Demos meets with MPs Steve Baker and Matthew Hancock today to discuss Solvency II, new EU legislation providing a unified set of rules for insurance companies operating in the Europe. It aims to increase capital requirements and risk management standards across the EU, making the financial system more secure, increasing capital efficiency and improving the ease of doing business. Solvency II also aims to instill risk awareness into governance, operations and decision-making of the EU insurance and reinsurance businesses. It’s estimated that this will affect over 3,600 companies across 27 countries when this legislation comes into force in 2014. But while this means big changes for the whole sector, it will affect some countries more than others.

Major changes to international financial architecture do not come without costs. A study by Accenture revealed that 30 per cent of insurance companies surveyed expect the cost of implementation to exceed €26m in the short term. Industry consolidation, another likely result of these regulations, is likely to harm UK consumers in the long run. Solvency II regulations may also negatively impact the revenues of insurance companies operating in the UK, as the new requirements make them less competitive against insurance companies abroad.

Jackie Hunt, finance director at Standard Life, considers Solvency II changes to be “manageable.” Yet, Ms Hunt has also stated concerns that Solvency II is creating an environment where “European insurers are effectively disadvantaged” compared to those operating out of North America.

Insurers based in the EU may have to apply new regulations to their non-EU operations. Specifically, the amount of capital required will be increased relative to underwritten risk, altering a company’s operational ability and how the company is able to use its deployable capital. Companies such as Axon, Aegon, Aviva, ING, Allianz and Prudential, which have large operations internationally could reasonably move their business outside the EU if regulations are too demanding. Prudential’s chief executive Tidjane Thiam stated he would consider moving Prudential’s headquarters abroad (probably to Hong Kong) depending on the particulars of Solvency II. Thiam specified that Prudential “wouldn’t be having this debate” without Solvency II. While “supportive in principle” of the regulations, the detrimental impact (including to invest in corporate bonds beyond a five year window) may be too much for the company to continue to head operations in the UK.

Even if insurance companies remain in the UK, the assets they purchase and the products they provide to consumers will be affected. For instance, Solvency II regulations will make Asset Backed Securities (ABS) less attractive. A movement away from ABS, will cause a reduction in market liquidity, and a widening of trading spreads in financial markets. More importantly, Solvency II limits the ability for banks to transfer risk through securitisation.

While the Solvency II regulations are focused on insurance providers, they may have a spillover affect to pension companies. Increasing regulation will increase the cost of holding extra capital. It is likely that these costs will be passed onto annuity pricing and force prices up. According to Delloitte, 36 per cent of insurers plan to re-price their products before Solvency II is implemented. Twenty six per cent of life insurance companies and 8 per cent of non-life insurance companies are planning on altering their product mix.

Many worry that Solvency II is stricter towards UK insurers. Over the years, European regulators have developed individually. One of the goals of Solvency II, is to combat these differences and increase coordination among regulators. Unfortunately, continental bodies tend to be more similar in their regulatory practices, as such Solvency II may hit UK companies particularly hard.

These negative effects may cause significant harm to the UK economy generally. According to the Association of British Insurers, the UK insurance industry contributes around £10.4 billion in taxes to the UK government, and employs around 290,000 people in the UK alone. The UK insurance industry is responsible for investments of £1.7 trillion (equivalent to approximately 25 per cent of the UK’s total net worth).

As Britain continues to move towards isolation from the rest of the EU, any power the UK has is decreasing. Consider, for instance, Cameron’s veto of December 2011 EU treaty. This aligned many European leaders against Britain, leaving them to develop a new accord without input from the UK. Last December Cameron also clarified that Britain's membership in the EU is based on its own interests.

While Cameron’s December 2011 veto of the EU treaty created a precedent for Britain to say “no” to the EU, many argue that it left the UK with less bargaining power. One industry insider stated that the veto created “a heightened sense of not wanting to do any special favours for the UK.” This creates increasing difficulty for Britain to influence the Solvency II capital regime.

Solvency II means big change, but the sector has yet to decide whether it will be wholly good or bad. Some of the questions Demos will seek to answer in the APPG on Economics, Money and Banking meeting today are:

Are these potential negatives of Solvency II regulation enough for the UK to take action?

Is Britain focusing too much on potential negatives, and forgetting about the improved risk management and the safety effects of the regulation? (Solvency II aims, after all, to protect policyholders.)

Is Britain failing to protect the individual, choosing instead to protect big business?

And what will happen to the UK if regulators and companies fail to apply EU law?

Mario Draghi, President of the European Central Bank, has suggested that financial stability is a ‘common responsibility in a monetary union’ and ‘ensuring a well-functioning Economic and Monetary Union implies strengthening banking supervision and resolution at European level.’

Yet, member countries of the EU have developed their own regulatory agencies and laws. It’s only recently, since the 2007 crises, that policymakers have attempted to coordinate regulations across financial markets. Unfortunately, many believe a clash still exists between regulations, and regulatory philosophy between the UK and the continent.

There are two narratives when considering UK banking regulation. The first suggests that Anglo Saxon financial centers are not regulated properly. According to this account, the Anglo Saxon model, which rests on deregulated capital markets and corporate governance reforms created by internal managers, led to the 2007 financial crises. As such, further regulation is required.

The second perspective suggests that EU and UK regulations are already fairly coordinated. Philip Whyte, Research Fellow at the Centre for European Reform, suggests that there is a significant overlap in European regulations as the UK typically implements regulations earlier and more stringently than other Eurozone countries. As such, the financial regulations currently being introduced should not impact the City too negatively. CRD4 and Vickers certainly suggest the second perspective has some validity, while the financial crises itself recommends the first interpretation.

Perhaps the solution to global financial stability, as Draghi conveyed, is not just further regulation but a banking union. At last week’s Demos Finance APPG event, Mathew Hancock MP argued that further institutionalisation is required to maintain the Eurozone, including a banking, fiscal, and monetary union. Considering that financial regulations currently being implemented, like Solvency II, seek to coordinate EU regulations, is further synchronisation an absurd idea?

Many have already spoken in favour of further financial union. André Sapir, member of the European Systematic Risk Board (ESRB) has stated there ‘needs to be some element of a banking union, with common supervision, deposit insurance and resolution regimes’ in order to ‘break the kind of vicious circle between sovereign debt and bank problems that we saw in 2011’. ECB executive board member Jörg Asmussen has similarly argued that without further integration, a system to monitor financial systems will have to be created externally. Christine Lagarde, Managing Director of the International Monetary Fund (IMF), suggests ‘we need more risk-sharing across borders in the banking system… monetary union needs to be supported by stronger financial integration, which our analysis suggests should be in the form of unified supervision, a single bank resolution authority with a common backstop, and a single deposit insurance fund’.

A banking union will be discussed at the 28-29 June EU summit. Already a draft has been created to turn the Eurozone into a political federation, which will include a European Banking Union under the supervision of the European Central Bank (ECB).

As one could expect, a banking union is an area of contention between the UK and EU. While the UK continues to back elements of EU regulatory changes, West the minster has been hesitant to give up power or support EU bailout funds. Britain is opposed to joining a banking union which would place the City under the authority of ECB. If Cameron vetoes the banking union it may result in a union that excludes the UK. However, if Cameron does sign the treaty, it’s possible that Britain will gain some of the influence lost in December. However, signing could result in British tax payers ‘propping up’ European banks.

In the context of regulatory changes, increasing international integration, and positive sentiment towards banking union, how should UK politicians act? What is necessary for European financial stability, and what role should the UK have in creating this stability?

Demos Finance, which launches today at an afternoon conference with the FT, will be discussing these questions through seminars, discussions and research papers. Watch this space.