Liz Truss took to the stage in Stoke-on-Trent for the Tory leadership debate in July promising to “realise the post-Brexit opportunities”.
This included a promise to “drive investment into towns and cities” that like Stoke-on-Trent, had been overlooked and underserved for too long.
Much of that promise would be based upon the reform of regulations that govern how UK insurers can invest their policyholders' premiums was a little more specific.
“We haven’t done the things like Solvency II…that would have unlocked investment into our country,” she told the studio audience and those watching at home, in reference to the insurance and banking industry regulations, before adding: “I want to turbocharge that.”
Solvency II, as the name suggests, is a set of regulatory measures that cover the financial, governance, accountability, and risk assessment activities of insurers that is designed and intended to ensure that in the event of financial stress, they stay solvent.
But with the UK having left the European Union and therefore no longer being required to comply with its financial regulations, the chance for the UK to set its own rules and regulations is increasingly being seen as an opportunity to unlock fresh capital in both financial and political terms.
For both Truss and her opponent in the former chancellor Rishi Sunak, it appears they will heed the Association of British Insurers (ABI) estimate that improvements to the regulatory regime could unlock up to £95bn of additional investment capital for the UK.
Indeed, while Sunak was still in post at The Treasury, both he and his economic secretary, John Glen, spoke of the “tens of billions” that could be used to support long-term infrastructure projects in the fight to combat climate change.
Furthermore, during a meeting that they held with senior representatives of the UK insurance industry, it was also understood that both sides were pretty much on the same page in terms of the direction the reforms should take.
However, despite that appetite for reform from within the Treasury, the Prudential Regulatory Authority (PRA) that will both set the rules and oversee them, has specific concerns.
Reducing the risk margin while strengthening the matching adjustment
Under the existing proposals put forward by the PRA, which are still subject to ongoing consultation, insurers would be granted a significant release of capital under a recalibration of the risk margin (RM) that requires them to hold additional capital above their liabilities.
Within the current economic environment, this would lower the capital requirement by 60% for life insurers and 30% for general insurers and lower the measures' sensitivity to changes in interest rates.
But while these proposals have been welcomed by both insurers and industry bodies as a positive step forward to freeing up capital, the proposals for the matching adjustment (MA) have proven far more contentious.
Designed to incentivise life insurers and annuities providers, which constitute a significantly larger share of the UK insurance market than the EU market, to invest in assets that provide a similar cash flow to their liabilities, the MA measure allows them to count future returns from certain assets as existing capital.
However, with the existing methodology for its calculation based largely on credit ratings or insurers own assessments, the PRA is of the view that it insufficiently accounts for the possible risks of downgrades or defaults of assets.
As a result, it has proposed to include a credit risk premium (CRP) within a revised MA that would be equivalent to at least “35% of credit spreads on average through the cycle”.
Outlining the regulators thinking on the reforms, which will also enable insurers to invest in a wider range of assets to reflect the sectors appetite to invest more heavily and at earlier stages in assets such as real estate, Sam Woods, CEO of the PRA, said that any package of reform without a change to the matching adjustment would be “seriously unbalanced”.
“It would simply remove bits of regulation that insurers don’t like without taking proper account of risks to policyholders, and would not provide a solid basis for investment,” he said. “I worry that some might consider such a thing to be a free lunch”.
Industry claims capital would be reduced
But while the PRA believes that the full package of measures, with the easing of the risk margin combined with the changes to the MA, would still result in a significant increase in available capital, which it calculates to be between 10%-15%, the industry has come out strongly to suggest the opposite in relation to the life insurance and annuities sector.
In its formal response to the proposals, the Association of British Insurers, said: “The current proposals would not achieve the suggested release of 10% to 15% of capital for re-investment. Life insurance firms would have to hold more capital than currently required, preventing them from being able to provide the funds that are needed for investment across the UK.”
For the UK life insurance and annuities sector, an issue of contention is that the proposals as they stand take too strict an approach in terms of matching cashflows while undervaluing predicable cash flows from assets that would in theory, provide the same level of income to cover liabilities.
An example of this is that under the proposals, an asset such as university accommodation, which provides a long-term and predictable income that could be used to cover life insurance and annuities liabilities, would be more harshly treated than under the existing Solvency II regime. This is an issue made more significant by the fact that such insurers have been more heavily investing in such private assets.
Speaking to ICAEW Financial Services Faculty, John Godfrey, corporate affairs director at Legal & General, explains that: “One of the things the life and pensions end of the sector want to do is invest more into real assets, including new types of asset class and we would like to see that requirement for precise cash flow matching to include highly predictable cash flows.”
“And in our view, that doesn’t diminish policyholder protection, because apart from anything else, the industry has vast capital buffers already, so in our case we have a Solvency II ratio of 212% and almost £3bn worth of credit default reserves.”
Stressing that the likes of Legal & General and other long-term investors are typically some of the most risk averse institutional investors, Godfrey suggests that such a change would be key in enabling them to invest in the types of assets that could contribute to combatting climate change and helping to grow the UK economy.
“By having highly predictable cash flows, as opposed to precisely matched cash flows, you can invest in types of assets where there are things like call options, prepayments and those types of things,” he says, referring to additional levels of protection afforded by such assets. “And that is really important amongst other asset classes such as for climate assets.”
Competition objectives of policyholder protection and competitiveness
This apparent inconsistency between the political rhetoric that wishes to unlock and free up the capital of such long-term investors in order to invest more heavily in the UK and the proposals put forward that appear to be restricting that capital, is something that Matthew Francis, insurance director at KPMG also sees.
“Whilst illiquid assets would still offer a larger spread than bonds following the introduction of a credit risk premium in the fundamental spread adjustment, the proposal may disproportionately reduce the attractiveness of holding illiquid assets, such as real estate and infrastructure debt, relative to the current regime,” he tells ICAEW Financial Services Faculty.
“Therefore, rather than creating incentives for insurers to invest in illiquid asset classes capable of driving growth in the economy and helping the UK transition to a net zero economy, these proposals could in fact diminish the incentives to invest in them.”
And so, with the clear frontrunner to become the next Prime Minister promising to “turbocharge” investment into the UK economy as a result of the reform of Solvency II and the man in charge of the regulator itself making clear that there will be no “free lunch” for the industry, how might this circle be squared?
One factor that could prove particularly significant in this is that in addition to being charged with ensuring that policyholders are protected, the regulator will also potentially be required to help drive competition within the sector.
Should this materialise, then the PRA could find itself under greater pressure to give the sector more freedom around its investments, but the prospect of it being ’turbocharged’ any time soon appears unlikely.