Solvency II: Roadblocks to Sustainable Investments Remain Despite Reforms

UK ministers enthuse about the post-Brexit potential to unleash a new wave of green investment, but not everybody is convinced.

Solvency II, a foundational European Union regulation for the insurance industry, has never been universally loved, certainly not on the northern shores of the Channel. Critics said it tied up excess amounts of capital in an attempt to make the insurance sector ‘safer’, binding it by excessively bureaucratic rules.

In part, this piece of Brussels law-making was a response to the collapse in September 2008, at the height of the financial crisis, of the world’s largest insurer, American International Group.

It had used the sort of complex derivatives at the root of the crisis to insure vast quantities of corporate debt and personal mortgages. Battered by a wave of claims over mortgage defaults, it was taken over by the US government in return for US$85 million.

Now, more than six years after the Brexit vote, which took place in the same year, 2016, as Solvency II came into effect, HM Treasury is planning to slim down Solvency II as it applies to the UK. A statement on 28 April launched a consultation that ended in July, three months after which – in other words, about now – the government’s response is imminent. However, given all that has happened over the summer, from the energy crisis to the death of the Queen, there may be some delay.

For those eager for Brexit to usher in a new age of enterprise, the Treasury’s statement will have been music to their ears. “The consultation on reforms to the Solvency II regime capitalises on the UK’s post-Brexit freedoms to spur a vibrant, innovative and internationally competitive insurance industry.

“It cuts EU red tape and unlocks investment, helping to create jobs while also maintaining a high level of protection for policyholders.”

Green afterthought?

But for sustainability-minded investors, the more intriguing line was: “The proposals will unlock billions of pounds of investment in UK infrastructure and green projects.”

If implemented, the reforms would free huge sums by reducing the safety margin demanded of insurers, in combination with rule changes to make it easier for them to invest in long-term assets. However, will these necessarily by green long-term assets? After all, in the three pages of the April 28 statement, the word “green” appears just once.

Does that suggest that the supposed green dimension to the reforms is something of an afterthought? Opinion is divided.

“We have submitted our response to the proposals and expressed our concern about the lack of sustainability principles,” said Isabella Salkeld, Senior Policy Office at ShareAction, which promotes responsible investment.

“It’s very concerning. There are no climate safeguards. More capital will be freed up but there’s no guarantee it will flow towards ESG investments.”

A global hub

But Nicola Kenyon, Head of Insurance Innovation & Change at Hymans Robertson, the independent pensions, investments and risk consultant, said: “I don’t think the reference to green investments in the April Treasury statement was an afterthought. The reforms are still under consideration, so it is too early to say what will be in the final package.”

“I would say it is very much part of the objective to promote investment in green projects to support net zero,” said Anthony Plotnek, Director, Insurance Investment Team, at insurance adviser Willis Towers Watson (WTW).

The April statement included a commitment from John Glen, then Economic Secretary to the Treasury, to “cement the UK’s position as a global hub for financial services”.

He added: “There will be a substantial reduction in the risk margin for long-term life insurers, including a cut of about 60% to 70%, and we are consulting on the appropriate level for general insurers.

“This step will release capital on insurers’ balance sheets.”

An indirect route

The UK government will also, Glen said, encourage new entrants into the insurance market to increase competition, drive growth and create jobs.

But Salkeld at ShareAction called for a much more active approach from the authorities to encourage this newly-released money into sustainable investments. “We suggest raising the capital requirements for insurers in relation to carbon-intensive assets. This would not prevent fossil fuel investment but would make it more expensive.

“Furthermore, only ten of the world’s insurers have a plan to phase out oil and gas investments. All should be required to produce phase-out plans, and insurers should be made to have a robust stewardship policy.”

She concluded: “Smart regulation is desirable in encouraging green investment. At the moment, even the greenest insurers are still funnelling billions into oil and gas.”

ShareAction has also called for a “streamlined double materiality” approach for insurers to assess their impact on climate. “Insurers should report not just on the financially material risks of a changing climate, but how their financing decisions contribute to climate change,” it said.

Plotnek at WTW suggests an explicit and mandatory linkage between ESG risks and capital requirements is not on the cards: “The regulator has said insurers need to report on ESG matters, but there is no sign it will seek to use higher capital requirements for some assets to divert capital to green and other investments.”

However, he added, there may be a roundabout way of achieving this by arguing on prudential grounds for the harsher treatment of assets that do not support the transition to net zero.

Balance sheet volatility

Kenyon at Hymans Robertson has considered the impact of the proposed reforms on both policyholder protection and the market. “As with any regulatory changes, policymakers will need to weigh up both protection for policyholders and supporting investment in the real economy.”

Turning to the bulk purchase of annuities (BPA) in which insurers buy a pension plan’s assets and liabilities, she added; “BPA insurers have long-dated illiquid liabilities, which should mean they are well-placed to make long-dated, less liquid investments, such as in ‘green’ infrastructure.

“An unintended consequence of the Solvency II reforms may be increased balance-sheet volatility leading to pro-cyclical investment behaviour, which in turn might reduce insurers’ appetite for long-term, illiquid investments.”

The topic of long-dated liabilities leads to another proposed part of the reform package, that relating to the ‘matching adjustment’” (MA). Under this heading, insurers whose expected capital in-flows closely match their long-term liabilities can take up front any excess, which can be paid to shareholders as capital.

But the system inherited from the EU has certain weaknesses, according to Sam Woods, Bank of England Deputy Governor for Prudential Regulation and Chief Executive of the Prudential Regulation Authority (PRA). For example, it calculates the MA on what may be outdated historical data and assumes a dominant role for government and corporate bonds.

A far cry

Speaking on 8 July, Woods proposed a balanced package that would make the sector safer while promoting investment: “Our analysis indicates to us that the combined effect of the reforms – in particular loosening the risk margin while tightening the MA – should free up a significant amount of capital for insurance companies across the sector, which they could choose to re-deploy into investment if their boards support that course of action rather than returning it to shareholders.”

All of this tends to presuppose that the Solvency II reforms will work as intended, even if those intentions, disappointingly for some, do not include a specific commitment to direct capital to green projects.

The Association of British Insurers is far from convinced. On 21 July, the ABI responded to the proposals: “Our own analysis, and that of independent technical experts, indicates the current proposals would not achieve the suggested release of 10% to 15% of capital for re-investment.

“Life insurance firms would have to hold more capital than currently required, preventing them from being able to provide the funds that are needed for investment across the UK. Increases in capital are also not costless. Rather they are paid for by customers through lower returns and by society through less investment in productive assets.”

This seems a far cry from the billions of free-up cash about which the Treasury is enthusing. The ABI’s independent technical expertise is supplied by WTW.

Reaction “strongly negative”

ABI Director General Hannah Gurga said: “The insurance and long-term savings industry could invest more capital to help level up the UK, boost the economy and support the transition to net zero.

“The current proposals do not realise that opportunity and would risk penalising pension customers as a result of the increased costs associated with the proposed reforms.”

She added that the ABI was committed to continue working with the government and others to improve the proposed package.

Woods of the PRA admitted that responses to its revised proposals had been “strongly negative” but gave short shrift to those hoping the UK would mirror the EU’s version of Solvency II, itself subject to reform.

“To be honest I think this is a red herring,” said Woods. “The Government has been clear that the point of leaving the EU, at least insofar as financial regulation goes, is to enable us to tailor our regime to make it work better for the UK.”

With the new government under Liz Truss promising to reform or ditch all legislation derived from EU law, this seems clearer than ever, even though the UK’s path to net zero is now under review.

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