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The Actuary The magazine of the Institute & Faculty of Actuaries
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Letters: A brief comment on “The fatal error of Solvency II” by Huerta de Soto

In a note in The Actuary (1 December 2008), “The fatal error of Solvency II”, JesÚs Huerta de Soto criticized the Solvency II project and its basic construction. I believe that he is missing some of the main issues within the Solvency II structure.

Huerta de Soto makes a difference between risk and uncertainty. This could be illustrated as in Figure 1. He talks about the “field of natural science” as a class, having an insurable risk for the whole class. This could be compared to the collective risk in insurance mathematics. According to Huerta de Soto, the elements of this class, the cases or events, constitute a “field of human action” having uncertainty. This could be compared the field of “insurance contracts” or policy-holders.

Figure 1 The class of events can be compared to the collective of risks, in the collective risk theory, and its elements to the “insurance contracts”/policy-holders.

This description is the basis of insurance and actuarial insurance mathematics. You seldom insure a single “case”, but a collective of “cases”, because when you have a collective or pool of them, and some knowledge of their interactions with other “cases” (or “actors”), you can calculate probabilities on their behaviour. Huerta de Soto also states that market, credit, interest, operational and other risks are not risks but uncertainties and in that meaning could not be assessable. In the meaning of the description made here I believe that they are pure risks. The market risk does not consist of a single case/event, but different cases/events which could be calculated using probabilities. Even if a single case (or actor) possesses certain subjective beliefs or convictions, the beha¬viour of the class of cases can be predicted and used in a risk analysis.

Huerta de Soto then applies this to Solvency II and consider the class as the insurance industry and the single cases or actors as insurance companies. This is illustrated in Figure 2 below.

The fatal error of Huerta de Soto is that he does not see that the Solvency II project is an application of an enterprise risk management, ERM, with three Pillars, viz.

>> Pillar I: the quantitative rules imposed on the insurance companies (99.5% confidence level, a one year time horizon, etc.)
>> Pillar II: the qualitative assessment of the industry taken by the supervisory review process (SRP), >> Pillar III: the disclosure of company specific information to both the supervisor and the market.

The ERM approach gives a holistic view of the company or a group of companies belonging to the same enterprise. With Figure 2 in mind, we can interpret the 99.5% confidence level of Solvency II as a protection against more than just one company out of every 200 failing every year (= the time horizon). This is taken care of in the Pillar I solvency assessment, for example, the solvency capital requirement, SCR. The uncertainty of a single case, i.e. a single insurance company, failing is protected by Pillar II- and Pillar III-actions.

Figure 2. The Solvency II assessment with three pillars: Pillar I is a protection on the industry level and Pillar II and Pillar III on the company level.

The world has changed. We can not rely on the industry built on excessive implicit buffers that neither the regulators or supervisory authorities nor the customers have any idea about. In a global market we need transparency – irrespective of which market we are considering. This is also true for the insurance industry. The last financial turmoil has showed the need of a global financial regulation and a need for pure transparency.

The Solvency II-project is a project for consumer protection. That is why we have the 3-pillar-system. This applies both on solo companies and groups of companies. For the latter, the group support is a vital part of the project and for consumer protection.

Arne Sandstrom
Swedish Insurance Institute
Sweden

2 December 2008

To view The fatal error of Solvency II by Huerta de Soto go to www.the-actuary.org.uk/827734