ABI: Solvency II reforms would ‘disincentivise’ infra investment

In April, the government launched its consultation on Solvency II with the intention of reforming the regime to help insurers invest in infrastructure and green projects.

Insurers follow the Solvency II framework, which sets out the prudential regulatory requirements for insurers across the European Union across areas including risk assessment and governance.

The consultation asked how a reduction in insurers’ risk margin – the difference between their technical provisions and best estimate liabilities – would impact policyholders and their level of protection, along with their effect on insurers’ decisions surrounding investment and pricing.

This will penalise (not incentivise) investments in long-term productive finance counter to government goals

The Association of British Insurers

The consultation, which closed on July 21, also asked how the government’s proposed reforms could impact investment in infrastructure including water, clean transport and digital assets, as well as how these changes will help support the UK’s transition to net zero emissions.

The ABI’s criticism targeted reforms to ‘fundamental spreads’, which are used by insurers to calculate the risk-free curve for liabilities within a matching adjustment portfolio.

Willis Towers Watson, meanwhile, cautioned that increasing insurers’ resourcing requirements could reduce pensioner protection and access to the market.

Government proposes changes to fundamental spreads

The government has targeted channelling institutional money from pension funds and insurers towards UK infrastructure as part of its ‘levelling up’ programme.

Local Government Pension Scheme funds were asked earlier this year to set out plans for investing up to 5 per cent of their assets in domestic initiatives.

The ABI did welcome some of the government’s proposed Solvency II reforms, agreeing that changing the risk margin and expanding the eligibility of liabilities and assets available to insurers would broaden their investment portfolios and increase infrastructure investment.

It added, however, that any benefits would be “more than offset” by the impact of the reforms to the fundamental spreads.

In its consultation, the government noted the “credit, illiquidity and other residual risks” that insurers face when investing in long-term assets. 

“That there is not yet consensus on how the fundamental spread should be reformed demonstrates how important it is and how difficult it is to get right,” the government said. “The higher the fundamental spread, the lower the matching adjustment benefit.”

It has proposed reforming the fundamental spread so that it better measures credit risk, which the government argued “would increase confidence in a wider variety of assets being suitable for inclusion in matching adjustment portfolios”. 

“It would also justify increased flexibility in how such investments are treated when there is a matching adjustment application or breach,” it added.

Proposals could raise barriers for customers

Changes to fundamental spreads sit alongside the government’s proposals to reduce the risk margin of around 60 to 70 per cent for long-term life insurers, introduce more flexibility to facilitate investment in long-term assets and cut back on EU rules.

The ABI said that changes to the fundamental spread “would disincentivise investments in illiquids”.

It argued that the reforms introduce a direct link to spreads, which it said would lead to “material pro-cyclicality and balance sheet volatility”. 

“This will penalise (not incentivise) investments in long-term productive finance counter to government goals, especially when spreads increase from their current historically low levels,” it said.

It added that the new rules would add increased complexity for all assets, but particularly for illiquid assets, owing to an increased need to rely on indices to set the fundamental spread. They would also incur extra costs.

“The current proposals would not achieve the suggested release of 10 to 15 per cent of capital for reinvestment,” the ABI said. “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,” it continued. “Rather they are paid for by customers through lower returns and by society through less investment in productive assets.”

Willis Towers Watson, meanwhile, warned in its own response that the reforms threatened to reduce protection for pensioners.

“Increasing insurers’ financial resource requirements,” it cautioned, “will increase prices and could raise barriers on customers’ access to the insurance sector.”

“Reducing the availability and accessibility of the pension buyout market to pension schemes and scaling down an important source of long-term investment could potentially significantly hinder the growth prospects for the UK economy, and perversely reduce pensioner protection if the insurance sector is used less.”

A HM Treasury spokesperson said:“Now we’ve left the EU, we are determined to ensure the rules around the insurance sector work in the best interests of the UK.

“We want to support our vibrant insurance sector to invest in this country, while continuing to ensure protection of policyholders.

“We’re working closely with the regulators and the industry to redesign the rules so they best suit our country’s needs.”