Solvency II – Feature
He adds that insurance investors have a “natural ability to invest in assets providing long-term income, such as infra- structure 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 plan- ning 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 mar- gin 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 fun- damental 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 con- cerned 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 prefer- ence 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 com- petitiveness against European insurers, with the EU not plan- ning 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 govern- ment’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 govern- ment’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 diversi- fication 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.”
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.
KPMG
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