Post Brexit, the government is set on reforming a critical piece of EU financial regulation called Solvency II. This is designed to protect consumers by making sure that insurance companies hold a cushion of assets to be able to withstand financial shocks and honour commitments to policyholders – for example, pay pension annuities.
The reform of Solvency II should be seen in conjunction with other reforms to financial regulation intended to align financial market behaviours with climate goals.
Our submission can be found here: FIC HMT BoE PRA Solvency II consultation response final 210722
We have two primary concerns in relation to the proposed reforms of Solvency II and wider financial market reform.
- The prudential regulation of UK insurers (and therefore consumer protection available to policyholders) should be robust and maintain trust and confidence in the sector over the long term; and
- Market, prudential, and conduct of business regulation should align UK financial market behaviours with climate goals.
The insurance lobby is arguing that post Brexit provides an ideal opportunity to relax some of the measures contained in Solvency II, claiming this would free up investment to support the green transition. We think this is disingenuous and the real intention of the insurance lobby proposals is to weaken regulation to provide a windfall for shareholders, not finance the green transition.
In our submission we conclude that the state of some of our major insurance companies means regulatory standards need to be toughened, not weakened. There are more effective ways of directing the financial resources of financial institutions to support the green transition without compromising consumer protection and undermining long term trust and confidence in the insurance industry and pensions.
Overall, we conclude that the proposals in Solvency II would do little to align behaviours in the UK financial system and markets with climate goals.
Impact on consumer protection
It is our view that the current approach to Solvency II is fundamentally flawed. The use of a technique called the matching adjustment (MA) is of particular concern.
The use of the MA is fundamentally flawed as it enables insurers to artificially create capital. Insurers are able to recognise, up front, future returns from investing in MA assets so allowing them to reduce the amount of real capital held. This benefits shareholders at the expense of policyholders who are exposed to the risk that these higher returns do not materialise over time.
There are some rules on the eligibility of assets for the MA. Even so, the current approach already incentivises insurers to seek out ‘too good to be true’ assets – ie. those that provide a higher return but are rated as a similar risk to other assets offering a lower return. Moreover, many of those assets are internally rated by the insurers themselves which obviously creates conflicts of interest. [1]
Allowing insurers to assume that higher risk assets will deliver expected returns is inherently risky. But, the MA is even more perverse. It goes against one of the fundamental rules of finance – that if a financial institution is exposed to higher risks it should hold more provision against those risks. The MA allows insurers to reduce the amount of provision held against those higher risks.
The scale of MA assets already involved is already worrying. Total assets held in MA portfolios amounts to around £380bn. It delivers a capital benefit of £80bn – an increase of £20bn from £60bn when first introduced. That £80bn is more than two-thirds of the entire capital base of the life insurance industry of £112bn. For some specific insurers, the MA makes up the bulk of their capital.[2]
Moreover, the increase in the inclusion of illiquid assets in MA portfolios can heighten the risk to policyholders. The proportion of assets in illiquid assets has grown from 31 percent in 2018 to 41 percent in 2021.[3]
The widespread use of the MA to artificially create capital means there is an illusion of balance sheet strength in some of our major insurers. The UK approach to prudential regulation has already allowed the UK insurance sector to make far greater use of this artificial capital creating mechanism than its major EU competitor markets.
This cannot be a good position to be in. It is not just traditional personal pensions/ annuities that we need to consider. Employers have been transferring pension liabilities to insurers in very large volumes. In total, the BoE/ PRA estimates that over 8 million policyholders are served by this sector.
The insurance lobby wants: i. a reduction in the amount of capital they have to hold; and ii. to gain even more benefit from the MA. We note that the government and BoE/ PRA’s proposals would mitigate the impact of the insurance lobby’s demands. The BoE/ PRA would be content to relax some of the rules on how much capital held but, to offset this, would tighten up on the use of the MA.
But, it is also worth noting that the combined effect of the proposed reforms would still reduce overall capital levels from their starting position and will inevitably lead to some reduction in financial resilience amongst insurers. [4] These would release capital equivalent to 10-15% of the current capital held by life insurers.
We would argue that the current state of the insurance sector does not warrant any across-the-board weakening of prudential regulation standards. If anything, policymakers and regulators should be toughening prudential regulation standards given the current state of insurers – this is all the more important given the prospects for financial markets.
The Bank of England (BoE)/ Prudential Regulation Authority (PRA) proposals to tighten up on the use of the MA seems to have angered the insurance lobby who are saying that if they are not allowed to take further advantage of the MA, they will not invest in green assets/ levelling up.[5] We urge the government and BoE/ PRA to call the bluff of the insurance lobby on this.
The government is considering reforming how the MA is calculated. The BoE/ PRA is concerned that the current approach allows insurers to take too much benefit from the MA. But, we argue that this does not go far enough. We do not think that the MA should produce any value given that it artificially creates capital.
Our approach would lead to a more financially resilient, better regulated insurance sector at the aggregate and individual firm level. Of course, the impact on specific insurers would be different depending on the degree to which they rely on artificial regulatory capital. Those insurers which depend heavily on the MA would clearly be affected more than their peers who do not rely on the MA. The MA reliant insurers would have to hold more real capital to meet regulatory capital requirements.
The government thinks that its reforms could release 10-15% of capital currently held by insurers and unlock ‘tens of billions of pounds’ for long term productive investments including green assets. So, increasing the amount of real capital held by insurers may not be the outcome the government wants to see.
But, looking at the balance sheets of certain individual insurers, there is a compelling case for robust interventions to strengthen financial resilience given the reliance on the MA to artificially boost regulatory capital. As mentioned, we think the use of the MA per se is fundamentally flawed. However, if the government and BoE/ PRA insists on allowing insurers to retain some value from using the MA, then reforms should not result in any release of capital by those insurers heavily reliant on the MA. Indeed, there is a strong case for ensuring the combined effect to result in an increase in real capital held by those insurers.
Furthermore, the BoE/ PRA should require those insurers heavily dependent on the MA to develop financial resilience transition plans to reduce reliance on the MA over a reasonable period.
Aligning financial markets with climate goals
As well as having concerns about the impact on consumer protection, we conclude unfortunately that the government’s proposals on Solvency II will do little to align behaviours in the UK financial system and markets with climate goals.
As we set out in our submission to HM Government: Update to Green Finance Strategy Call for Evidence,[6] and in the Annex below, we do not think the legislative and regulatory framework, and specific regulations, rules, and guidance are fit-for-purpose and will not drive the necessary change in the financial system and markets. A different approach will be needed if the UK financial sector is to contribute to climate goals and if the UK is to be a leading effective, trusted, and reputable global centre of green finance.
The key objectives of climate related financial market reform should be to:
- Effectively align the behaviours and activities of the financial system,[7] markets, and institutions with climate goals; and
- Efficiently direct resources to climate positive economic activities and away from climate damaging activities. For this to happen, financial policy and regulation must be as efficient as possible at: i. causing financial institutions to disinvest and divest from their existing stock[8] of climate damaging assets; and ii. ensuring the flow of new funding (public and private)[9] is allocated to climate positive economic activities and directed away from climate damaging activities.
Greening the financial system and underlying real economy will require sustained efforts over the long term. Therefore, it is important that any redirection of resources is sustainable and available funding is aligned with the long term in nature of climate goals. This will be a challenge given the short termism prevalent in UK financial markets.
In our view, the proposals made by government for reforming Solvency II would not encourage significant flows of resources to climate positive activities, and away from climate damaging activities. At best, the proposals might make a marginal contribution to channelling flows of assets but at a cost to the consumer protection available to insurance policyholders. Moreover, the proposals do not appear to contain robust measures that would cause insurance companies to meaningfully divest or disinvest from their existing stock of climate damaging assets.
The insurance industry has been vocal in asserting that the current design and implementation of Solvency II stops them from investing in green technology/ infrastructure and that reform is needed to enable such investment. These arguments are disingenuous. It is not at all clear why government believes that, with reforms, insurers might choose to invest in green assets (or levelling up) rather than create further windfalls for shareholders by investing in high return, speculative assets.
Solvency II does not prevent insurers from investing in green assets or levelling up. What insurers actually mean is that unless they are able to make greater use of the MA, they will not be able to provide shareholders with windfalls.
Moreover, there is the important point that private finance (including insurance and pension funds) is a much more costly way to finance environmental and economic policy goals (green assets and levelling up/ social infrastructure) compared to state financing mechanisms.
Furthermore, we also note that the finance industry is lobbying for the state to ‘de-risk’ green assets (such as new green technologies or green infrastructure) by underwriting the associated early stage risks. This is what is known as ‘socialising the risks, privatising the rewards’. Again, it does not seem to be an economically sensible approach.
We would understand the dilemma facing policymakers and regulators if weakening prudential regulation was the only option to encourage investment in green assets/ levelling up. But, this is not the case. There are more effective ways of directing the financial resources of financial institutions to productive uses without compromising consumer protection and undermining long term trust and confidence in the insurance industry and pensions.
A much more effective means to ‘incentivise’ insurers to invest in productive assets would be to penalise the holding of, or directing new funds to, unproductive or climate damaging assets. This would provide the necessary incentive by making productive assets more attractive (in economic and regulatory terms) and a better way of achieving the twin goals of dealing with the flow and stock of assets.
To redirect resources from climate damaging assets, financial regulators should require insurers (and banks and asset managers) to have credible and demanding climate de-risking transition plans in place, with clear targets and timeframes.
Once transition plans have been approved, specific policy tools will be needed to implement these plans. We very much support the idea that policymakers and prudential regulators should adopt the “One for One” Rule. That is, for each £ of resource that finances new climate damaging activities, insurers should hold a £ of their own-funds held liable for potential losses.[10] An alternative would be to adjust the ‘own-funds requirement’ by reference to an independent assessment of the climate damage caused by an economic activity.[11]
If government and BoE/ PRA insists on retaining the use of the MA (see above), then assets which contribute to climate damage should be excluded from assets eligible for MA portfolios.
That would address the flow of new funds. We would still need to deal with the stock of existing climate damaging assets. This could be done by requiring insurers to hold a proportion of own-funds against existing climate damaging holdings – this proportion would be ratcheted up over an appropriate time frame to incentivise insurers to divest these assets in line with the transition plans described above. This should apply to assets already held in MA portfolios.
[1] Solvency II: Striking the balance − speech by Sam Woods, Deputy Governor for Prudential Regulation and CEO of the Prudential Regulation Authority, Bank of England Webinar, 8th July 2022, P7
[2] Sam Woods Solvency II: Striking the balance − speech by Sam Woods | Bank of England and Regulation is masking the true condition of insurers | Financial Times (ft.com)
[3] HM Treasury, Review of Solvency II, Consultation, April 2022, para 3.6
[4] PRA, DP2/22 – Potential Reforms to Risk Margin and Matching Adjustment within Solvency II, para 49
[5] Solvency II reform proposals need further work to meet objectives | ABI and Aviva explores using shareholder money to fund infrastructure projects | Financial Times (ft.com)
[6] HM Government: Update to the Green Finance Strategy – Call for Evidence | The Financial Inclusion Centre
[7] When we refer to the financial system, we include institutions of the state and the Bank of England, not just private sector institutions
[8] Held in the form of loans provided to and shares and bonds held in listed/ tradeable companies or larger privately owned companies
[9] When we refer to climate related funding or financial resources we include state/ public funding not just market based private finance (eg. banks, insurers, pension funds, asset managers, private equity and so on)
[10] https://www.finance-watch.org/the-one-for-one-rule-a-way-for-cop26-ambitions-to-manifest-in-policy/
[11] So, if an economic activity was rated as 4 out of 5 in terms of its climate impact, insurers would hold 80p in the £ and so on. But, this would require a robust foundational taxonomy which we do not yet have.