Actuary and macro consultant, Cathal Rabbitte, tells Life Insurance International (LII) why he believes Solvency 2 is dead in the water. In Rabbitte’s view Solvency II was built for a world of 2% inflation that no longer exists.
He argues insurance companies who follow the Solvency 2 rules to the letter are actually more vulnerable under Solvency 2 – than they were under Solvency 1.
Actuaries tend to focus on business as usual rather than the thinking that underpins the financial system. This is a pity since the future of Solvency 2 depends on the macro picture. The macroeconomic principles that anchor the architecture of modern neoliberal finance can be summarised in 3 points:
- Fiscal policy is ineffective
- Responses to shocks are reflected quickly in a return to full employment
- Inflation is solely a function of the money supply
Key principles destroyed
The ongoing financial crisis has destroyed these key principles. Monetary policy in the form of QE has been unable to generate target inflation anywhere in the OECD including the US.
Full employment is a very long way off, 7 years post-Lehman. Real unemployment in the US is 10% and even worse in the Eurozone.
The financial system is prone to stagnation and current policies have led to another phase of stagnation. The following charts relate mostly to the US, but are just as germane to Europe where the same processes are in evidence, with the political incompetence of the Eurozone’s leaders on top.
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Normally, pay rises granted to workers facilitate increased consumption and thus economic growth. However, recent data shows that workers are barely keeping up with inflation, if at all.
The Household leverage ratio chart shows that workers seeing stagnant or falling real incomes have no option other than increased leverage to support spending.
Source: David Stockman’s Contra Corner
The next question is where does all the money go? It is not invested in businesses
Central Banks have tried to use quantitative easing to generate growth. But there’s not enough growth and inflation remains well below target. [See the chart below].
Unemployment also remains stubbornly high. Bond markets are extremely pessimistic about all of this and trillions are now invested in bonds with negative yields.
Central banks are unable to generate inflation because labour is not getting pay rises. The system is thus rigged in favour of capital, but in actual fact everybody will suffer in the end since economic growth of zero will destroy the system anyway.
Threat of deflation
Without target inflation, the system becomes more and more exposed to the threat of deflation, of which the negative yield bond market is a strong sign. Another way of looking at it is as a savings glut driving yields below zero.
Bonds need 2% inflation and economic growth of at least 2% per annum to be sustainable.
With 2% a year inflation, 100 in debt reduces to around 82 after 10 years in real terms while 1% deflation would increase it to around 110.5 or an increase of 34% compared to the inflation scenario.
Taken for an economy such as Italy which has 2.2 TRILLION Euro in outstanding debt, deflation will make sovereign debt impossible to repay. 2% inflation renders debt safe. Deflation renders debt toxic.
Many German insurers offering guaranteed savings products are already technically insolvent. In addition to increasing the real value of debt, deflation also strangles economic growth since so much real money must be diverted to repay it.
My estimate is that at least 30% of European Sovereign debt will never be repaid. Solvency 2 is dead in the water because it was built for a world of 2% inflation that no longer exists. The notion that sovereign bonds are risk free dies in the world of deflation. Insurance companies who follow the Solvency 2 rules to the letter are actually more vulnerable under Solvency 2 than they were under Solvency 1.
Join the debate!
What’s your view? Do you agree with Cathal that Solvency II is dead in the water?
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