The current Solvency II formula used to calculate risk margins is causing higher premium rates, reducing competition, and is poor value for consumers, according to analysis by Willis Towers Watson (WLTW).
The consultancy firm argues that the risk margin has become an increasingly material component of insurers' balance sheets, leading to challenges and changes in business practice.
These are incentivising insurers to offload risk using reinsurance companies outside the EU, causing asset liability matching challenges, and growth in the longevity reinsurance market.
WLTW director, Kamran Foroughi, said: "We believe the high level of risk margin currently attached to long-term insurance products is resulting in higher premium rates and reduced competition, leading to worse value for consumers.
"The Solvency II draft directive was published in July 2007 and defined the risk margin to be part of the technical provisions and calibrated as a 6% per annum capital charge on non-hedgeable risks.
"Throughout the rest of the Solvency II project up to adoption on 1 January 2016, there seems to have been no mechanism available to revisit this definition."
In response to the European Insurance and Occupational Pensions Authority (EIOPA) discussion paper on the upcoming review of Solvency II, WLTW believes a revision of the risk margin formula's methodology and calibration is needed to address these concerns.
"After a fundamental review to confirm the broad model for the risk margin, stress and scenario testing should then be used to determine whether it should also change in different markets," Foroughi continued.
"If a risk margin model were to be permitted that varies with market movements, we would advocate an anti-cyclical approach as opposed to the current approach, which we believe ends up being dangerously pro-cyclical."
This comes as the Prudential Regulation Authority (PRA) revealed that they are to conduct a review of Solvency II reporting requirements, after the Association of British Insurers (ABI) raised concerns over the burden they can place on businesses.
ABI head of prudential regulation, said: "It's reassuring that the PRA has listened to the sector's concerns and committed to an urgent review of reporting requirements.
"The volume of reporting for firms under Solvency II is four to eight times greater than under the previous regime - it is right that this is an area of concern for regulators as well as industry."
