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Changes by the UK to the Solvency II framework, announced by the Bank of England (BoE) in November 2022, are prompting many UK-domiciled insurers to rethink their investment strategies.
Given the potential of large amounts of newly freed capital being released – the industry could invest over £100 billion in the next ten years – one of the main questions is which project/s should take precedence for investors.
There has been recent attention to social infrastructure investment, the looming net-zero transition, and ‘levelling up’ – the UK’s flagship fund backing community building projects – as significant opportunities.
Investment teams at insurance organisations should, unsurprisingly, expect to see further allocation to UK infrastructure assets, said Dean Heaney, Head of UK Institutional at Franklin Templeton. He added that these measures are beneficial as they would provide highly predictable cashflows – with a specific focus on social and environmental projects, ultimately helping to boost the UK economy.
“The proposed change to matching adjustment may result in broader exposures in this area and to assets that specifically target an insurer’s wider strategic priority,” he said.
The strategic priority to which Heaney referred indicates an ongoing focus on sustainable growth and strengthening the immediate domicile economy. The UK government’s recent attention to levelling up and financing a Just Transition have supposedly been main priorities since 2021’s COP26, in which over 30 nations signed the Just Transition Declaration, which advocated for the needs of workers and communities in the midst of the shift to a zero-carbon economy.
“The proposed change to matching adjustment may result in broader exposures to assets that specifically target an insurer’s wider strategic priority.”
At Clear Path Analysis’s winter 2023 Insurance Investor Live | Europe event in London, Aileen Mathieson, Group Chief Investment Officer at Aspen, said that she believed upcoming Solvency II changes would be a reconfiguration of the ways government and institutional investors could work together on big project, such as those involving green and ESG investments.
This capital inflow would be especially beneficial with regards to post-pandemic recovery plans in local communities. For example, Mathieson mentioned the situation in which the Scottish government calculated it needed £6 billion to get its communities “back on track” post-lockdown, but only £600 million was offered by central government. This, in turn, meant that public-private partnerships and other sources of funds became wholly necessary cover.
Situations like the aforementioned are examples of ways Solvency II capital could be used to assist communities and have a clear, material impact on the lives of UK citizens. A 2022 report from EY on the government’s levelling up ambitions noted that, post-pandemic, the main factor to economic recovery success will be consistent policy initiatives. This, the analysis highlighted, included “seeding faster-growth sectors” and “leveraging green investment”.
It continued, saying that “the structural forces driving [the] UK’s regional inequality are deep-rooted and call for sustained, coordinated action to balance growth across the country.” Public/private partnerships could be the way forward for investors seeking to boost regional sectors – such as manufacturing and utilities, which could aid in net-zero goals whilst bringing jobs and enhancing quality of life.
There are, however, some potential headaches on the horizon, alongside the positives.
Willem Loots, Senior Director at Fitch Ratings, noted that, under the current proposals, assets with prepayment risk would be eligible as matching adjustment assets. This means that the supply of long-term assets – especially those connected to infrastructure, as mentioned – could be significantly increased.
For insurers, investing in these areas has been historically difficult. Loots said that one of the main challenges from a policy standpoint is that insurers’ infrastructure have been previously confined to established projects with fixed cashflows. “Enabling insurers to invest in early-stage project could stimulate investment in the sector,” he said.
However, Loots added that there would also be additional risk involved. He said that because insurers have often worked around existing requirements by restructuring assets to create fixed cash flows, new criteria would remove the frictional cost of restructuring, rather than increasing the supply of underlying assets.
This means there could be limited attractiveness to assets without fixed cashflows.
Loots, however, was optimistic about the changes, and said he believed proposed reforms would likely be finalised this year, going into effect in 2024.
“Insurers [will] deploys some of the capital freed into long-term investments,
attracted by the prospect of higher returns.”
When asked where he stood on another recent concern, the supposedly higher chance of bankruptcy for insurers due to proposed changes, Loots said that he felt the UK life insurance sector would remain steady despite loosening rules. “The UK life sector will continue to maintain strong capitalisation despite the government’s proposals to loosen Solvency II rules to release capital for insurers to invest more in long-term assets.”
This was because most insurers maintain Solvency II ratios well above the minimum requirements, Loots said – adding that the probability of failure was lower than 0.5%. Repudiating the bankruptcy concerns, he said insurers would likely remain within existing risk appetites to avoid unnecessarily depleting capital and jeopardising credit ratings. “Most insurers have strong capital headroom in their ratings,” he said.
However, Loots did say he expected a shift in capital deployment going forward. “Insurers [will] deploys some of the capital freed into long-term investments, attracted by the prospect of higher returns.”
These predicted changes mean investment teams will need to be aware of their peers’ strategies, to continue to be competitive and remain in alignment with market standards.
They might also mean weathering the headaches to get to the eventual benefits.
“These are positive outcomes that are both good for insurers and consumers,
and confirm that the regime is working as designed.”
Paul Davenport, Finance and Risk Director at Lloyd’s Market Association (LMA), said that since the implementation of Solvency II frameworks, insurers have significantly strengthened their governance models and risk management capacity – changes he was glad to see. “These are positive outcomes that are both good for insurers and consumers, and confirm that the regime is working as designed,” he said.
Despite these positive outcomes, there are still many frustrations. Davenport said there is a need for greater clarity around a concrete timescale for development and implementation. He also noted that “the changes to the matching adjustment and risk margin are not expected to make a material impact on non-life capital requirements.”
The aspects of Solvency II reform most relevant to non-life insurers are changes to internal model requirements and reporting burdens – which, he continued, were overall disappointing and would only lead to additional costs and headaches for insurers. “The proposals for reductions in reporting burdens are disappointing and likely to lead to additional cost and burden rather than a reduction,” he said.
This is because the London non-life insurance market is a global marketplace, and more than 50% of covered risks are outside the UK. More than 50% of capital backing is also derived from outside the UK. The lack of standardisation across domiciles was worrying to Davenport. “It is vital that UK Solvency II reforms do not undermine the international recognition of the robust nature of prudential regulation in the UK,” he said.
“Although the proposals seen so far have been disappointing, we are confident that they will improve through the current consultation process.”
Nevertheless, Davenport was hopeful that proposed reforms will bring positive benefits for specialty insurers – such as the members of the LMA. “Although the proposals seen so far have been disappointing, we are confident that they will improve through the current consultation process,” he continued.
Industry stakeholders see both positives and negatives to the proposed UK Solvency II changes, and the sentiment remained geared toward long-term growth and economic aid, with investment strategies for life insurers likely to shift down the line. In the short term, however, investors can expect a continued lack of clarity, slow processes, and new operational headaches.
