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Financial regulation is ostensibly designed to discourage reckless risk-taking behavior. However, it tends to shift attention away from the risky business decisions towards a concern for regulatory matters. As a result, managers are drawn into performative compliance, creating the illusion of responsibility without substance. American philosopher Harry Frankfurt’s later work on the ethics of speech1 – notably his conception of an indifference to truth, as distinct from lying, which cares about truth enough to conceal it – aptly describes this dynamic.
Managers generally act with good intentions, yet the focus on regulatory expectations can obscure what is truly at stake in risk-taking. Solvency II, the European regulatory framework for insurance and reinsurance, illustrates this challenge. Although it provides guardrails and room for professional judgement – both positive features – it cannot fully prevent poor or irresponsible decisions. Sometimes, compliance becomes a shield that distances managers from the consequences of adverse outcomes. This disconnect is increased by the fact that regulators and managers do not themselves bear the financial consequences. Shareholders and policyholders, who have little influence over regulatory design, remain exposed. As a result, procedural correctness can unintentionally take precedence over substantive accountability.
The Solvency II approach to risk quantification is built on modeling exogenous shocks rather than volatility, which is the inherent fluctuation in chance outcomes.2 The standard capital adequacy model under Solvency II uses shock scenarios (e.g., pandemics or natural disasters) for every type of risk calibrated to reduce ruin probability to less than 0.5% over one year. While this may appear rigorous, it rests on assumptions about the distribution of shocks and their intercorrelations that lack empirical validation.
Consider, for example, the correlation assumed in the Solvency II standard model between an investment shock and an insurance shock. If you calculate a standalone capital requirement of 100 for investment risk and 80 for insurance risk, the model’s correlation factor of 0.25 results in a combined solvency capital requirement of 143.3
Market behavior, however, tells a different story. Major global catastrophes are typically accompanied by severe financial market downturns, and the COVID‑19 pandemic was no exception. From this perspective, a correlation factor of 1 would more accurately reflect real‑world dynamics. In our simplified example, this would increase the total capital requirement from 143 to 180.
Volatility is measurable and endogenous to pricing decisions, while exogenous shocks are unpredictable and not amenable to meaningful statistical analysis. Niklas Luhmann, a German sociologist, suggested distinguishing risk from danger: one is exposed to danger (in our case: exogenous shocks) but risks are consciously assumed or avoided.4
Solvency II conflates the two, treating unpredictable dangers as if they were manageable risks. In the words of the American economist Frank Knight, we are dealing with “situations which are far too unique […] for any sort of statistical tabulation to have any value for guidance.”5 He cautioned that the use of subjective probabilities to measure danger or uncertainty would be “meaningless and fatally misleading.”6
Given the limitations of Solvency II, reinsurance emerges as an indispensable mechanism for managing risk. It dynamically transfers risk from insurers to reinsurers. This process aligns incentives more closely with actual risk exposure and provides a market-based check on reckless behavior. In the Solvency II framework, reinsurance is treated merely as a substitute for capital. However, if we consider that endogenous risks – those arising from managerial decisions and misaligned incentives – may pose an even greater threat than exogenous shocks, then reinsurance should be elevated to a central role in risk management. It offers a way to mitigate behavioral hazards that regulation fails to address.
Historical experience supports this view. In the Dutch disability insurance market of the late 2000s, regulators failed to prevent firms accumulating exposure to parameter risks – such as benefit periods and replacement ratios – for which no empirical data existed. Competitive pressures suppressed premiums, and claims emerged only after long deferment periods. When losses materialized, claims ratios soared to 300%, far exceeding the 135% shock assumption under Solvency II. This illustrates how regulation can be blindsided by endogenous risks.
By placing greater emphasis on the substance of actual risk transfer – without compromising any aspect of regulatory compliance – reinsurance encourages insurers to address the underlying nature of risk rather than its formalized representation. This shift could help restore the primacy of risk awareness in financial decision‑making.
Ultimately, the prevalence of regulatory formalism – what Frankfurt associated with an indifference to truth – reflects a deeper skepticism about our ability to know and manage risk. The pursuit of sincerity through compliance, rather than truth through accountability, has led us astray. Reinsurance offers a path back to substance, where risk is confronted directly rather than obscured. Regulators and insurers alike would benefit from treating reinsurance not merely as a capital substitute, but as a complementary and central component of effective risk management.
