European Union: The road to insolvency

Europe's Solvency II directive for insurance and pensions could trigger a vicious cycle driving bond yields through the floor.

If all goes well in the European Union, sensible monetary and fiscal policies should eventually reduce global anxieties related to the stability of sovereign debt among certain EU nations. That’s the good news. The bad news is that even if creditors stop squealing over the health of Europe’s economic PIGS (Portugal, Ireland, Greece and Spain) in the near future, the EU’s financial sector will still be counting down to a little-known regulatory change that critics claim could easily create another round of economic turmoil.

Unless you work in financial services overseas (or seriously need to get a life), you probably have not heard about the EU’s so-called Solvency II directive, which will come into effect on Jan. 1, 2013. But as Niels Jensen, managing partner of London’s Absolute Return Partners, points out, the world’s market participants need to do some homework on this topic since it involves a dramatic adjustment to the holdings of EU insurance firms and pension plans regulated as life insurance companies. And the “indications are that the directive has already had a meaningful impact on bond markets, and there could be a lot more to come over the next 24 months.” (The Europeans have the world’s largest insurance industry. As of January 2009, it held about $9.5 trillion in shares, bonds and other assets.)

Simply put, Solvency II — which could be expanded to include all pension schemes in the EU, since enormous pressure to include them is being placed on Brussels — will adjust capital adequacy standards in the European insurance and life insurance industry by introducing a risk-based approach to reserves. As a result, risky asset classes such as equities and commodities will be assigned much higher reserve requirements than bonds, which is why some insurance industry players are already dumping equities to hold a greater proportion of bonds.

“Going forward,” as Jensen noted in a recent market commentary, “European insurers will have to be able to pass a 1-in-200-years’-event stress test, which has been designed to give the industry enough cushion to withstand even the most severe of bear markets without being forced to sell out in the darkest hour.”

Jensen says the dollar amounts that have already been shifted from equities to bonds are enormous, and much more will follow if pensions across the EU are included. In the U.K. alone, he says, pension plan sponsors would have to cough up ?’500 billion to meet the raised capital standards. And the impact on plans in the Netherlands would be worse, since Dutch pension funds are seriously underfunded.

Furthermore, when bond yields drop, due to low inflation or other market forces, insurers and impacted pension funds will have to rebalance portfolios in favour of more bonds and fewer equities, which will push bond yields even lower. “This self-perpetuating mechanism amplifies an already unstable situation,” Jensen says. “I am not sure if policy-makers understand how potentially dangerous this situation is. We are on the road to insolvency.”

According to John Mauldin, a Texas-based wealth adviser to the rich and author of the popular Thoughts from the Frontlines market newsletter, Solvency II is not on the radar screen of most people outside the arcane world of European pension funds and insurance companies. But Insolvency Too, as Mauldin calls it, “may be one of the more explosive problems in our future.” Indeed, after recently being briefed on the matter by European pension players, he concluded the possibility of serious defaults in the wake of these new rules “is all too real. And more pervasive than we now think.”