The United Kingdom could save £350m a week by leaving the European Union, a slogan displayed on a campaign bus read ahead of the Brexit referendum. Cynics point out that five years on, this fortune is yet to materialise. Nevertheless, opportunities have arisen from the UK leaving the EU.
For British insurers the result of the referendum offers scope to review the liquidity requirements set out in Solvency II, which could potentially unlock billions of pounds to be invested in illiquid assets such as infrastructure. The Prudential Regulation Authority (PRA) is holding a consultation about the scope for change.
If a decision is made to relax the liquidity requirements, its timing would be politically convenient. Last year, the government outlined a £650bn national infrastructure and construction pipeline, but a large chunk of this needs to be funded by private capital as the public purse cannot foot the bill alone. Chancellor Rishi Sunak has attempted to secure the funding needed by writing to institutional investors outlining how he intends to “ignite an investment Big Bang”.
While the 1,000-page Solvency II directive has been implemented into UK law, the PRA is reviewing whether some of its contested elements could be updated, potentially enabling insurance companies to broaden their investment horizon.
One of the directive’s most controversial elements is the risk margin, which is used to calculate a life insurer’s technical provisions.
The insurance industry has long complained that this margin is too high and drives up costs. This makes buyouts for defined benefit (DB) schemes more expensive and puts insurers at a disadvantage against the new pension consolidators, such as superfunds, do not have to comply with Solvency II, the Association of British Insurers (ABI) has said.
Another contested element is the matching adjustment, which is the mechanism deciding the type of assets insurers can hold to match their liabilities. Being initially drafted in the aftermath of the 2008 global financial crisis, the mechanism aims to prevent a liquidity crunch by requiring insurers to hold investment-grade assets and have a maturity and profile matching their liabilities. This effectively excludes many infrastructure assets.
One of the stakeholders pressing to relax the rules is Pension Insurance Corporation (PIC). In a report published in January, economist Steve Hughes predicted that relaxing the risk margin and matching-adjustment rules could see PIC’s investment in productive finance increase to £50bn during the next eight years, of which £500m would be invested in renewable energy.
Hughes predicted that the additional capital could, for example, build 34 new wind turbines a year, while £450m per annum could be invested in making social housing more energy efficient.
For the industry more generally, ABI predicts that relaxing the Solvency II rules could release up to £95bn in additional investments in infrastructure. This estimate includes an additional £60bn out of the £300bn matching-adjustment portfolios which could be re-allocated to assist the transition towards a greener economy, according to KPMG.
But the regulator is taking a slightly more cautious stance on the matter. Speaking at an event organised by ABI in autumn last year, Sam Woods, the PRA’s chief executive, welcomed the opportunity to reform Solvency II. But he also cautioned against a straightforward easing of the rules, warning that it could conflict with the regulator’s statutory objective to protect policyholders.
Woods stressed that the liquidity matching requirements were an aspect of regulation that the UK initially campaigned for in talks with the European Insurance and Occupational Pensions Authority, the EU’s financial regulator.
“Matching is prudentially beneficial and may make annuities cheaper than they would otherwise be, but, of course, it also involves taking more risk because it boosts capital levels and lowers capital requirements,” he said.
“Removing barriers is one thing and if, for example, investment in green assets is being held back by excessively backward-looking forms of measurement of risk, then that is something we should change. But it is a fundamental pillar of the prudential regime that it be risk-based: disregarding the risk in individual investments is a recipe for an under-capitalised financial system that would not be a robust or sustainable source of investment,” Woods added.
The PRA closed its first round of the consultation in December. It intends to organise a series of roundtable events in February for insurers to discuss the potential scope for change.