In the wake of Brexit, the Government last year announced that it would be reviewing certain features of the EU directed prudential regulatory regime for insurance firms, known as Solvency II. The aim of this review was to explore whether Solvency II reflects the unique structural features of the UK insurance sector, given that it was designed with the EU insurance sector in mind.
The UK insurance sector currently has approximately £1.9 trillion of assets under management and is a significant contributor to the total GDP of the UK with the ‘total output’ from the insurance sector standing at approximately £90bn based on ONS statistics. It is clear therefore, that optimising the efficiency and effectiveness of the prudential regime could have wide reaching impacts across the UK economy as a whole. While the Treasury Select Committee reported that there was no appetite to start again and design an entirely new regime, there are areas that represent “significant weaknesses" for the UK industry.
Earlier in 2021, in conjunction with the ABI, we analysed the potential impact on the UK economy of different scenarios of regulatory change. The report highlighted that amendments to the calibration of the Risk Margin and the Matching Adjustment (MA) qualification criteria could have significant impact on GDP growth and boost investment. Firstly, the Risk margin is designed to represent the additional capital that a third party would need in order to run off an insurance firm in the case of a 1-in-200 year event arising, with the overall intention being to arrive at a market consistent valuation of liabilities. The calculation of the Risk Margin is prescriptive and was developed under quite different economic circumstances to the current day. In particular, the fixed cost of capital rate of 6% is argued to be out of line with investor expectations. The Risk Margin is sensitive to long-term interest rates; hence the current low interest rate environment has resulted in Risk Margins increasing significantly requiring insurers to hold high levels of capital.
Recalibrating the Risk Margin can be achieved through a combination of amendments, including a reduction in the absolute level of the cost of capital, tapering of the duration of the calculation and recognising diversification between contracts. Capital released through a reduction in risk margin will be offset to some extent by a decrease in the transitional measure on technical provisions (TMTP) in respect of business sold prior to 2016.
The impact of a Risk Margin reduction on annuity new business is of particular interest, as firms will likely reflect the lower cost of capital in their pricing and longevity risk appetite and be less incentivised to cede longevity risk to jurisdictions outside of the UK. The increased capital available for writing new business, especially in the Bulk Purchase Annuity market, could allow insurers to pursue other investment opportunities to the benefit of policyholders or the sectors invested in.
With the UK insurance sector holding approximately £300bn of assets backing annuities within matching adjustment (MA) portfolios at year end 2019 and the expected flow of new money over the next few years, the MA is also of particular relevance. A shift in regulations governing the MA may pave the way for reinvestment of a proportion of current assets.
The MA has strict quantitative and qualitative criteria for demonstrating eligibility for both assets and liabilities. The requirements range from the quality and the nature of the assets to strict matching for future cash inflows and outflows by nature, timing and currency. Asset eligibility is a key constraint since they must either have a fixed set of cashflows (or be packaged with instruments to deliver fixed-cashflows). This restricts the access to a wider range of long-term assets such as bonds with floating interest rates or callable options.
In our report, we identified a number of changes which could increase the access of insurers to a wider range of assets within the MA, these include:
- Strict fixity of cash-flows qualification criteria is replaced with a broader principle of matching tolerance. This would allow insurers to access a broader range of issuances and sectors, remove re-structuring costs and increase balance sheet efficiency;
- Re-calibration of the Fundamental Spreads to remove prudence from base methodology and introduce additional granularity in the allowance for expected recovery rates on collateralised investments. This would improve balance sheet efficiency and remove some areas of relative disadvantage between asset types;
- Review of credit SCR calibration to smooth ‘BBB cliff’ would allow insurers to invest in opportunities for which achieving investment grade is a challenge, but the asset represents an attractive risk-adjusted return. There would also be a reduction in the capital requirement held in respect of credit downgrade via replacement costs.
- Allow firms flexibility to manage defaults within the MA fund through additional time to resolve or liability management. Insurers could adopt a more buy-and-hold strategy for downgraded assets, thereby easing some of the cyclicality issues potentially encouraged by the current framework. There would also be a reduction in the capital requirement held in respect of credit downgrade via replacement costs.
- A reduced equity capital charge where the insurer holds a significant loan with the counterparty, which will allow insurers to support certain types of initiatives more easily, e.g. some forms of local authority lending.
- Standardise an approach for setting an appropriate credit rating for assets, where an external rating agency has not provided a rating, improving efficiency and incentivising a broader range of investments.
- Streamline the Matching Adjustment application process for investment in new assets. This would allow insurers to be more agile in pursuing new investment opportunities which may currently be missed since they are not explicitly permitted within the approvals.
While insurers are not about to diverge from the fundamental principles of cashflow matching and liquidity management or fundamentally change their appetite for sub-investment grade assets, there is a significant amount of capital which is currently under utilised within the insurance sector due to the regulations of Solvency II and the MA in particular. Release of this capital opens up opportunities for innovation within the insurance sector and more potential for growth.
There are also wider economic gains which could be achieved through enhanced insurance sector productivity. Initially, there are impacts within the sector via increased profitability, higher returns on investment, lower premiums and more attractive products which in turn incentivises the insurance sector to increase in size. In a competitive market, these “within sector” effects could then have a ripple effect, resulting in gains in other sectors and the rest of the economy. Lower premiums lead to greater household expenditure and lower input costs for buyers of insurance, and increased output leads to increased demand for labour and inputs in other sectors of the economy. Overall, this results in higher UK economic output, increased real wages, and improved tax receipts.
Redeployment of invested capital to reduce financing costs and increase access to capital in other sectors would mean other parts of the economy benefit from both lower insurance costs (via the within sector gains) and through lower costs of capital as the capital redeployment makes UK capital markets more efficient. Further, with the need for new forms of capital across sectors to achieve HMG’s Net Zero Carbon targets, productivity improvements in the insurance industry will help enable sectors across the economy to better contribute towards these goals.
We expect the Treasury’s initial response to industry feedback to be published this month, so, like many industry participants, are waiting expectantly for indications of their direction of thinking on the future regulatory landscape.