the western world. In the UK alone, insurance premiums equate to roughly 18% of GDP. How that money is invested has a major bearing on the economic health of the nation. And the crucial thing about Solvency II is not just that it requires all the risks to carry a capital weighting, but it also applies the same principle to how the companies invest their premiums.

A seminar yesterday run by Aviva Investors, an organisation which can make fair claim to thought leadership in this complex area, explored how these new rules would affect investment strategy.

The answer was dramatic - but discomfiting. Solvency II could sound the death knell for investing in equities, it will be bad news for long-dated corporate bonds and it would force insurance companies to commit themselves even more to buying government debt.

This is a direct consequence of the capital weighting - or the perceived risk the different asset classes have in the new system. Solvency II penalises companies for what are considered risky investments - so naturally they will stop buying them.

Now think what this means for the wider economy.

At the very least, companies will have to pay more for their debt which means that the cost of capital will rise. Some infrastructure companies, vital investors such as National Grid, rely on very long-term money and could be particularly badly hit. More generally a higher cost of capital means less investment and slower growth.

There is a further specific challenge. The banks, as we all know, need more capital, and they are being asked to raise it through the long end of the debt markets. But those issues will come out, just at the point when the traditional natural buyers of such bonds - the insurance companies - will have decided because of Solvency II that they no longer want the stuff. So the recapitalisation of the banking system is likely to be made much tougher, and that too will have a negative effect on economic growth.

It is worth reflecting on the wonderful circularity of the argument. SolvencyII is about making the system safer, and pushing insurance companies to invest in government debt is seen as a means to this end. However, government debt relies for its long-term safety on the continued health of the economy.

Solvency II weakens the economy by forcing up the cost of capital. Thus the more Solvency II forces the insurance industry to buy government bonds, the less safe those bonds become.

You couldn't make it up.