A major theme of recent IIS Seminars has been insurance regulation.  The 2010 Madrid Seminar included several presentations on the subject.  One of two research topics included in the Geneva Association/International Insurance Society research program was this topic
Insurance regulation has been conducted by countries worldwide for well over a century.  In developed countries it has two main objectives.  The first is to assure that companies offering insurance have the financial strength to meet future obligations, or, are either strengthened as needed or wound up with minimum damage to policyholders (prudential regulation).  The second is to assure that companies treat policyholders fairly (market conduct regulation).  In developing countries a third objective seeks to build a strong national insurance industry to foster economic development.
The recent “Great Recession” of 2008-2009 has stretched thinking about the regulation of financial markets, particularly whether extreme events are appropriately accounted for in prevailing risk management processes, both in terms of regulatory standards and business practices.  This latest challenge follows similar concerns raised by natural disasters (e.g., Katrina), man-made disasters (e.g., 9/11) and excessive, unrestrained risk taking (e.g., Enron, credit default swaps).  Even though the financial crisis did not involve traditional insurance risk assumption, it did involve regulated insurers for their investment activities and participation in other financial markets.  National and international financial service regulatory bodies are taking action to address these concerns. 
Concerns about the adequacy of protection against business risk in insurance is not new.  In banking, concerns about the adequacy of the structure and level of required bank capital led to rethinking reflected in the Basel I and Basel II standards, the latter now in the process of being implemented around the world.  The recent market dislocation has inspired discussion of further revision of bank capital and trading requirements to absorb similar future dislocations (e.g., Basel III).  Following the Basel discussion for banks, insurance regulators, particularly within the EU and in the global standard- setting body, the International Association of Insurance Supervisors (IAIS), have formulated Solvency II for Europe to make an upgrade from Solvency I standards, similar to the evolution from Basel I to Basel II for banks.  Solvency II is slated for effectiveness in 2013 in Europe.  The now evolving IAIS standards are following a very similar path and various other national regulators are using Solvency II as the defacto global standard of comparison.  Solvency II embraces a standard for required capital more closely tied to individual company risk assumption and economic measures.
Many questions are raised within this debate.  They begin with the proper definition of risk that can and should be addressed within a regulatory solvency system.  Past history provides a wealth of experience on the drivers of financial stress, e.g., interest rate changes, asset value changes, correlation of multiple risks.  Past data also gives some indication of common patterns of impact on financial markets and even typical market actor reactions to the changes.  But, the current concern is less about the “normal” behavior of markets within the known range of historic volatility, or even past abnormalities.  It is the behavior that is outside past experience that is of most concern.  This may be just a different market pattern or may be stimulated by new financial products or actor behavior.  What is clear is that the regulatory standards of solvency need to anticipate new and more severe risk volatility patterns than those experienced in the past.  Although the approaches vary, most proposed solvency standards involve larger amounts of capital to be maintained against a particular amount of assets, liabilities or financial products.
Another major issue is how to distinguish the risks of different types of financial activity.  Once, “insurance”, “banking” and “securities” were fairly distinct businesses.  Today they blend into one another.  The good part is that inventive minds seek more efficient ways to manage assets, liabilities and risk.  The trouble is that these efforts change the risk exposures, sometimes with unanticipated adverse consequences.  These efforts include the use of operating authority and product design that minimizes regulatory capital requirements while increasing the risks (i.e., regulatory arbitrage).
The policy choice for regulators is a balancing act.  If capital requirements are too high the result is higher costs of financial products to consumers and incentives to avoid the cost of maintaining what are considered to be excessive capital requirements (e.g., Triple X reserves in U.S. life insurance).
Another concern is to address the increasingly global character of insurance markets.  Insurance regulatory systems are generally national, with some “multinational” regimes, e.g. the EU, and some even more segmented systems (e.g., the U.S. state system).  Where inconsistent standards exist there is the opportunity for regulatory arbitrage, i.e., placing insurance operations in a jurisdiction with relatively low standards.  The current process of viewing Solvency II as a benchmark standard appears to be leading to greater consistency in standards but the path to global consistency is still long.  The IAIS approved a Guidance Paper on group supervision at its October 2009 Annual Conference, establishing a framework for international cooperation among global regulators concerning multinational groups. But, the issue is not limited to “insurance.”  Consistency and communication among regulators of banking, insurance and securities is needed to avoid problems for regulated entities that arise from less or unregulated activities (e.g., AIG’s non-insurance financial products problems).
At least as important as the legal requirements is the approach and capabilities of insurance regulators to enforce the rules.  The current trend is toward a “principles-based” approach, where regulatory objectives and guidelines are provided, rather than strict rules.  This approach places great reliance on regulated entities to adopt the regulatory objectives and exercise good judgment in applying the principles to their circumstances.  Regulators are then required to evaluate each entity’s compliance.  Evaluating the exercise of judgment requires much more time and skill than comparing results to a fixed standard.
The future success of solvency systems will require significant upgrades of traditional regulatory staff skills.  This could be a good thing if regulation adopts a more market and economic approach to evaluating company and market activity.  But will government budgets and agency management be able to step up to this challenge?  If not, will the systems revert to unwarranted resistance by regulators to proper self-calculation of capital requirements or to a lack of adequate regulator oversight for lack of resources or skills?
One possible way to improve the application of the principles-based rules could be greater reliance on professionals to certify analysis.  Company accounts are now subjected to accounting audits with reliance put on audit reports of compliance with accounting standards.  Reserves are generally subject to an appropriate actuarial certification.  Solvency standards may be subjected to similar professional certification to provide regulators with some assurance of compliance with guidelines.  Although not always reliable, rating agencies offer some additional insight into company performance and risks.
Another current debate is about the structure of the regulatory system.  Should monetary policy be separated from bank regulation in a central bank, or combined?  Should banking, insurance and securities be combined in a single regulatory agency?  Should prudential regulation be combined with, or separated from, market conduct regulation?
Concerns about solvency also raises questions about how to deal with failing institutions.  Should institution size and complexity be limited to avoid having one institution with the power to threaten markets systemically?  Should lines of business be separated?  What powers do regulators need to step in to prevent insolvency or to manage a workout or a least damaging insolvency?  Who should have protection (e.g., a guarantee fund) against loss due to financial institution insolvency?
Another popular topic of the day is the question of the appropriate compensation of executives and key personnel (e.g., traders).  How can financial institutions attract and retain the best managers without then being responsible for unpopular payouts when public support becomes necessary?
Finally, although regulation is often considered a burden on the conduct of the business, which adds to its cost, it can also create new opportunities.  The current developments in solvency regulation parallel reconsideration of accounting and capital measurement systems that involved fairly arbitrary requirements, with more realistic measures.  The parallel work on the insurance project within the IFRS remake of international accounting standards by the IASB is leading to a more market-consistent, economic approach to measuring risk, capital and performance.  The insurance industry has long struggled to measure itself using separate accounting systems for regulators, tax, general reporting and profitability analysis.  These systems are now converging with either consistent measurement or easier conversion from one to another.  The use of internal company models to determine capital requirements should provide a more realistic measure of capital needs, based on business risks that can be used directly to develop company strategies and the most efficient operating approaches.  That is, if they are prepared with appropriate assumptions and methods.
A fundamental prerequisite to these changes is the reshaping of the internal risk management processes of financial institutions.  These must address the full range of risks, normal and extreme, and measure the overall, enterprise, impact of them.

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