But of course the existence of this safety net blunts the policyholder incentive to distinguish between a high risk and a low risk insurer at the point of taking out a policy. Paradoxically the stronger the safety net, the stronger the other two regulatory pillars need to be to hold it up. The less the market and policyholders discipline a firm, the more the regulator needs to do it for them, including by policing financial standards. Pillar 2: intervention and risk management Pillar 2 contains a range of qualitative measures, but broadly speaking they can be divided into the ladder of intervention, and requirements for good risk management, including the prudent person principle. These are both intimately connected to how we define capital adequacy. The ladder of intervention is critical to preventing gambling for resurrection: it formalizes and defines the power to intervene before the interests of shareholders and policyholders diverge, in the same way that debt covenants protect creditors by giving them the ability to intervene in clearly defined circumstances under which their interests will diverge from those of the providers of equity capital. The role of regulatory capital in relation to the ladder is to buy time for that intervention.
Beyond a certain level, concentrations and other exposures to irreducible uncertainty simply make it impossible to say that any feasible level of capital is adequate to play the part it needs to in delivering policyholder protection. That is not a viable business model for a regulated financial firm and the remedy lies not in higher capital – which will do little if anything to address that irreducible lack of confidence in adequacy – but in restructuring the balance sheet and business model. A balanced approach I have discussed how capital requirements interact with other factors that vary across the sector and between firms – the strength of market discipline, the ladder of intervention, ease of exit – and also given an example of an important source of lack of resilience that cannot be remedied with capital: the susceptibility of balance sheet and enterprise risks to modelling. Arguments about the level of capital need to be rooted in these factors: it is not enough to assert that, if only we didn’t have to hold so much capital, our policies could be so much cheaper, we could supply so many more of them, and we could expand our investments. If only it were that simple. I recognise that there is an opportunity cost to higher regulatory capital: capital that supports the risks in existing business cannot also be used to support acquisitions or expansion into innovative fields. But price is not the same as value.