Brexit leaves insurers playing regulation waiting game

Local regime likely to be tougher than Solvency II, although risk margin might change


Bankers and lawyers say within hours of last week's UK vote to leave the EU they were fielding questions about whether Solvency II would still apply for UK insurance companies.

Across the industry, the chance of any big change is seen as remote. "The UK would want to be deemed an equivalent regime, so I don't see relief from a Solvency II-like setup," one UK insurance chief risk officer (CRO) tells But insurers are still guessing at whether a future regime will be wholly unchanged or whether the UK referendum opens the door to adjustments to Solvency II requirements.

The referendum result took many in the industry by surprise, with contingency planning before the result having been "rudimentary", according to one London-based lawyer. Nevertheless, insurers say market volatility so far has been comfortably within the stresses they apply under Solvency II, and bankers describe the response of insurance clients as relatively calm.

During Friday, June 24, following the announcement of the result, UK firms reported every few hours to the Prudential Regulation Authority (PRA) on a range of pre-agreed questions relating to their solvency position, risk sensitivities and market liquidity. But the exercise was largely theoretical, they say.

"The first question was around solvency," says the CRO. "The second was about solvency sensitivities. But something like this doesn't even trigger a recalculation.

"Short-term volatility is not a big issue for most insurance companies because it is well within the levels we would see as a normal stress. It is not even a severe stress."

Markets have functioned well, he adds: "Liquidity has been a non-issue."

A "perfect storm"

Eric Viet, global head of financial institutions at Societe Generale, based in London, describes the combination of falling equity markets, widening credit spreads and lower rates as a "perfect storm" for insurers, but also emphasises the stress is lower in magnitude than those used in internal models or the Solvency II standard formula.

"The most significant impact may be the fall of long-term interest rates, which should affect all insurers considering the challenge to match very long-term liabilities," he says. But part of the negative impact will be offset by the increased value of foreign operations, for which sterling surpluses should increase following the currency's fall, particularly against the US dollar.

Deutsche Bank analysts wrote in a note to clients on Tuesday, June 28: "The questions we are getting are around the sensitivity of solvency to changes in market factors, as well as asset quality and ultimately our view on dividend-paying capacity – currently, we do not see any threat to dividends."

Several insurers have sought to reassure investors about their capital position as the sector's share prices have tumbled. The Stoxx Europe 600 insurance index fell 18% between Thursday (June 23) and Monday's close (June 27).

L&G and Aviva both published updates earlier this week, with L&G's Solvency II ratio down to 156% at Monday's close from 169% at the end of 2015, and Aviva saying it was "close to the top" of its 150–180% solvency coverage target range at Friday's close. L&G said 10 percentage points of the drop was owed to dividend payments and its acquisition of Aegon's UK annuity portfolio, with the rest caused by the fall in risk-free rates.

Meanwhile, the industry is struggling to answer questions about the medium-term impact of the result on insurance regulation. Many think negotiation over the UK's future relationship with the EU might result in Solvency II continuing as the binding regime. But the possibility of the UK diverging from the directive in some areas cannot be discounted.

If the outcome of negotiations is UK membership of the European Economic Area (EEA), the ability of the UK industry to influence solvency regulation will be reduced, warns one former senior European regulator: "If the UK remains a member of the EEA – like Norway – Solvency II would still apply, but the PRA would no longer be an active member of the European Insurance and Occupational Pensions Authority (Eiopa). They would only be observers, and could not vote on any changes.

"Influence might still be high because the UK is a big market, but it would not be as high as before. The PRA may not be able to take part in the review of Solvency II in 2018, but would have to implement any changes made."

The PRA may not be able to take part in the review of Solvency II in 2018, but would have to implement any changes made
Former senior European regulator

Meanwhile, if outside the EEA, insurers say they would expect the UK to seek equivalence to Solvency II. In such a case, some divergence from the European directive might be expected.

"I think the regulator is happy with the concept of the risk margin – but would look to take action to reduce its sensitivity to interest rates, probably focusing on the assumptions about cost of capital," says one UK banker and insurance specialist.

The PRA is also seen as diverging from European counterparts on how the fundamental spread for the matching adjustment is calculated – the UK regulator would like to see a more economic approach – as well as on the application of the volatility adjustment (VA).

"The PRA doesn't like the VA, and treats it differently to other EU regulators. They don't like it because they don't think it's realistic," says an investment manager for a UK insurer. Under a UK regime, the PRA might look to change the reference portfolios used to calculate the VA, says the banker.

The PRA would also have more scope to impose tougher requirements on firms in its treatment of internal models – with industry participants saying they might expect capital add-ons in areas where the regulator has historically been more conservative compared with others, notably in the treatment of longevity and credit risk.

"We were hoping that, over time, Europeans would benchmark [internal model approaches for] longevity because we believe in the UK the regulator has been more conservative," says the insurance CRO. But that hope has now gone. "I would expect the same continued conservatism. The PRA has generally been more conservative across the board."

A critical question is what happens to 'passporting' – the arrangement whereby firms within the EU are able to sell financial services into other EU nations.

"Our judgement is that the British government will have difficulty trying to replicate the passporting regime," wrote Hugh Savill, director of regulation at the Association of British Insurers in London, before the referendum.

"All that we can say for sure is that insurers will face a period of uncertainty as to the future regulatory regime."

Likewise, the UK insurance company CRO says there is no reason the EU will be "warm-hearted" in its approach to negotiations. Wider aspects of European law also complicate the issue of operating across borders, he points out.

For example, an insurance company offering general insurance outside its home jurisdiction will have to comply with European data protection laws. "Where do you process data? Where do you do actuarial work? Are you marketing centrally? All of that would change immediately if you don't get a negotiation. The problem is they are different rules," the CRO says.

The likelihood of a deal that makes it easy for companies to operate across the EU from just the UK is slim, he concludes.

The PRA has already asked insurers to set out any organisational changes they anticipate in response to the referendum decision, but such questions are impossible to answer amid so much uncertainty, according to the London-based lawyer. Nevertheless, as the industry struggles to grasp the full implications of a Brexit, educated guesswork might be the only basis on which decisions can be made for some time to come.

Image: Shutterstock

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