Solvency II: Insurers unleashed


23 May 2022

With the stringent liquidity rules governing insurers set for a shake-up, Mona Dohle looks at what it could mean for investors.


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With the stringent liquidity rules governing insurers set for a shake-up, Mona Dohle looks at what it could mean for investors.

It is no secret that the government sees institutional cash as key to filling the gaping funding hole in its infrastructure ambitions. While pension schemes have received widespread coverage on the role they could play here, insurance investors have received less attention. This is partly due to the stringent rules of Solvency II, which make it harder for insurers to invest in illiquid assets, such as infrastructure.

But the government plans to tackle this by reforming Solvency II to free up insurance investment into infrastructure as part of its plan to unleash a “Brexit bonus”.

But how successful are those changes going to be and what pitfalls do they need to consider?

Keeping up with the Schultz’s

With some £1.9trn in assets under management, insurers are the UK’s second largest institutional market and one of the wealthiest insurance markets in the world. But due to Solvency II, they have to be relatively more conservative by building fixed income-heavy portfolios.

While there is little data available on the asset allocation of the insurance sector as a whole, a survey of the insurers managing the 10 largest annuity books in the UK revealed that some 70% of the £320bn they collectively manage is invested in fixed income.

A mere 4% are held in equities and property combined, while 16% is invested in loans and mortgages, according to a KPMG report commissioned by the Association of British Insurers (ABI).

The industry body predicts that if the Solvency II rules are eased, it could free up an additional £95bn to be invested in projects like renewable energy or social housing.

Jacob Rees-Mogg, the minister for Brexit opportunities, has a good reason to speed up these reforms. The EU announced its proposals to reform Solvency II in September, which included a €90bn (£74bn) capital injection to bolster insurance investment in illiquid assets, and Britain’s government is keen to ensure the competitiveness of its insurers.

The UK’s reforms are expected to be part of the Financial Services Bill to be included in the Queen’s Speech in May. If the government wants to establish competitiveness with Europe’s insurers, it will need to crank up the pace of its reforms.

(Mis)matched adjustment

For insurance investors, by far the biggest obstacle to greater investment in illiquid assets are the Matching Adjustment rules. The purpose of the rules is to ensure that long-term investments will meet long-term liabilities. But this effectively forces insurers to allocate most of their assets to investment-grade debt.

In the current environment of low yields and rising inflation, this raises serious problems for investors.

The Pension Insurance Corporation (PIC), which specialises in de-risking defined benefit (DB) pension schemes, describes Solvency II as “the economic equivalent of riding a bike wearing three helmets – extremely secure, but ultimately limiting to overall performance.”

The Matching Adjustment also presents a challenge for ESG-focused investors.

The ABI is one of the most vocal opponents of Solvency II believing that the rules are an obstacle to building greener investment portfolios. “It is currently much easier to invest in a highly-rated mining company than it is to invest for 30 years in a wind farm,” the ABI said in a report.

Allen Twyning, PIC’s head of affordable housing, argues that the Matching Adjustment rules are the biggest problem facing insurance investors, but they are also the easiest to address. “Matching Adjustment eligibility specifies which assets we can use to back our liabilities. At the moment, these assets are not callable or come with a pre-payment penalty. If a borrower wants to repay the debt early they have to pay us enough so we can buy another asset.

“So, if we were to lend to a housing association and they wanted to repay the money early, they would have to give us enough money that we could repay the cashflows with say government bonds. That is expensive for any borrower to take on,” he says.

Add to that the fact that many infrastructure investors are struggling to find appropriate projects to invest in so insurers stand to lose out to the banks, which are not restricted by these lending rules.

Compared to other insurers, PIC already has a significant allocation to infrastructure, which accounts for roughly a fifth of its £50bn of assets. But the buyout and buy-in provider expects its assets to double rapidly during the next decade, as DB schemes continue to mature. If Solvency II rules are relaxed, it expects to expand its infrastructure allocation by up to £50bn during the next eight years.

Tom Sumpster, head of private markets at FTSE-listed insurer Phoenix, also sees the opportunity. “Solvency II is overly restrictive for the investments we would like to make.

“There should be greater flexibility in terms of the capital that we have to apportion against our Solvency II investments,” he adds.

“If we were given capital relief, there would be a greater potential to make investments in the markets where we want to do that, and where we can make a real difference, such as supporting social housing and the transition to renewable energy.”

As long-term investors, life insurers, in particular, should be well placed to invest in illiquid assets.

“The private market has now matured to a certain degree, providing us with an opportunity to invest in real assets where we can make a difference to people’s lives,” Sumpster says.

He adds that insurance investors have a “natural ability to invest in assets providing long-term income, such as infrastructure and real estate. Pension liabilities are a natural fit for this type of income environment.”

Treading carefully

But will insurers be able to increase their allocations? A look across the channel could offer an early indication of the scope these changes could bring. The EU has set the bar low by planning to ease the risk margin. However, it has proposed no material changes to the Matching Adjustment Rules.

So, will reforms in the UK be more ambitious?

At the moment, this is far from straightforward. While the government is keen to attract more cash, the Prudential Regulation Authority, which oversees the insurance sector, is taking a more cautious stance.

There are signs that the regulator plans to tackle the risk margin and the Matching Adjustment as John Glen, City minister and economic secretary to the Treasury, promised in a speech delivered to the ABI in February.

In the speech, he indicated that the government plans a 60% to 70% cut in the risk margin for long-term life insurers. He also suggested that the government plans to re-assess the fundamental spread used to calculate the Matching Adjustment, “to better reflect its sensitivity to credit risks”.

Glen’s speech suggests that the financial spread, the measure which is used to indicate the cost of future credit downgrades and defaults, could be the focus of the regulator’s attention. The financial spread is based on long-term average default rates, which have been historically low following more than a decade of quantitative easing.

What Glen did not mention is that the regulator is clearly concerned that this economic environment might be coming to an end as inflation rises and central banks are tightening their purse strings. The Prudential Regulation Authority’s preference is to introduce a financial spread based on current and recent average spreads.

But this could reduce the Matching Adjustment benefits more swiftly if credit spreads were to widen, a potential double whammy for UK insurers.

Firstly, this would reduce their competitiveness against European insurers, with the EU not planning to introduce any changes to financial spreads.

Secondly, a more rapidly changing spread would make long-term investments in illiquid assets relatively less attractive. In both cases, it would be the precise opposite of the government’s desired outcomes.

In a blog post, Huw Evans, a former director general of the ABI, warned against changes to the fundamental spread, stressing that it was “clear that the insensitivity to credit spreads is a design intent, not an unintended consequence”.

“If it were more sensitive to those short-term pressures, it would become pro-cyclical which is not in the interests of the ultimate policyholders or the Prudential Regulation Authority which is responsible for financial stability,” he adds.

Looking ahead

At the time of writing, it remains unclear what the government’s stance on changes to the Matching Adjustment and the financial spread will be. But investors are keen to stress that the challenge of predicting credit risks and default rates is already on their agenda.

“When we focus on any investment and their banking liabilities,” Twyning says, “it is a rigorous process to capture their credit quality and our ability to go through economic cycles without significant credit losses, we capitalise against the process of doing that.

“We have a rigorous process in terms of asset selection and our solvency buffer is there to absorb any losses for any policyholder,” he adds.

Sumpster highlights that Phoenix has hired an in-house credit risk team to undertake independent assessments prior to investing. “We also think carefully around the portfolio diversification and strategic asset allocation of the portfolio as we build it so that we are not overweight a certain risk of a certain sector, certain jurisdictions,” he says.

While the future is uncertain, Sumpster remains optimistic. “We are big supporters of changing the rules to allow us to make powerful investments, to allow us to think about social value, as well as economic value,” he says. “That way we can change people’s lives, we would welcome those changes in order for us to put pension fund capital to work in the right way.”


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