Treasury Committee
Oral evidence: EU Insurance Regulation, HC 852
Wednesday 25 January 2017
Ordered by the House of Commons to be published on 26 January 2017.
Members present: Mr Andrew Tyrie (Chair); George Kerevan; Kit Malthouse; Mr Jacob Rees‑Mogg; Rachel Reeves
Questions 74 – 151
Witnesses
I: Nigel Wilson, Chief Executive Officer, Legal & General; Huw Evans, Director General, ABI; John Parry, Head of Finance, Lloyd’s of London; and Julian Adams, Group Regulatory Director, Prudential
Written evidence from witnesses:
Witnesses: Nigel Wilson, Huw Evans, John Parry and Julian Adams.
Q74 Chair: Thank you very much for coming to give evidence to us this afternoon. I apologise that we had to rearrange this hearing at relatively short notice. There will not be a vote until 4.00, so we have a bit of time this afternoon. Hopefully we will be done before then.
Can I begin by asking whoever wants to answer the question—maybe I will start with Julian Adams—whether Solvency II is a threat to competition in the UK insurance market?
Julian Adams: We would say that, yes, it absolutely is. Perhaps Nigel might want to speak about the domestic impact of that. As a little bit of background, we have come a long way from the “man from the Pru”. We have 25 million customers, of which 6 million are in the UK and over half are in Asia. We have to apply Solvency II to that Asian business and it massively affects our competitiveness in that market with local market competitors as well as American competitors. It does that through certain devices in the directive that are only—
Chair: Specific examples would be helpful.
Julian Adams: Specific examples would be that the matching adjustment equivalent is only available in US dollars and European currencies, so it is not available to us. The VA is only available in those currencies. We have to use UK lapse assumptions on our Asian business. A European construct about contract boundaries is applied to markets that are as diverse as Cambodia, Vietnam, etc.
As well as the whole construct of the risk margin having to be applied to those markets, those are all practical ways in which it makes it more difficult for us to compete in Asia.
Q75 Chair: Nigel Wilson, we had a very brief meeting beforehand in which every time you tried to speak, I interrupted you. Now that we are in public session, I will go quiet for a few minutes at least.
Nigel Wilson: The key with our business is that financial services is very complicated. I am therefore going to do an analogy from another industry to try to capture what is really happening. If we were a car industry and regulators came along and told us that we had to hold three to four times as much capital in the UK car industry for manufacturing cars, particularly car engines, those car engines would very quickly be produced in America or other jurisdictions and we would have to import them at higher cost for customers.
That is not a good outcome at all, and that is what we are seeing in our industry. We have produced a system that has way too much capital for all sorts of different reasons. In part it is because we have imported banking technology into the insurance industry and we are not banks. We have much greater stability than banks, we do not have liquidity risks, we do not have maturity transformation risk, and we are a very long‑term business.
The consequence of that is that we end up owning a huge amount of assets in America to back UK liabilities, because that is the way the system ends up working. Because the risk margin and all the complicated things that were imported from the banking industry, uniquely, into the UK resulted in a massive amount of extra capital, we cannot take on some of the risks that we are world leaders in. Instead we have to outsource them to third parties—the capability, the tax revenue and everything. The car, as it is manufactured now—
Chair: It flows to the States—
Nigel Wilson: No, the car is eventually not manufactured. We have stopped doing the engine and wheels already. It is more expensive to the customer here than it would be if it was domestically manufactured because of the nature of the regulatory rules over here. This is widespread across our industry—the life industry as opposed to the property and casualty industry in the UK. That is not a good outcome for customers or society.
There is billions of capital available outside of the UK that would come into the UK that could be invested with a better regulatory set up. That is important because over time that supply of liabilities against which you can create assets diminishes and diminishes and diminishes, and much more of that ends up being managed outside of the jurisdiction of the very onerous capital regulation here in the UK. That is a terrible outcome for customers, a bad outcome for jobs and investment here in the UK, and over time it is not a good risk solution either. People keep thinking that this is a better risk outcome if we hold lots of capital in the UK; that is just not true over a long period of time, and we require long‑term thinking, recognising that we are a long‑term capital market business, and not a banking business.
Q76 Chair: Can you explain why the risk is not reduced with the extra capital?
Nigel Wilson: The risk is not reduced with the risk capital because we end up writing no business. From a regulatory point of view, you end up managing a whole bunch of American, Canadian and Swiss private equity firms based in all sorts of different jurisdictions around the world, and the domestic industry, from a competitive viewpoint, shrinks. As a consequence, your ability to compete on a global footing with everybody else—echoing the point that Julian made earlier—diminishes over time, because not only do you have the problem that Julian alluded to in his discussion, but you have the extra problem that your UK domestic business becomes less competitive over time, and that is not a good outcome for the UK.
Julian Adams: In writing retail annuities, that at least diminishes the supply or choice for UK consumers. These are practical consequences of the way the directive is both constructed and being implemented.
Q77 Chair: I am going to bring in Mr Evans and Mr Parry, who of course has a somewhat different perspective from Lloyd’s of London. I want to come back to Mr Wilson for just a moment. If you are correct, why is it that the regulators have got it so terribly wrong? Why have they heaped so much excessive regulation?
Nigel Wilson: The regulation was developed by some theoreticians a number of years ago in a different environment, and was lifted out of the banking regulation and imposed on our industry. Therefore the activities we engage in like longevity are pretty unique to our industry. There is no banking equivalent. The technology that was used looked at these assets as if they were very bad assets that could not be insured or de‑risked as a consequence, and therefore a set of assumptions were made which resulted in a huge amount of extra capital required. In the short term we can partially resolve that by outsourcing it to foreign competitors and allowing them to, in effect produce, the engines for us, but over the long term that is not a good solution for us competing here in the UK, but exporting to other parts of Europe and the rest of the world in the future.
Q78 Chair: Are you saying that the regulators are captive to some group of obsolete theoreticians?
Nigel Wilson: That is absolutely the case, yes.
Q79 Chair: I promise to bring you in in a moment, Mr Evans, but I want to pursue this for just a moment. When you go along to the regulator, as I am sure that you do, and you say, “Have you grasped that you have been captured by an obsolete theoretician?” what do they say?
Nigel Wilson: Sam Woods, who is a very good regulator, has recognised already that the risk margin is not fit for purpose and needs changing. It is rather like Andy Haldane; they have come out and been very honest about what is going on. How we solve it is the problem now.
Q80 Chair: So Andy Haldane at least, who is a theoretician, is not obsolete?
Nigel Wilson: Yes, he is modern. We have regulation that encourages us to buy—in the UK—US, German, particularly sovereign, and even Greek bonds in preference to UK assets. That cannot be a good outcome from a UK point of view, but that is the way the regulation works at the moment. That prevents us investing. We want to invest in new real assets that create real jobs here in the economy in the UK. We have done about £8 billion so far, but we could do a lot more if we were required to.
Q81 Chair: You are now in this conversation with Sam Woods; is he saying, “Do not worry; I am about to fix it,” or “You are quite right. My predecessors used to be captive, but I am not”? What happens then?
Nigel Wilson: The theory was developed in a different age.
Q82 Chair: I understand that. I am trying to get to the heart of whether the regulators are about to—
Nigel Wilson: The regulator has the power to change the rules to the benefit of UK consumers, firms like ours, and indeed the UK economy. They have to decide, and we have put a number of suggestions to the regulator that they are currently considering, whether they can change them quickly or whether they go through the whole of the European process, which will take two, three, four years, or however long it takes to get us to a better solution than the one that we have today. The one that we have today is not working in the way that the regulators thought that it would work, and there are all sorts of short and long‑term consequences.
Q83 Chair: The short‑term consequences are that it is quite bad for our industry; the long‑term consequences are that it is catastrophic for our industry. Do I have that right, on the basis of your evidence?
Nigel Wilson: Yes.
Chair: Mr Evans, you finally have the floor.
Huw Evans: Part of this relates to the timing and how long it has taken for Solvency to be developed and implemented, and now the environment in which we need Solvency II to succeed, both now and for the future, particularly in a post‑Brexit environment. That gets to the heart of your question about competitiveness.
When Solvency II was first being devised, it was viewed very much sensibly as a means of tidying up and having a more orderly process than the previous Solvency I regime, which was basically a collection of 14 different pieces of regulation.
By the time it was in the most detailed phase of being developed and the core working assumptions put in place, we were in the middle of the worst financial crisis for 80 years. Inevitably, that affected the way in which it was framed and shaped and, as Nigel has said, that resulted in some quite profound impacts on the way in which it was devised.
That has also then affected both the culture and the practice of the national regulators who have had to implement it. There are not many prizes for regulators immediately after a financial crisis in taking any risks with the stability of the financial system, including those that might be needed to encourage greater competitiveness. Where we are now is quite a long way on from the financial crisis in many respects, particularly in the insurance sector that did not collapse under the weight of the financial crisis anyway.
Looking forward to what the industry needs to do to continue to be a world‑leading player in a post‑Brexit environment, it stands to reason that we need to be having this discussion about how Solvency II and insurance regulation can evolve and adapt both to free itself from the shackles of some working assumptions, methodologies, ways of operating and practices that really belong to an immediately post‑crisis environment, but also to look ahead to what the UK needs to do to be genuinely competitive post‑2019. This is the right time for this Committee to be having this discussion because it is a very real challenge.
Chair: I take it that all of you want to keep Solvency II but improve it now that you have had all of the sunk cost put into it.
Huw Evans: The Committee sees from the submissions that it received from across the industry a desire not to incur another £3 billion of cost in unwinding Solvency II for the sake of it and inventing something else, but very much to take an open mind to what needs to be done to refine and adapt it, to make it more suitable for the industry, whether we are staying in the European Union or not, and, to your point, to make it more effective and competitive for a post‑Brexit environment.
Both of those things need to be taken into account. As I am sure we will look at during the course of this session, quite a few of them can be done by the PRA without reference to permission from Europe and some would obviously need to be done in a structure that was post‑Brexit.
Q84 Chair: Do you have the impression that the regulator has someone looking over their shoulder when they are doing this work, and that every time you come to them wanting some change they are saying, “I do not know. We will have to go away and discuss it,” rather darkly and with others?
Nigel Wilson: No. As Huw was saying, they have the legacy of the past looking over their shoulders, in that they have made a number of assumptions in the past which are constraining their ability to help us create a great business for the future.
Q85 Chair: Is the answer “no”?
Nigel Wilson: The answer is “no”.
Chair: Mr Parry has been very patient.
John Parry: I was going back to your first question regarding competition. For general insurance writing and global policies, when you are competing, the level of regulatory capital is not the level of capital that you hold. It is much more about your financial strength rating and the total capital you will have, which should be considerably in excess of a regulatory minimum. In terms of Solvency II or other regulatory regimes damaging competitiveness on capital and return on capital, no, we have not seen that. It is early days for Solvency II, I would agree, but we have not seen at Lloyd’s new entrants being put off by the fact that they are entering a Solvency II regulatory regime.
You mentioned the words “sunk costs” and we would agree with that, in that the implementation of Solvency II, as Huw said, happened over a long period of time, then it put the brakes on, and then went again, which has increased the cost of the implementation. We must remember that the time it was put in was post‑2008, and a change of the regulator from the combined FSA to two. A lot of that is past, and now we face the fact that uncertainty has a cost, whether it is regulatory, tax or judicial. Any regulatory change does incur cost in systems and process, but also there is an opportunity cost with senior management time. They should be dealing with changes in risk and risk profile, rather than changes in regulation and having to get up to speed and devote resource to that.
Yes, there is some cost. We would agree there are some significant changes that could be made to the Solvency II regime, and again I would agree with Huw that a lot of that is within the gift of our regulator, the PRA, rather than requiring legislative change.
Q86 Chair: I will bring you back in again, Mr Adams; you have been motioning to have another go for some time. I will ask you a question: should the PRA’s secondary objective on competition be turned into a primary objective, and what effects would that have on the way in which they are doing their work?
Julian Adams: We feel very strongly it should because if you do not, the incentive structure of regulators is always to encourage greater and greater caution. I understand that you asked the same question of the first session, and one of the objections was, “Does that not introduce a conflict of interest?” I would argue that conflict of interest exists at present. There is always a tension between micro‑prudential regulation and its impact on competitiveness. At the moment, that conflict is neither recognised nor managed.
I would encourage competition from two perspectives. I would encourage competition in the sense of low barriers to entry, to encourage domestic competition, with the so‑called challenger bank issue, but, in particular post‑Brexit, we would encourage them to have regard for the international competitiveness of the UK relative to other financial centres. It is a difficult balance, but there are regulators around the world who in my view recognise and manage that more effectively than in the UK.
Q87 Chair: As the judge said to the jury, is this the view of you all?
John Parry: We would say that the primary focus of a prudential regulatory authority should be prudence. It should be on the prudential side. There is no doubt that competitiveness is a mixture. Both capital efficiency and capital sufficiency are necessary for us to be competitive. We have seen other regulators being able to embrace that dual focus, so having a secondary objective, or having mind to competitiveness of the UK when we are competing on a global scale for capital and talent, yes. However, we would say that their primary focus should be prudential.
Huw Evans: The ABI is in a different position. Our members are overwhelmingly in favour of it being an equal objective, partly because scepticism—
Q88 Chair: A primary objective?
Huw Evans: Yes. You expressed some scepticism in the earlier session, Chairman, about whether secondary objectives ever really get taken into account at all. That has been our own experience, so we feel it has to be, as Julian said, something that is a primary objective. That would be good for the market. This is a market, not least because of the wider public policy landscape, freedom of choice in the life side, the challenges of meeting new risks in the GI side, such as cyber and different types of flood risk, that needs need innovation in the market to thrive and to continue to make sure it is a market that works for consumers, and internationally that it continues to be one of the leading markets in the world, as it always has been.
That cannot just happen by accident in a more challenging environment. We think that having a regulator that was attuned to that, and one full of highly intelligent people who are perfectly capable of striking a decent balance in operational, day‑to‑day practicalities, is not just doable but desirable.
Q89 Chair: What the industry has to do is demonstrate, which perhaps can be demonstrated, that the AIG experience is not waiting around the corner if we relax the rigour of the prudential requirements. Is there anything you want to add, Mr Wilson, before I bring in others?
Nigel Wilson: I agree. We would like to see the regulatory aspiration about how we build world‑class businesses in the UK. Ourselves as Pru, and others, are on that journey, and lots of people around the world have a huge regard for us and other firms. We have EIOPA to consider, the European Union to consider, and lots of others. They would be the shoulders that the PRA are looking towards, if you like; as they are looking over their shoulders, they are looking towards those institutions.
Solvency II was meant to create a pan‑European harmonisation of regulation; it absolutely has not. We have sold our Irish, French, Dutch, German and Italian businesses over the last two or three years. There is a greater chance of us entering the European market in a post‑Brexit world, because in a post‑Brexit world, bizarrely, we have much more of a level playing field than we have in the pre‑Brexit world.
Particularly if we have an enabling regulator, who sees one of our objectives as being to create great businesses here in the UK, and allow them to export, which is the original intention, across the world—we have a hugely successful American business, like the Pru, and emerging opportunities in Asia, etc, but we want to develop the intellectual property, capability and scale that are required here in the UK to do that—the current rules make that pretty difficult.
Q90 Chair: The structure of British insurance and life assurance was never really suited to the structure devised with Solvency II. We have always been trying to fit something into a shape that was wholly unsuited to it; that is basically what people tell me.
Nigel Wilson: Yes.
Q91 Chair: And that is why we would be better off out altogether, and then you would be competing from outside. That is what you are saying.
Nigel Wilson: In terms of an option for us as a group, there is more optionality from not being at such a massive competitive disadvantage as we are today in terms of the amount of capital that we require, which is much more than anybody else requires, in our own domestic market. It is a very odd solution to have to a problem.
Q92 Chair: I am aware of the point; other Committee members may not be, but it might be helpful if it were set out on a piece of paper with a numerical example that can illustrate the disproportionate adverse effect of Solvency II, as it affects British firms and your firm. I have seen this in the context of the Pru in an exchange of letters that I think I had with Tidjane a long time ago now. You have probably seen them; yes, you are aware of it. You were wanting to come in again; this time really will be your last opportunity.
Julian Adams: You asked a question with a presumption that the people giving evidence did not want to. We would argue that the UK approach needs to be fundamentally reviewed. The problem you have with Solvency II is it was a compromise between 28 different countries. Our policy priority should surely be to have a regime that is appropriate for the UK. We would argue that that is best delivered not by forgetting all of the work that we have done with Solvency II, but going back to a framework similar to the one that we had before Solvency II. That is where you have a simpler, Pillar 1 construct with a simpler, more straightforward initial standardised formula, and in Pillar 2 allow firms to develop internal models, and then allow supervisory review to take place within Pillar 2. That would be a fundamental review of Solvency II, but we think it would be more appropriate and allow greater competition.
Q93 George Kerevan: I will pick up from there and look at some of the more technical aspects, so that we can possibly tweak your evidence. There is a basic capital requirement under Solvency II, then we have certain modifications. One of those is the matching adjustment, and correct me if I am wrong, but that was put there at UK request. It is basically to try to help firms with very long-term investment profile in order to match a very long savings profile. However, having been put in place, the matching adjustment does not seem to be working. Could you explain why something that we wanted in Solvency II has not worked out the way we imagined?
Julian Adams: I would argue it is because of the excessively rigorous implementation of rules around cash flow matching. For instance, equity release mortgages, residential or commercial mortgage‑backed securities and commercial mortgage lending all have uncertain payback periods. Yet we would argue that, as an asset class, each of those would be appropriate in aggregate to match the liabilities that we would be looking to hold. As a result, it has restricted our investment in those assets, and you could make similar arguments for infrastructure lending as well.
Huw Evans: The thing with the matching adjustment is that it is policed and run by the PRA, so it is not something insurers can use automatically. They need the PRA’s permission to use it. The PRA police what assets are allowed to be adjusted for the calculations, and they control the process by which that is done. In part this is about the way in which that process is applied, and then the judgments that are reached, as Julian has said, about which assets are allowed to be used or adjusted for it to be fully useful.
Part of the challenge here is that the matching adjustment is only used by the UK and Spanish markets, so it is not as if there were a benchmark of all the other European states using it in a certain way. It is very much down to the PRA to decide exactly how it wants to do it and how it chooses to use it. That in practice, as I am sure Nigel will testify, has proved onerous and challenging for some of the firms who want to get the maximum benefit from it.
Nigel Wilson: Can I just make a point? Lots of the assets we have do not achieve matching adjustment compliance, and the matching adjustment compliance test is policed by the PRA. We can readily invest in German government bonds, Greek bonds, or US corporate bonds, and sail through the matching adjustment test. If we want to invest in very interesting, helpful assets, which have all the characteristics you would want to put into long-term assets here in the UK, there are very onerous tests—
Q94 George Kerevan: Green infrastructure?
Nigel Wilson: Infrastructure is a very good one. We have extra capital requirements for doing this, as well, never mind the question of whether we can get them to qualify. I have armies of people trying all the time to figure out how we can get assets that are very helpful to our industry, based here in the UK, invested in these long-term businesses. The easiest solution is to call my colleagues in America and say, “Can we have a few billion dollars of extra US corporate bonds?” because we know those will sail through any tests that the PRA have.
Q95 George Kerevan: How do we change that? Is it a matter of rewriting the rules on matching adjustments, or is it a matter of the regulator taking a different view?
Huw Evans: We think it falls much more in the latter category.
Julian Adams: I think the latter, which leads me back into the objectives that you have set the regulator. They clearly look to optimise to their objectives, and so by making the objectives more expansive and more balanced, you will achieve that outcome.
Q96 George Kerevan: My problem is that, cynic as I am, I assume always that industries, whoever they are—not necessarily yourselves but all industries—push back against the regulator. How do we frame an ask that is more than just, “We want the regulator to have a lighter touch”? You are saying that there might be some specific rule changes that we could write in, in a way that was transparent, that would allow you to greater flexibility in your asset investment but still met the regulatory requirement.
Nigel Wilson: We restructure a lot of ours. We have assets that are ineligible, then we have a whole bunch of assets that we restructure to make them matching adjustment compliant, and then we have assets that are matching adjustment compliant. We effectively have three boxes. A lot of what is in the first two boxes are in the gift of the PRA. They force us into doing lots of stuff for the second box. The first box is stuff that they will not allow us to classify as matching adjustment compliant.
There is a second box that is stuff like equity release, for which we have a massively, unbelievably complicated process, because of the second order non‑certain cash flow characteristics. Again, this is unique to the UK, so it is absolutely within their gift to make this much easier for us to do, and they have chosen not to. They could be guided that that is a very acceptable asset to include in it. The industry does it anyway, but we could do much more of it.
The third one is that there are lots of assets that are on the shelf, and because the UK is a very immature capital market, a lot of those assets do not yet exist in the UK in such a way that—
Q97 George Kerevan: Would you mind clarifying: “The UK has a very immature capital market”?
Nigel Wilson: The US has a very mature capital market. We are a very banking‑centric market. The assets here have not been structured in such a way; the US has a very deep capital market compared to the UK.
Julian Adams: I quite understand the cynicism, but we should think of this as the private sector trying to optimise for capital. What we are talking about here is how citizens in the UK finance retirement. Can they use equity in homes? Can we provide long-term guarantees, such as in the form of guaranteed retirement income—otherwise known as an annuity? That is what we are actually talking about here. That is why an overly narrow focus on micro‑prudential safety and soundness delivers distorting outcomes for the UK.
Q98 George Kerevan: When you put these points to the regulator, what is the regulator’s defence?
Julian Adams: “We have to optimise to our objectives.” In fairness to the regulator, every time they stand up and give any public speech, all of the references are to their objectives. They are highly focused on achieving their objectives.
Huw Evans: That is the difference, Mr Kerevan, relating to the challenge you have raised about how this is different from any other industry pushing back against its regulator, blah, blah, blah. The insurance industry has a core economic and social purpose. Its social purpose is along the lines Julian described: to provide retirement income for people, and to help society and businesses manage their risks, whether in general insurance or long‑term savings. It also has a core economic duty, I would argue, to invest in infrastructure and assist this country to continue to develop in the necessary way to ensure its economic growth and prosperity.
That is what the insurance industry’s core purpose is. Yet we are in the slightly odd position where something that the UK asked for and was a public policy ask of the UK Government, which was secured in the negotiations, is being policed in such a way as to obstruct the industry from performing those core functions. This is not ultimately for the benefit of the industry; it is for the benefit of the economy, the businesses and the individuals that we are here to serve. That is why there is a public policy purpose in taking a fresh look at this and encouraging the regulators to move on from a post‑2008 mindset in terms of how they do it.
Q99 George Kerevan: Briefly moving onto the risk margin, one of the arguments I have seen criticising the current way risk margin is applied is that it is potentially pro‑cyclical, and could in certain circumstances, if interest rate regimes change, reinforce instability. What are your views on that?
Julian Adams: I agree with that. The whole market‑consistent nature of the directive exacerbates that, and in another way there are two other factors that are potentially new. The first is the use by the PRA of benchmarks, which essentially allow or encourage herding, like—
Q100 George Kerevan: What do you mean by “benchmarks”?
Julian Adams: They call them “quantitative impact indicators”, or something like that. Essentially, what they do is to benchmark the industry, and force coalescence around a certain point. That herding is potentially pro‑cyclical, and in a final way the directive could potentially take some freedom away from the PRA. In the past, the UK regulator was able to exercise discretion in a way that it may feel constrained by a directive towards maximum harmonising.
To a question earlier about whether they have anyone looking over their shoulder, I would say that they certainly feel EIOPA is a body to whom they have to have regard.
Q101 George Kerevan: Moving on, Mr Evans, in your written submission you raise a particular point that the way Solvency II has been written and is being implemented might have a particular deleterious effect on small firms and specialist firms in the industry. Perhaps you could elaborate on that for me?
Huw Evans: Yes. There are two particular areas that I would draw to the Committee’s attention on that. The first is obviously the extent to which Solvency II has been over‑engineered, either in its original drafting or its implementation, clearly has a more challenging impact on smaller firms that lack maybe the resilience to deal with that.
Q102 George Kerevan: What do you mean by “small”?
Huw Evans: I am not talking about the people who are on the panel today. One example would be a medium‑sized life company that might offer two or three products, or that has a specialist focus on a particular part of the market. However, it is not diversified across lots of different businesses, bringing in different sources of money, and therefore has a modest–sized compliance department to deal with the regulator. For a firm of that nature, the requirements of Solvency II put a huge burden on it, and it cannot necessarily draw in resource from other parts of the organisation.
Q103 George Kerevan: In a way the previous ICAS regime did not.
Huw Evans: The previous ICAS regime was certainly a challenge for it, but most of our medium-sized members felt they were able to cope with that, or at least had adapted to that. Specifically, the point I would always want to draw out is data. Data is a very, very different order of magnitude from the previous ICAS regime. The data requirements on firms under Solvency II are of an order of magnitude between four and eight times greater, depending on the firm.
For small firms in particular, both the volume of data they are required to submit and the limited amount of time they are giving to turn it around is a consistent theme in virtually every submission you received. It is the biggest single complaint that small and medium-sized firms have with the Solvency II regime. That is both because they fail to see the value of a lot of the data they are submitting, or indeed question whether there are enough people in the PRA to ever read it, but also because of the fact that there are just—
Chair: Or capable of understanding it.
Huw Evans: The requirements on them to produce it are so onerous that they take away resource that would otherwise be devoted to innovation, customer services and other things that you would want an insurance firm to have focus on.
Chair: This has been a complaint right across the piece, for years.
John Parry: I am preaching to the choir, but yes, in terms of the reporting burden, the smaller you are, the bigger it is. While the directive has frequent references to proportionality, when it comes to the reporting, you have to do it whether you write £1 million or £1 billion. There are plenty of small businesses in the Lloyd’s market. When I say small, they are maybe writing less than £300 million, or you have new businesses wanting to enter. The reporting burden is huge.
Q104 Chair: Why do you not, Mr Parry and you, Mr Evans, send us a list of what you consider to be disproportionate demands?
Huw Evans: Perhaps I can just give you one illustration while I am here. Every quarter, under Solvency II, every entity, which is not necessarily a whole firm, because a group may have lots of entities within it, has to submit 10 different templates. The same entity has to submit 70 templates annually. One of our very large members, a household name, has a quarterly data submission of 60,000 line items with 20 data points on each. That is 1,000 pages, if it were printed out, per quarter. This is just to give you a flavour of what we are talking about.
Q105 Chair: What I think it might be helpful for you to do is not only to give us a list of the disproportionate demands being made, but also—and I realise this may be disproportionately demanding of us—to estimate what the compliance burden is on the firms. That will enable us to see what the bottom-line effect of all this is. This is not all free information, where we can say, “We are taking someone off doing something for a few minutes.” What we are talking about is taking high quality people out of whatever they are doing, because you cannot leave this to untrained or mid‑ranking staff. It has to be right, because it is going to the regulator and you have reputational risk on the line if there are serious errors.
I had looked into this with the Committee, with respect to the wealth management business, a long time ago now—five years ago, in fact. We got to a bottom line of what the total cost was for the wealth management business, just of servicing the regulator. It was controversial, and there was quite a lot of tension about the production of the figure, but let us start moving in that direction. I think it is important. We are the only people who can act as a countervailing pressure on the urge to always over‑regulate. It is quite understandable for the regulator, who has people like us on their back, to say, “How on Earth did you miss this or that problem?” On the other hand, we need a countervailing pressure not to over‑regulate.
Q106 George Kerevan: I had a final question to Mr Parry. Obviously, I and other Members of the Committee have read that Lloyd’s of London is establishing an outreach station in the EU in advance of a potential hard Brexit. Perhaps you could just take us through your thinking on that and what the company imagines might be the issues involved?
John Parry: Our priority is to maintain mutual market access to the EU post‑Brexit. That remains where a lot of the focus is on lobbying, talking to Ministers and officials, working with TheCityUK and other trade bodies to maintain access as close as possible to now. That may not happen, and certainly we are not expecting to get certainty on that any time soon. We want to be able to service our clients as seamlessly as we can, by establishing it before transition arrangements are clear.
The two alternatives are to set up branches in Europe, where you would operate as a third-party country, or via a subsidiary option in the EU, owned by the corporation of Lloyd’s. The branches carry a lot of issues. A lot of capital would need to be put up, and for insurance, putting up capital in each different place that you trade is very inefficient. If I insured everybody’s house in this room, but I had to hold the capital in case your house burned down just for you, I would hold an awful lot of capital. It is not going to be very efficient. Branches are out, so setting up a subsidiary is not the preferred option but we will need to progress it to offer that certainty to clients in advance of any decision on either transition arrangements or single market access.
Q107 George Kerevan: What does setting up the subsidiary involve?
John Parry: It involves talking to the regulators around Europe, discovering what the tax regime would be, the cost of actually establishing it, a board, management, what would be required locally, and how much of the support system we would need. We are insurers, but we also have the brokers that produce a lot of the business, the claims and loss adjustors, lawyers, accountants and that whole ecosystem around it.
Q108 George Kerevan: Would they be locally based?
John Parry: We would expect at least some of that activity to be. One of the considerations is how much of that could be kept in London, around the Lloyd’s building and the other different businesses. The more frictional cost you add to it, the less attractive our platform will look. We are competing for capital and talent globally, so international groups could set up their own. We want to offer an attractive proposition, and obviously we need to do that at an efficient cost.
Q109 George Kerevan: Are you testing the waters, or is this a negotiating ploy with Mr Davis?
John Parry: We are doing more than testing the waters. We need to make sure that we have a realistic plan that we can offer our market participants, in the event that we do not get single market access or transitional arrangements post‑Brexit. This is the price of uncertainty. If we do not know what is going to happen, we will need to progress. I guess you might expect that with insurers: you plan for the worst. That is what we are here for. We do risk management, set up the subsidiary, and hopefully it never has to operate or write a risk, but we need to complete every stage that we can, so that we know we have what I guess we would call Plan B.
Q110 Chair: Suppose the Government came forward now and said there would be a standstill at the completion of the negotiations, at the end of the two‑year period provided for under Article 50, of, say, three years before any of the exit provisions are implemented. In that period, everything would stay exactly the same, giving you a period to adjust. Would the fact that that commitment had been made now as a primary negotiating objective have any bearing on any of your contingency planning?
John Parry: We would certainly welcome it. Our contingency plan would continue, because we would also need the two parties. Is it a contract or a negotiation? If the UK makes a point of it being a primary objective in the negotiations, that is not certainty. We can understand where the UK is coming from, but what would be the EU’s response to that?
Q111 Chair: If you got favourable noises in pre–negotiation, or right at the start, say, in the spring, in a few months’ time, from counterparties that this was going to be looked at favourably, would that have a bearing?
John Parry: We would look at it and gauge the risk. It would be a risk assessment of how much certainty we can offer our clients.
Chair: That is your trade.
Huw Evans: This applies to quite a few of our members, who are wrestling with these conundrums at the moment. It is a valid point to raise, because, as John has said, boards are in the challenging position of having to make a judgment call on how long it will take, and be ready to serve clients at the point of any change. In many cases, with many of the regulators they are talking to, it is an 18‑month to two‑year process just to get the regulatory approval, never mind the logistical requirements to set up the business, transfer the people and be ready to ensure a seamless service for customers. There is, potentially, a disconnect, as we have warned repeatedly, between the political process and what can be achieved in a reasonable timeframe in those negotiations, and the level of certainty that a business needs to be ready to deal with the—
Q112 Chair: That is why, on a personal basis, I have been pressing the view that some kind of standstill might be a good idea, and it is why the Committee collectively has been investigating transitional arrangements.
Huw Evans: It is encouraging, and it has been noted as such within the insurance industry, that that issue has acquired a higher prominence. It is quite rightly being viewed now as an implementation issue, rather than, as I think some feared, a delaying tactic. It is not a delaying tactic by the insurance industry at all; the industry just needs as much certainty as possible, as soon as possible, so that it can continue to serve its clients and reach proportionate judgments of the type that John has described.
Q113 Mr Jacob Rees-Mogg: Good afternoon, gentlemen. If I can continue on that, because it is a very interesting point, which Mr Parry hinted at: there is unfortunately a conundrum with a standstill. You do not know that you have a standstill until negotiations are completed, and you therefore have to make arrangements on the basis that there is not a standstill, in which case you do not need a standstill, because you have made the arrangements already.
Q114 Chair: That is a Sir Humphrey‑esque question.
John Parry: I heard that as a statement.
Q115 Mr Jacob Rees-Mogg: But was that broadly what you were saying? Unless it was announced very early on in the negotiation, perhaps in the first six months, that both sides had agreed to some transition period, the value of the transition period declines quite sharply thereafter, because you cannot risk there not being a transition, so you have to have plans in place, assuming that there is not one.
John Parry: That probably sounds reasonable in that, yes, you need to make the plans, absent certainty. I would agree. There is this timing thing. A decision today that we are going to set up a subsidiary in Country X does not mean that we are in a position to write and issue insurance policies in 2017.
Q116 Mr Jacob Rees-Mogg: Absolutely. How much of your business currently benefits from a passport?
John Parry: In 2015, at 2015 rates of exchange, that was approximately £3 billion of premiums, so over 10% of our business. In fact, after the United States and our home market, the UK, it is our third largest market.
Q117 Mr Jacob Rees-Mogg: Is that passported, or in the European Union?
John Parry: That is from the European Union.
Q118 Mr Jacob Rees-Mogg: How much is passported?
John Parry: We have a mixed business between reinsurance business and writing direct insurance business. The direct insurance business is approximately two‑thirds of that, so approximately £2 billion, and reinsurance is approximately £1 billion. Direct insurance is the market that we would see as having more growth, and we see that globally, too.
Q119 Mr Jacob Rees-Mogg: And that is the passporting bit—the direct insurance.
John Parry: Yes.
Q120 Mr Jacob Rees-Mogg: So that is about 6% or 7% of your business.
John Parry: Yes. If I may, the other thing, of course, is that insurance is based on diversification. You want the widest possible product lines and geography, and the more that you restrict and restrain that, the less opportunity there is to spread risk, which clearly is beneficial for insurers and the consumer.
Q121 Mr Jacob Rees-Mogg: Absolutely, but it is quite interesting that over 93% of your business is done without EU passports into the European Union. There is a very strong underlying business in Lloyd’s that has built up by your history of paying your debts, even when this was difficult, over many centuries.
John Parry: Yes, you are right; we trade in a lot of territories. The United States is the largest, and the EU is not the 40% that the US is, but it is about our ability to offer a global service to clients, and again this is an uncertainty, a position where a client or broker has to check, “Is this a passporting one or does this need a special arrangement? Let us go somewhere else where we know we have them.” Global policies are also affected.
Huw Evans: In terms of the issue of transitional/implementation periods, to your point about whether they diminish in value if you do not achieve some sort of agreement within, say, the first six months, that may be the case for a firm that is waiting to make a decision based on any early indicators, but most firms, for the reasons John has outlined, would basically, if they felt they needed to make a change, proceed with the basics of the planning anyway. There is still huge value for the insurance industry in achieving an orderly implementation of the new world, and that is of value whether firms are directly affected by freedom of establishment of services or not. I would hope that that therefore remains a priority for the Government negotiating team, however difficult it may be to achieve.
Q122 Mr Jacob Rees-Mogg: What policy changes could be made domestically to help insurers in the event that there is not the sort of agreement you are looking for, particularly if you had to set up a subsidiary and you have to separately capitalise it? Are there things our regulators can do to count that capital within your home capital, options that would be open to them, which would ease the pain?
John Parry: It would be important that there is close co‑operation between our principal home regulator, the PRA, and the overseas regulators. Maintenance of a seat at the table with the international regulatory bodies that there are will assist—
Mr Jacob Rees-Mogg: Which will remain.
John Parry: Yes.
Q123 Mr Jacob Rees-Mogg: Can we come back to Solvency II, because the more we have looked into it on this Committee, the worse it seems to have been? I wonder if you can help me; perhaps, Mr Evans, you are the right person to ask about this. Is it really true—because it seems so ridiculous if it is true—that if your base currency for your business is sterling, you cannot hold and get the full benefit for your dollar liabilities and dollar assets: that there is a disadvantage in matching your currency liabilities and assets because your home currency is sterling?
Huw Evans: Yes, I think it is standard formula, is it not, the way the currency risk works?
John Parry: Absolutely; you are penalised for being a sensible and appropriate risk manager.
Q124 Mr Jacob Rees-Mogg: So you have a perfect match of assets and liabilities and you still lose out?
Huw Evans: Yes; the currency piece is one of the challenges around the standard formula, which has to be looked at as part of the wider review of the standard formula that EIOPA is conducting in any case.
Q125 Chair: It is amazing you do not want to scrap the whole thing.
Julian Adams: Not all of it.
Q126 Mr Jacob Rees-Mogg: That is right; the Chairman wisely pre‑empts my next question, which is whether you have a list of the things that you would get rid of. The reason I asked you about the one I just mentioned is is because when it came up at the last evidence session, I could not believe anything so silly could be true. That would be on my list.
Nigel Wilson: The risk margin as well; billions and billions of wasted capital.
Q127 Chair: Is that locked up?
Nigel Wilson: Locked up unnecessarily, and resulting in very long-term adverse outcomes for the UK.
Q128 Mr Jacob Rees-Mogg: The risk margin basically means you are running an extra margin on top of a once-in-200-year event?
Nigel Wilson: Yes; it is a multiple of capital. It is not a 10%; it is two or three times as much capital as you actually need.
Q129 Chair: Could you provide us on a piece of paper an illustration of what you think a sensible, balanced regulator might consider the right amount of regulatory capital, so that we can find something more robust than merely an assertion that it is two to three times? If I may say so, you did, I think, earlier on in your evidence come out with a larger multiple than two to three.
Nigel Wilson: That was a combination of both the risk margin and the capital required for managing the risk under the internal model, as approved by the PRA. It is a combination of the two things that made the capital even more onerous. As a consequence of that, you do not have much risk margin in the new world, because you do not enter into any of the economic activities that generate the risk margin, because they are undertaken by third parties. That is the unintended consequence of this: we do not do it, and therefore we do not incur risk margin.
Q130 Mr Jacob Rees-Mogg: So they move offshore.
Nigel Wilson: They move offshore to a different regulatory regime.
Q131 Mr Jacob Rees-Mogg: What cost do you think this has to your customers? This is a question for Mr Wilson and Mr Adams really, I suppose.
Julian Adams: I said earlier that what it essentially means is that we withdraw. We sell annuities, so there is less choice and probably moves the price against the consumer. Again, the point I was making earlier is that it affects both sides of the balance sheet: both the long‑term guarantees that you can give to people, and what you can do with those assets. Both sides of the balance sheet, we would argue, are constrained by Solvency II.
As importantly from our perspective, however, is the earlier part you may have missed: of 25 million customers that we have, over half are in Asia. We are imposing a directive that was a difficult compromise for 28 European countries on Asia. That involves contract boundaries, assuming lapse risks that are maybe appropriate in the UK on countries as diverse as China, Cambodia and Vietnam. It is ludicrous.
Q132 Mr Jacob Rees-Mogg: Can you structure yourselves, as the Prudential, to escape that?
Julian Adams: No, because the directive gives the PRA a role as the global regulator. We have to apply Solvency II to our Asian activities unless they are in an equivalent jurisdiction, in which case, in our US operations, where we are the leading annuity provider in our space, which is a massive operation, we can rely on, albeit with extra buffers, the US approach.
Nigel Wilson: On the annuity side there are two parts, as Julian mentioned. On the liability side, it is probably about a 5% cost to the consumers, just on the liability side of this particular thing. On the asset side, we do not really know, because we have not come forward with what assets would be allowed to be included. We have hugely committed to the private rented sector in the UK, which is an asset class that does not yet exist but would fit very well with these sorts of products. The question is, “What does the lifetime mortgage market and the equity release market look like going forward? How is infrastructure going to be categorised and treated going forward, under Solvency II?”
There is a huge price to pay, not just in prices for customers but real investments in real assets here in the UK, creating real jobs in new real assets.
Q133 Mr Jacob Rees-Mogg: That is an interesting point, and one I was unaware of: the regulations do not keep up with the asset classes that are available, so they cannot apply a risk level to them because they do not think they exist?
Nigel Wilson: They do not exist, so it discourages innovation, because you want to get into these asset classes. You want to create them because it results in a good outcome and the social purpose that you talked about. There is a huge need: we have under‑invested in infrastructure for 30 or 40 years, so there is a massive catch‑up. The UK remains a great place to invest. We look after 3,200 pension funds and sovereign wealth funds around the world, about £900 billion of assets. There is a huge demand sitting out there, which ironically attracts capital into the UK to invest in asset classes that do not yet exist.
You need a very large, UK‑based investor to lead on some of these initiatives, and not just here in London but in Newcastle, Leeds, Manchester, Birmingham, Bradford, right across the UK. There is a massive demand for it, but it is still difficult to do under Solvency II, even though it is the right solution for customers and the UK.
Q134 Mr Jacob Rees-Mogg: It also contradicts government policy, does it not? There was something in the Finance Act last year to encourage the set‑up of domestic property funds, and the stamp duty relating to the set–up of them. The Government have been pushing for investment in this area, and then you as an insurer are whacked by the regulator saying, “This is not something we understand.”
Julian Adams: It is important, and perhaps this is a point that could have been made earlier, that in a way we are all collectively using Solvency II as a collective noun. Analytically, what you need to do is distinguish those problems that are part of its construction from parts that are to do with its interpretation and implementation. The nastiest effects are where there is essentially not a collusion but an interaction between the two.
Q135 Mr Jacob Rees-Mogg: The PRA can change the domestic bits relatively easily if it wants to.
Julian Adams: If it wants to, yes.
Q136 Mr Jacob Rees-Mogg: The EU‑level bits are very difficult.
Julian Adams: Yes, which is why we would argue very strongly that as we go into post-Brexit, the policy position of the UK should be to have a regime that is appropriate for the UK, and where it is manifestly not working for the UK, e.g. the risk margin, we should not be afraid to take action to correct that.
Huw Evans: That is a debate we can start now. There are 23 different areas where the PRA has the ability to take its own decisions under the Solvency II directive. There are some where the directive sets the rules absolutely and there is no discretion, but there are 23 different areas where there is discretion. As we have talked about, now is the time to start to focus on those. We believe that applies to the risk margin. The PRA does not believe that; it believes the risk margin is something that can only be done by Europe. Our legal advice is that it does have some ability to change it.
Certainly, around data, there are 14 different data requirements that the PRA loads on top of what is already required by EIOPA, and certainly, as Nigel and Julian have highlighted, in terms of some of the assets and investments and the way in which the matching adjustment works. However, for the purpose of balance it is probably also worth saying there are good things about Solvency II. We have not heard any, but it is important to say that there are. It is a much more risk‑based system.
We should not forget some of the failures of the past, most obviously Equitable Life, which required regulators—initially the FSA, and work that Julian worked on in his previous life—to develop a much more robust, risk‑based supervision system. It has made for a much safer insurance system for the UK and for our customers. It requires better governance and better engagement from boards. Some of that is overdone, but some of it is worthwhile and valuable and protects customers. It has also driven greater harmonisation and convergence within the EU—not as much as was originally anticipated, but better than the patchwork quilt that preceded it.
It is important to have a bit of balance, just as it is to remember that the PRA are, as I think we would all agree, hardworking public servants who introduced Solvency II in an ordered and measured way into the UK environment, and work phenomenally hard to clear a lot of internal models. All those things are also true, as well as some of the challenges we have set out before you, about the ways in which it is implemented now and could be perhaps modified in future.
Q137 Mr Jacob Rees-Mogg: It is important that you have added that, because it was getting pretty difficult to see that there was any advantage to Solvency II. I certainly think what you are saying of the PRA is true, and the PRA recognises the considerable shortcomings within Solvency II itself and has mentioned those to us in evidence. However, the advantages seem quite slim in comparison to the £3 billion cost, and perhaps most importantly, the fact that it simply makes it harder to do new business. It is a cost for consumers, but the cost for innovation makes it a very stultifying regulation.
Julian Adams: If I may, Huw anticipated a lot of this. With the ICA regime, we had, we could not wait post‑Equitable to come up with something, so we came up with the ICA framework, and the framework worked very well for the UK. The marginal benefit that we get from Solvency II is not worth £3 billion. That is why, in a way, the Prudential’s position is that we should go back to the analytical framework of the ICA, with a simple, standardised formula, and put models into Pillar 2.
The understandable regulatory caution arises from the fact that you are giving two firms the discretion and ability to decide regulatory Pillar 1 capital. That is a very big decision, so because of that there are 200 and something requirements that you have to go through. You were talking about the implementation requests. When we were applying for a model, we had to submit 300 documents, 20,000 pages. We had to submit another 17,000 pages of documents that simply relate to our internal model. It is a very big decision.
We would argue that the better approach is to have something fit for purpose, which you can do as a single country as opposed to trying to compromise with 28 other countries. You can come up with a simple, standardised formula, move models into Pillar 2, and then allow supervisory overlay of models in Pillar 2.
Q138 Mr Jacob Rees-Mogg: But then do you not also, to some extent, have to consider what the risk is of an insurer failing to the wider economy? If Prudential or Legal & General got into trouble, it would be an absolute catastrophe, but if I set up an insurance company tomorrow and it went bust in a year’s time, it would not matter, unless I was very successful. This currently seems to regulate everybody on the assumption that if they fail, it is very damaging, and for small companies, who cannot develop their own models because that is much too complicated, they have to keep even more capital, when in fact the risk of their failing is lower.
John Parry: Yes. Just on Solvency II: it is here. We have been living with it for a while, but it has only been in operation for 15 months. There is already a process to look at it. If I look at the wish list that we have, at least four or five are within the PRA’s gift. It does not need the rulebook to be changed. They are model change requirements, the level of work you need to go through to update your model to take account of a change in your risk profile, which must be at the forefront of all insurers’ minds. You need to keep up to date with risk.
They are using a standard formula when you already have an internal model, and comparing it; contract boundaries, when insurers buy reinsurance in turn, that is appropriate when you buy it before you commit yourself to the inward risk to match it, so it is corresponding; and these national templates that Huw has talked about, with the extra reporting on top. They are all with our home regulator. The fifth one, which I think is the most common ground there is in this room, is on the reporting and the data. That one needs looking at.
Q139 Mr Jacob Rees-Mogg: Mr Evans, is this a role for the ABI? What I get the impression is needed is the pulling together of all the difficulties with Solvency II and a delineation as to who it lies with: is it with the directive itself or the PRA? Then, post‑Brexit, there could be a complete change but even prior to Brexit, there could be an amelioration of what is in our hands. Is that something the ABI is working for? I am loath to ask the commercial businesses for further information for this Committee. We have the burden Mr Tyrie has already given you.
Huw Evans: That is what we are here for. We have done that analysis. Of the 23 different areas—13 Pillar 1, six Pillar 2, four Pillar 3—we have a working description of each of them and where the PRA’s power lies, which we would obviously be very happy to submit as additional to our evidence.
Q140 Chair: You did say that there is a dispute about whether the risk margin is for domestic or EU decision, and that there is legal advice around on this point.
Julian Adams: This is about how longevity—
Q141 Chair: Okay. Is this legal advice that has been given to the PRA, of which you are aware, or is it legal advice you have commissioned?
Huw Evans: It is legal advice that, between us, we have commissioned. We have submitted it to the PRA, but the PRA’s lawyers do not agree with it.
Nigel Wilson: I think they are still reviewing some of it. They have not yet disagreed with the legal advice, it is fair to say. It is an open‑ended question, but they have not warmly encouraged the meetings.
Q142 Chair: We are warmly encouraging a look at it, and perhaps you could let us have a look at the legal advice. Might that be possible?
Huw Evans: Yes; we will talk to our lawyers, to just check where we are on privilege and so on, but we will obviously look to find a way to brief the Committee on the content of it.
Chair: It would be very helpful if we could have the legal advice, with any awkward sentence or so redacted. I cannot think of a reason why we should not be able to see it.
Mr Jacob Rees-Mogg: Could we take this up in correspondence with the PRA, to find out what their answer is?
Chair: We have them coming in very shortly, so we will be able to put some questions to them.
Q143 Rachel Reeves: Thank you, gentlemen, for coming along to give evidence this afternoon. From the insurance industry’s perspective, what should the Brexit negotiation priorities be in light of the Prime Minister’s speech last week? Maybe I will start with you, Mr Evans.
Huw Evans: Certainly. We have highlighted five key areas that matter most to us, and with which I think all of our members are in agreement, whatever their respective trading relationships are with the EA or otherwise. The first has already been name‑checked. It is the need to have a regulatory regime, whatever the future relationship between the UK and the rest of Europe, that ensures that as the largest market in Europe and the insurance capital of the world, the UK has a regulatory regime that works for it, and that it has a say in.
The second point is around trying to maximise the amount of mutual market access that is available. Clearly, that matters far more for some firms than for others. As John has highlighted, it is very important for parts of the London market, but also for parts of the long‑term savings market.
Thirdly, we have talked about the importance of labour market access. As a world‑leading sector, the insurance and long‑term savings industries attract a lot of talent to the UK, often working in key regulatory functions. We want to continue to have access to that labour market, and certainty as soon as possible, so that those EU citizens, in particular, who are already working in the UK in core insurance functions are not destabilised.
We have talked about the importance of ensuring complete ongoing convergence on data requirement. As an industry to which data is central, and with a new EU data regulation coming into force in 2018, we do not want that to be an area where there is a desire to have something different for the sake of it. That would cause a huge amount of problems. Finally, we have talked about the importance of maximising the medium‑term opportunities of trade, particularly in emerging markets, which will become increasingly important for the UK insurance industry as it looks to chart a path going forward.
As Julian and John have highlighted, some firms are already highly invested in that, but for many of our members who have an interest particularly in servicing some of the growth Asian markets, a government focus that is continuing to try to open up those markets and break down regulatory barriers offers some real medium term opportunities. That is a high‑level flavour of some of the things we have submitted.
Q144 Rachel Reeves: Thank you, Mr Evans. I was particularly interested to hear about how important it is for the insurance industry that the UK retains passporting arrangements currently provided for under Solvency II.
John Parry: If I may, we would say this would be the priority: that we continue to have the mutual market access to the EU, rather than focus on changes to regulatory regimes. Change brings cost; uncertainty brings cost, but we want to continue to service the clients we have in Europe. This is not an instance where the UK industry wins and European industry loses. London, being the centre for global specialist insurance and reinsurance, also needs European insurers and reinsurers to be able to operate here. That gives the City more attractiveness. You have the support of law firms, claims adjusters, and brokers. It is not just the insurance industry that is bringing jobs and prosperity.
Julian Adams: In terms of the list Huw gave, the ones that we would prioritise would be for Government to not wait for free trade negotiations with third countries. For services, very often bilateral agreements can be not only easier and quicker to effect, but they can actually deliver more good. We would encourage, and have encouraged, the relevant Departments to focus on bilateral arrangements that they can do now—they do not have to wait for free trade agreements—and also to focus on countries beyond the self‑selecting ones of India and China, such as South‑East Asia, Malaysia, Singapore, Vietnam, etc.
Nigel Wilson: The world is becoming a technology‑driven world. We have great technology companies here in the UK, who will work as our partners, and L&G as a firm is pretty strong in the technology area. We want to become a globally competitive business, and we will be exporting that capability in a future with a more favourable regime here in the UK. Our challenge is that having an unfavourable regime in the UK makes it difficult.
Once the Solvency II issues are resolved, and I am confident they will be, we would look at building out our capability right across many, many attractive markets, and not just the EU. We are uniquely placed, because there is a massive under‑insured world out there; there is a massive under-pensioned world out there. We do not have an office in Korea; we do not have any salespeople in Korea or any people who speak Korean. Nevertheless, we manage money for the Korean authorities, because people trust British firms across the world, because of the reputation they have earned over hundreds of years, as Jacob mentioned earlier. Indeed, all of the firms here have been around for approaching 200 years. That is really important across the world.
We are only achieving a proportion of our true capability as firms because we have excessively onerous regulation here. If I can just go back to the car industry, if this were happening in other industries there would be much more clamour around it. We have a huge unfulfilled potential around the world, on which we should truly seize, and we are not at this moment in time.
Q145 Rachel Reeves: That does not sound to me, Mr Wilson, as though you are that concerned about us leaving the European Union. It sounds as though you see our opportunities further afield. Would that be right to deduce?
Nigel Wilson: No, it is right across the world, but the impact of us on leaving the European Union on our particular business is not that great. Bizarrely, in a world in which the playing field is adjusted differently, as Julian articulated, and the possibility of getting better treatment for how we deal with China, India, America and other parts of the world, the so‑called white space that we have, the opportunities around the world are immense.
Julian Adams: In terms of dealing with the problems in the legislation of Solvency II, if there is a problem with the risk margin, post‑Brexit we can change it. There are things we can do already, but if we do not like the construct, we can change it.
Rachel Reeves: So, again, like Mr Wilson. you feel quite—
Julian Adams: We would certainly see it, absolutely, as an opportunity for us.
Q146 Rachel Reeves: Mr Parry, your answer was a little bit different from Mr Adams’s and Mr Wilson’s. You seemed to be more concerned about passporting perhaps in particular. Is that because the nature of your business is quite different? If we did not get passporting agreements, what sort of effect do you think it would have on your business?
John Parry: Those gentlemen can speak for their business. Yes, for us. We think the passporting, to use the shorthand, is the biggest priority. We think it is part of our offering as a place to write global, specialist insurance and reinsurance. Having access to the EU post‑Brexit keeps that intact. I know we have talked about what percentage of our business that is, but it is offering certainty to our clients to service all those local needs.
Q147 Chair: Just to be clear, it is not the percentage share; I have seen the total share of the market being as high as 20%, but it is certainly above 10%, which is the original figure you gave. It is not even the relatively small proportion of that which could be attributed to passporting, which is as low as 6% or 7%. What matters is the fact that—and I think this is the point you are making—it is part of the offer that you make to clients, that you have access to all these markets. It means that you attract other business, apart from the passporting business, which you would not otherwise get were you to lose passporting. Is that correct?
John Parry: I think that is right. Nobody wants to throw away £3 billion in premiums, or whatever the mix is between the reinsurance and insurance, yes, but equally I absolutely agree with your second point. Why should we introduce the uncertainty? “If I go to Lloyd’s or a London insurance market, I can place that part of it, but I go somewhere else for that.” You have two different insurers, two different product lines, which introduces cost and complexity, and you would just go for the simpler option.
Q148 Chair: Have you made any estimate of what proportion of your client base would be vulnerable in that respect to a loss of passporting?
John Parry: That is something we are working on, and talking to our board about next week.
Chair: It would be very helpful to see any output on that issue.
Q149 Rachel Reeves: I am also keen to understand, Mr Parry, if we were not to get those passporting arrangements, how you would reorganise operations so that that business could still be done? We spoke to banks and others a couple of weeks ago at this Committee, talking about setting up branches or subsidiaries in other European countries. Is that something that would also have to happen for you?
John Parry: Yes; absent access to the single market, or certainty about it, you have two options. One is going down the branch route with a third-party country branch, and the other is going via a subsidiary. We have rejected the branch route, because of the amount of capital you would need to hold in each single territory, and the fact that you cannot passport via a branch. If you set up a branch in Germany, that gives you access to Germany. Going to the subsidiary option, that would be a subsidiary set up in an EU country to transact the business that we are unable to transact on the current basis of cross–border business for that. That would largely be the direct insurance rather than the reinsurance business.
Huw Evans: For those firms that are most directly affected, there are whole rafts of these challenges to work through: for example, policies that may renew during the period of actual exit, during the 2019 year. Firms, even if they have made an in-principle decision to go through a subsidiary model, are then having to engage with regulators and work through that process, to get the approvals that are required over a two‑year period. They have to move their staff and set up their operations and IT in a way that is compliant locally.
For those firms that are affected, there are very significant challenges here. What I do not think you are getting from any of those firms is much time spent wishing they could turn back the clock. They are taking the view that the vote has happened, we live in a democracy and we have to get on with it. Therefore, what they are asking for is as much certainty as possible—going back to your line of questioning, Mr Rees‑Mogg—as early as possible in the process. As you have flagged throughout with this Committee’s hearings, there is a need to get as much clarity around implementation timescales as possible, to enable those firms to manage those challenges.
Q150 Rachel Reeves: Mr Evans, if we did not have passporting, we could seek equivalence arrangements, but does that risk us becoming a rule‑taker? People have already mentioned that we are the insurance capital, not just of Europe but of the world: if we become a rule‑taker rather than rule‑maker, would that work? Would you even seek equivalence?
Huw Evans: You are quite right to ask that question, because equivalence as a notion has had a bit too much put on its back in terms of what it can bear. I am sure the others will bear me out on this. As you know, equivalence does not guarantee market access anyway. It is a framework by which regulators can work with each other in order to enable trade across borders, but it does not guarantee that trade itself. You still have to have some sort of agreement around the trading relationship.
Equivalence is currently a political process, which can be withdrawn very quickly. It is something that, of course, has been designed and used by the European Union, not for huge member states that are departing it, but for countries like Bermuda and Switzerland that have always had a parallel relationship with it. It is not something that can, under its current form or its accepted usage, bear the weight of expectation that is being placed on it.
That is why we are all in agreement that the way to move forward, whatever the ultimate political settlement, is to have a bespoke treaty between the UK and the European Union. The treaty should cover much of the same ground, but do so in a way that is appropriate for this huge insurance presence immediately neighbouring the EU 27, and can ensure the full range of access and regulatory co‑operation that would be required to make that relationship a success. It should not use something that was never, ever designed for it.
Q151 Rachel Reeves: I want to come back to you in a second, but if we had a bespoke relationship, presumably it would have the capital requirements of Solvency II that Mr Wilson and Mr Adams have spoken so strongly against. Is it a bespoke relationship we want, Mr Adams and Mr Wilson, or is it something totally different?
Julian Adams: Huw is absolutely right to be cautious. Equivalence, to my mind, allows too much discretion to Europe. That is the first thing. It is a European judgment, and it is also something that can be unwound very quickly. We are on surer ground if we think of mutual recognition: that the frameworks that we develop deliver broadly equivalent outcomes, whether those are for policyholder protection or for financial stability. In that way, you can potentially decouple either a slavish following of, or not following of, action taken by 27 other countries, and prioritise what is right for us.
Nigel Wilson: Europe has the same problems and issues that we have. They may differ in colour at certain times, but a massive shortage of infrastructure, totally under‑equitised societies with de‑equitised stuff, and so on, no innovation in developing new asset classes, poor outcomes for savings for insurance, etc, run right across Europe. There is absolutely a common interest, and when I talk to my French or German counterparts anywhere across Europe, everybody has the same issues.
We have a common problem to solve, but we are not solving it anywhere. It is not that everybody else is doing a marvellous job, investing in new infrastructure, creating all this innovation and driving down cost. Certainly, making and allowing the firms in the UK to be more innovative, more capital‑efficient, larger, with better economies of scale, so that we can offer better-value products everywhere, has to be part of the solution.
We must focus on the customer outcomes and the UK plc outcomes, both of which need to be much better, but also for all the other countries at the same time. For firms like ours, if we invest an extra £15 billion or £16 billion, which out of £950 billion is not a huge amount of money, that is almost 1% of GDP in the UK. The big insurance firms in the UK can make a huge difference to investment in the UK. Our hands are tied at the moment, and we urge the Committee to untie our hands and invest more here in the UK.
The same pattern is elsewhere, so we find, wherever we go in the world, people welcome us, want to engage with us, and it is only the constraints of our regulation that make it more difficult for us to engage with the rest of the world. Those are common problems pretty much everywhere.
John Parry: I think you were talking about being a rule‑taker. There are other ways for us to do that. The PRA, a respected regulator internationally, can operate in the international space with other regulators. Obviously, on regulation, if anything the trend is towards Solvency II. You have seen other countries adopting the good bits of it, in parts. We have seen China introduce a risk‑based capital system; we have seen South Africa looking at parts of it. If anything, there is a trend towards Solvency II. Outside the regulatory regime, yes, our European insurers and reinsurers have similar issues to those in London, and that is where you need trade bodies to speak with a joint voice of the industry, so there would be an ability to have influence there post‑Brexit.
Huw Evans: It is eminently doable, the challenge you posed: “How can you have this market access agreement, if you like, if at the same time you are saying that all of these things need to be changed from Solvency II. There are two lines of answer to that. The first is obviously that we have outlined here ways that we believe the PRA could amend Solvency II in a way that would be beneficial, which are not reliant upon EU convergence in the first place.
The second is that we must not lose sight of the fact that Solvency II, through the process of developing it, has made the regulation of the UK insurance market and that of the EU closer, compared to where it was a decade or 15 years ago. We should not lose sight of the fact that we are starting from a point of a high degree of convergence. Therefore, it should not be beyond the wit of humanity to devise a route that ensures ongoing market access while ensuring the best of the regulatory regimes the UK needs for itself, and that the EU needs for the EU 27, can be done with some degree of harmony and co‑operation.
Chair: Thank you very much for coming to give evidence to us this afternoon. It has been extremely interesting, with a high degree of technical information coming across, which we will try to assemble and make use of for our hearing with the regulator very shortly, among others. Thank you very much indeed for coming.