GM and welcome to So What: a morsel of risk news to add extra fiber to your granola.

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1,834 words - 7 mins, 20 seconds read time

TL;DR

• Solvency II rules are EU rules that help regulate the insurance industry.

• Britain's Conservative Government is pushing to loosen some of these rules to help free up cash for investment and increase competition and consumer choice.

• Any loosening of the rules must also be accompanied by tightening in other areas to avoid introducing systemic risk to the industry.

• The Bank of England and others are concerned that the final rule change will not include the tightening required, which threatens firms, pensioners, consumers, and potentially the UK economy.

Nutritional Information

Today's post includes a heavy sprinkling of regulation and 110% of your RDA of Brexit.

What is Solvency II?

The 2016 Solvency II Directive is a set of European Union (EU) rules that apply to all insurance firms. Solvency II streamlined several legacy guidelines and ensured that insurers could better cover their liabilities.

There are three Pillars of Solvency II.

I - Risk-based capital requirements

• Insurance companies must hold sufficient capital reserves in relation to their risk profiles to ensure that they can cover claims.

II - Governance and risk management requirements

• Insurance companies need adequate and transparent governance systems and to conduct risk and solvency assessments regularly.

III - Supervisory reporting and public disclosure

• The EU and national regulators will review and evaluate whether insurance companies comply with the rule

• companies must submit regular reports to supervisory authorities and disclose information publicly.

(From the EU)

What Are the Reforms?

A vital element of the pitch for Brexit made by Britain's Conservative (Tory) Government was that breaking away from Europe would allow the UK to rid itself of onerous EU legislation. So far, there has been little meaningful change in this area, but reforming the Solvency II rules has progressed quite far and may be enacted soon.

(The resignation of Prime Minister Boris Johnson and Chancellor Rishi Sunak, both proponents of the change, may interrupt this progress, but the consultation and planning process appears to have advanced quite far and may have passed the point where their involvement is required.)

The specific changes and benefits the UK hopes to see enacted are:

• A substantial reduction in the risk margin for long-term life insurers (around 60-70%) and a change to the margin for general insurers to release capital on insurers' balance sheets.

• A more sensitive treatment of credit risk in the matching adjustment (MA provides incentives for insurers to issue long-term life insurance products by 'matching' them against assets with similar characteristics).

• A significant increase in flexibility to allow insurers to invest in long-term assets such as infrastructure.

• A meaningful reduction in the current reporting and administrative burden on firms...by doubling the thresholds for the size of insurers before the Solvency II regime applies.

• Revise other rules to allow more firms to enter the market and to offer greater consumer choice.

Source, UK Government Press Release

A recurring benefit stressed by supporters of the reforms is a surge in investment in infrastructure and green projects.

The Implications

The Good

Simplifying rules and increasing consumer choice by allowing more firms to enter the market is a positive step. Simplification reduces the administrative burden for firms and should enable more people to buy insurance, reducing their personal risk.

Moreover, freeing up billions of 'stranded' Pounds for investment in the markets is a double bonus: it means more market investment and increased shareholder returns.

These benefits are driving these changes, and even the normally cautious Bank of England supports reforming Solvency II.

However, the BoE's support is not unconditional, and the Bank is concerned about the risks these changes pose, particularly if the regulations loosen in one area without sufficient offset.

The Bad

This lack of offset seems to be the BoE's primary concern, particularly the fundamental spread and matching adjustment issue.

Current rules allow companies to recognize profits upfront and offset their potential losses with these future profits. Problems obviously arise if profits are less than expected and losses are greater. This is a highly correlated set of circumstances: a downturn or market collapse would damage profits and increase claims. However, markets have been relatively strong since Solvency II was introduced in 2016, so firms haven't had to manage this kind of imbalance.

The BoE also believes that these rules need tightening.

Moreover, the Bank seems concerned that the Government's changes will cause further imbalance by reducing capital requirements without tightening the FA and MA rules. This would increase both exposure and the means to mitigate impact.

The Ugly

Finally, emphasizing how the changes will increase investment in infrastructure and green projects feels disingenuous. Changing the rules and adding incentives may make infrastructure and green investments more attractive, but what firms actually invest in will be up to their portfolio managers. Moreover, there may be too much money chasing green investments anyway.

So if other sectors or asset classes remain more attractive, or there's nowhere to put this extra 'green' cash, the hoped-for boost to infrastructure and the environment won't arrive.

And none of this is a secret which is why this falls into the 'Ugly' category: proponents of the changes know all of this, but they aren't doing this to free up cash for new roads and wind farms. They're doing it to cut paperwork and boost profits but are trying to add a green halo to the whole endeavor.

It feels like prudence seems to have been set aside. As Davis notes

The Big Red Flag

Markets and economies are already under pressure, and several countries are flirting with a recession or some form of a downturn. Increasing the amount of systemic risk is always dangerous, but this seems particularly reckless at a time when conditions seem uncertain and fragile. Easing up on Solvency II would cause an immediate boost in investment and give the Tories a much-needed Brexit' win'.

But that would be at the expense of the stability of the overall economy. Similar to the hidden danger posed by sub-prime mortgages in the US, the disconnect between capital and exposure could go unnoticed for some time. However, a sharp shock to the economy or catastrophic event could easily set off a run. Claims would mount, coffers would run dry, future investment profits would disappear, and the Government would be forced to step in.

Pension funds and holders wouldn't see the planned returns or coverage for insured events sending an additional shock through the economy.

Unless the reduction in capital reserve requirements is matched by tightening of the FA and MA rules, this feels like the scenario we are facing.

So What?

Watch the Final Ruling on FS and MA

A maximal approach to relaxing the reserve requirements with no change to the MA rules would suggest that a large amount of risk has been injected into the economy. You should apply this change in your risk assessments to determine what steps you may need to take. A review will also help you assess the degree of systemic risk added to the British economy.

Monitor the macro conditions

A sustained downturn, low profits, and increased business closures would signal weakness in the insurance sector and make it susceptible to a shock that could trigger a collapse. If you see these conditions, you should assume that there is significant fragility in the sector and plan accordingly.

Monitor Your Provider's Behavior

Firms are under no obligation to loosen their own rules if regulations change, but most will look to take advantage of relaxation. Therefore, keep an eye on the changes the firms you use take. This will help you determine how prudent they are being and, in turn, assess how much risk they are taking on. These changes won't be evident immediately, but if you get the sense that your provider is maximizing their upside without doing much to cover your downside, then you should maybe look elsewhere. If it's a pension fund, you will need to take independent advice to determine your options and take appropriate measures.

Watch the Big Short

I recently rewatched the Big Short and now use it as a thought experiment by replacing 'sub-prime mortgage' with another market risk. In this case, an underfunded and over-exposed insurance industry would pose a similar degree of systemic risk to the economy with the potential to cause widespread damage. The US sub-prime crisis built up over years and the effects of changes to Solvency II would be similarly slow. But keeping track of the factors above will allow you to determine if the industry is moving forward with a solid foundation or if it will be resting on the equivalent of junk mortgage bonds.

This was a meaty one and a lot to get through (for both you and me!) - let me know what you think. Click a link below and let me know what you think.