Life insurers in focus as City looks to post-Brexit future

Capital rules governing life insurers have emerged as an important if complex battleground in the UK financial services sector’s protracted separation from the European Union, as regulators and the Treasury review the legislation governing the City’s post-Brexit future.

This Friday (19 February) marks the end of an initial government-led consultation of the EU’s Solvency II (SII) directive, a one-size-fits-all rulebook that codified the amount and type of capital European insurers must hold to protect them from insolvency when it was adopted just months before the Brexit vote.

Given the complexity of SII, around which insurers have built both balance sheets and enormous compliance operations, there is little appetite to abandon the rules so soon after the UK’s exit from the trading bloc.

When it launched the review last October, Westminster said it intended to “ensure a vibrant and prosperous insurance sector [and] provide long-term capital to support growth”, alongside boilerplate commitments to uphold policyholder protection and sound oversight.

The latter assurances have been in keeping with promises from UK lawmakers that Brexit won’t lead to a bonfire of prudential standards.

For example, in a speech urging his European counterparts to collaborate when a transition period ends next month, the Bank of England governor Andrew Bailey last week said he was opposed to reforms that would “create a low regulation, high risk, anything goes financial centre and system”, arguing that “such an approach is not in our own interests, let alone anyone else’s”.

But the insurance industry, regulators and government have identified one quick win, specifically around the so-called ‘risk margin’ buffer that insurers are required to include in their capital under SII.

When it was introduced in 2016, the rule hurt UK life insurers like Aviva (AV.) and Legal & General (LGEN), who were forced to outsource the risk that life policyholders might live longer than expected. This has been done by reinsuring long-tail longevity risk, which analysts at RBC calculate has cost the industry £9bn in profits.

The Association of British Insurers (ABI), which is set to publish its views on policy on 23 February, is keen to see changes to the risk margin and another unloved capital-calculation rule known as the matching adjustment, and for a removal of the current restrictions on the types of investments that insurers can hold.

James Dalton, director of general insurance policy at the trade body, this month gave a speech in which he said the shift “could lead to more balanced portfolios of investments” and “allow the industry to invest for the long term and in much more socially useful areas such as green technology, infrastructure or a wider range of corporate debt, without undermining the security of policyholders”.

The sector’s watchdog appears to agree. Last week, the Prudential Regulation Authority’s executive director of insurance, Anna Sweeney, argued that “in its implementation the output of the risk margin formula is too sensitive to interest rates, and when rates are low it is higher than it needs be to fulfil its purpose”.

Sweeney said this has “driven a misallocation of capital away from longevity risk”.

For investors in life insurers, a shake-up of the rule could therefore bring two benefits: a long-term increase in earnings as longevity risk is retained, and a gain to the value of business written prior to SII’s introduction. RBC thinks this could lead to a 12 per cent one-off gain in the book value of M&G (MNG), whose book of life insurance policies is in run-off.

The impact is less clear on Aviva, although the risk margin reduced the value of the group’s SII net assets by £4.2bn at its 2020 half-year results (see chart).

At its capital markets day in November, L&G did not “put a number on” where its risk margin would reduce to, but noted that changes to SII would give it more options around writing new business, capital deployment and use of reinsurance.