Why are America’s insurance commissioners trying to import harmful European rules?

With high prices and the threat of recession looming over America’s economy, another threat is emerging. Influential policymakers overseeing the U.S. insurance industry are on the verge of pushing through a disastrous rule for U.S. insurers strikingly similar to European regulations that have played a significant role in Europe’s economic malaise.

For nearly a decade, Europe’s insurance market has been governed by the Solvency II regulatory framework, a complex and burdensome set of rules cobbled together by European Union bureaucrats and ratified by the EU Parliament in 2014. Since it went into full effect on January 1, 2016, Solvency II has resulted in higher insurance premiums for European consumers and businesses and a shortage of long-term insurance policies such as annuities. It has also taken away billions in capital from enterprising European companies, harming the Eurozone’s growth rate.

Solvency II makes it prohibitively expensive for insurance companies to buy equities such as stocks and relatively cheap to purchase bonds, particularly those issued by governments and most giant corporations. Capital charges for equities range from 39 to 49 percent, while bonds range from 10 to 20 percent. This means that for every $100 in equities an EU insurance company buys, it must retain nearly half the value of that equity in cash, often making it cost-prohibitive for insurance firms to purchase stocks and other equities instead of bonds.

These mandates have forced drastic changes in the risk management of European insurers and are being reconsidered by European governments due to myriad negative consequences. A report on Solvency II by the House of Commons Treasury Committee in the United Kingdom found that “Solvency II has been very costly to implement” and that “extra costs in complying with the rules, and loss of access to some asset types, are leading to poorer value” for British consumers.

This report and other studies of the effects of Solvency II have noted a sharp reduction in Europe in the availability of annuities, financial instruments sold by life insurers that provide a stream of income for the rest of a person’s life. Funding these requires the strong financial returns that equities can provide. The Treasury Committee report noted that the annuity shortage will likely result in more dependence on the government to provide retirement income when European governments are already fiscally stressed. So, “in addition to reducing choice and value for consumers, this transfers risk to the State if and when individuals run out of money in old age,” the report concluded.

At the same time, the report found that Solvency II was slowing overall growth in the UK and the rest of Europe by putting “socially useful” investments out of reach of the war chest of insurance companies. It stated: “Absent Solvency II, there are a number of investments with widespread social benefits in which insurers would be the natural investors, such as infrastructure projects, student loans, and retirement funding. However, Solvency II appears to be hampering both investment from outside the EU, alongside investment within the EU.” The report quoted an insurance executive who maintained that Solvency II was keeping billions of dollars out of the hands of transformative industries.

At the same time, the justification for Solvency II that debt-based securities – particularly government debt – are massively safer than equities has crashed into the wall of reality with recent financial implosions. The bank run at Silicon Valley Bank in the U.S. began when the bank disclosed a loss of nearly $2 billion on U.S. government treasury bills. The British left-leaning newspaper The Guardian noted, “the common thread running through this and other recent crises is the bond market, composed of IOUs issued by governments and companies alike.”

The UK – as part of its post-Brexit reform of the EU financial services regulation – and countries within the EU are pushing to substantially scale back the Solvency II framework’s stringent capital charges on equities. The Financial Times reported in July that both the EU and the UK “are updating Solvency II insurance rules with the aim of making the system work better and freeing up capital for long-term investment.”

Yet amazingly, as Europe looks to shed itself of the constricting mandates of Solvency II, a powerful association of insurance regulators in the U.S. is considering enacting a similar regulatory framework here that would go into effect immediately. A “working group” of the National Association of Insurance Commissioners (NAIC) has proposed that, if enacted, could very soon hike the capital charges for equities held by U.S. insurers to a level on par with Solvency II.

States primarily regulate the U.S. insurance market, but many state insurance commissioners follow the regulatory rules and guidelines of the NAIC. Some state laws make these rules binding on states. Therefore, any power the NAIC comes up with will likely substantially impact the entire U.S. insurance market.

So, it is natural that many are viewing with alarm a pending rule of the NAIC’s lengthily titled “Risk-Based Capital Investment Risk and Evaluation (E) Working Group” – a small but powerful NAIC subgroup made up of staffers that serve under heads of state insurance departments — that would immediately hike capital charges a broad class of equities it calls “residual interests” to 45 percent. This would be smack in the middle of Europe’s 39 to 49 percent set under Solvency II.

If adopted by the NAIC at its upcoming Summer Meeting from August 12 through 16, the “residual interests” rule could hit American insurers even harder than Solvency II, due to the short time frame for implementation. Initially written to go into effect this year, the rule’s implementation date was slightly delayed until next year at the working group’s June 14 meeting, according to a statement by the NAIC.

This is still a drastically short timeline for U.S. insurance firms to prepare. As such, it may result in insurers’ sudden dumping of assets to remove equities from their books, triggering unnecessary capital charges. Such a selloff could deliver an instant blow to U.S. markets in addition to the broader long-term damage the rule could inflict on the U.S. economy.

J. Paul Forrester, a partner at the prominent financial services law firm Mayer Brown, recently told American Banker’s Asset Securitization Report that the NAIC proposal could result in “significant turmoil.” An insurance industry insider in the U.S. tells us that as currently proposed, the rule’s “increased charge could apply to residual interests in private equity funds, real estate joint ventures, and other investments that have been widely held for decades by the most stable of American insurance companies.”

Insurance regulators in Iowa, Connecticut, and Texas have also warned in comments to the NAIC of rising rates for insurance policies, a shortage of insurance products, and adverse effects to the broader U.S. economy due to the “residual interests” rule. Across the country, citizens are speaking out about the rushed process and likely harmful consequences of the law. Mark Comfort, a political activist in Missouri, recently wrote in a letter published by the Springfield (Missouri) Business Journal that “implementing this new regulation would be the equivalent of kicking Missouri’s seniors when they’re already down.”

Fortunately, the rule must be approved by a vote of every insurance commissioner (or supervisors of insurance regulation with similar titles, such as director or superintendent) of a U.S. state or territory. These insurance supervisors, accountable to the public as elected officials or appointees of elected officials, need to heed voices of concerned citizens like Comfort instead of those NAIC bureaucrats positioning the U.S. to follow the disastrous Solvency II regime that even Europe is abandoning.