Written evidence submitted by Pension Insurance Corporation (SOL0044)
About PIC
1) PIC is a specialist insurer providing pension insurance buyouts and buy-ins (bulk annuities) to the trustees and sponsors of UK defined benefit (“DB”) pension schemes. At 30 June 2016, PIC had £18.4 billion in assets under management and had insured more than 130,000 pension scheme members.
2) PIC was one of 19 insurers which received approval for its full Solvency II Internal Model in the first round[1]. PIC also successfully received approval for its Matching Adjustment, Volatility Adjustment and Transitional Measures applications.
3) With pension obligations that stretch out decades into the future, we are the natural home for investments that provide secure long-dated cash flows, such as infrastructure, and have built an internal team which has considerable experience and track record in sourcing and investing directly into infrastructure, housing and higher education funding.
4) Our pension fund clients include the London Stock Exchange, Philips, Alliance Boots, Total, EMI, Cadbury, Honda, the Institute & Faculty of Actuaries and the National Association of Pension Funds (now the PLSA), as well as the public sector, including DEFRA. PIC is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority (FRN 454345).
Introduction
5) The insurance industry plays an important role in modern economies. The pooling of risk enables better access to expertise in risk management, cost efficiencies and extreme event protection, all of which reduce the cost of managing risk and the jeopardy to the risk owner (be it a corporation or an individual) of not doing so. Investment in infrastructure by insurance companies also plays an important, and socially useful, role in the development of the UK’s economy.
6) There is much to be admired in the Solvency II concept. In particular, it is risk-based and it sets out the blueprint for a robust control environment and governance framework for insurance companies. We therefore do not see any need for a radical overhaul of Solvency II, or indeed for it to be scrapped altogether.
7) However, ultimately it is a regime which has, compared to the Solvency I regime that existed in the UK, increased solvency capital requirements for insurers overall, increased complexity, increased volatility and added to the cost of insurance for customers.
8) Whilst Solvency II has been successfully implemented by the industry (and certainly within the bulk annuity sector), it has required significant cost and effort. More time is also required to refine and bed down the regulatory framework so that it works effectively in the interests of insurance customers and the wider financial system.
9) The key question for us at this juncture is whether this regulatory framework in its current form really meets the needs of the UK financial system.
10) What we currently have is an insurance regulatory framework which secures a specific part of the total financial system to a very high standard. However, Solvency II contains flaws which could become systemic risks:
11) A whole-system approach would better align the nation’s infrastructure investment needs with the investment requirements of insurance companies under Solvency II.
12) This being noted, resolving the above regulatory shortcomings should be relatively straightforward, and could be achieved through the reform of the Risk Margin (“RM”) and the Matching Adjustment, rather than anything more radical. This would allow insurance companies to better meet the needs of those who use insurance to manage their own risk exposures, as well as free much needed private capital for investment in the real economy.
What is the Risk Margin?
13) Life insurance companies hold technical provisions (reserves), calculated on actuarial bases, to ensure they have sufficient funds available to pay their technical liabilities when they fall due. The technical provisions comprise a Best Estimate Liability (“BEL”) and an RM.
14) The RM calculation, which is prescribed under the Solvency II regulations, is unduly complex and results in a financial resource requirement that is very sensitive to interest rates. It is determined by considering the amount that a notional third party, a reference undertaking, would require in order to take over the liabilities and meet the cost of holding sufficient capital to support them over their future lifetime.
15) In practical terms, the RM increases the cost of doing business for life insurers, increases the premiums required from DB pension schemes wishing to buy insurance, and ties up more financial resources (or creates an additional cost to managing capital through the use of reinsurance).
16) It is calculated as the estimated cost of the Solvency Capital Requirement (“SCR”) for the reference undertaking in each future year, adjusted to exclude hedgeable items, such as market risk (longevity risk is, for the purposes of Solvency II, considered unhedgeable and is therefore included). The cost of capital is allowed for at a prescribed rate of 6% per annum and is valued by discounting the projected cost of capital at the risk-free rate. The SCR is assessed under the reference firm’s SCR basis so that Internal Model firms use their SCR basis and Standard Formula firms use the prescribed Standard Formula basis.
17) A significant issue with the RM calculation approach is that there are actually three layers of interest rate sensitivity built into the formula for calculating the RM:
18) This means that a 1 basis point movement in gilt yields would likely cause a 15 basis point move in the BEL and lead to a movement of over 45 basis points in the RM.
19) We have seen long dated interest rates fall by over 1% over the recent past, which has increased the RM requirement by over 50%. Whilst some of this impact has been mitigated for business written pre-2016, by the ability to hold (and adjust) transitional measures deductions, it represents a very significant increase in the overall financial resource requirements for new business, thus pushing up the cost of insurance for customers. A further consequence is that it artificially increases the perceived benefits of reinsuring the underlying risks, creating a potential systematic reliance by the UK life industry on such reinsurance.
20) The extreme interest rate sensitivity of the RM calculation also creates issues for life insurers seeking to manage their exposure to movements in interest rates. If the RM were to be fully hedged for interest rate movements, and interest rates rise, then life insurers would be exposed to a significant reduction in the assets they hold in excess of those covering the BEL, reducing policyholder security. If life insurers choose not to hedge the RM, their reported solvency position would be subject to potentially significant volatility.
21) Were the RM to be reformed in a way which made it less onerous, for example by reducing the prescribed 6% per annum capital charge, it would considerably increase the capacity of life insurance companies to help de-risk corporate UK pension schemes, whilst maintaining very high levels of security for existing policyholders. This would allow the companies sponsoring DB schemes to increase economic productivity. It would also have a positive impact on the wider economy as insurers are typically much better equipped than DB pension schemes to invest in long-term, illiquid assets, such as infrastructure.
22) The question that the Committee should therefore seek to review is whether by introducing the RM calculation in the way it is currently defined, Solvency II has gone too far and is in effect pushing risk out into the financial system more generally by making bulk annuity products unaffordable for many pension schemes.
23) An additional problem is that the RM is not standardised between Internal Model and Standard Formula firms. PIC, for example, has assessed its longevity risk within its Internal Model at a much higher level than would apply if it was assessed under the Standard Formula. This risk is currently considered unhedgeble in the RM calculation (even though we actually hedge more than 70% of it) and as a consequence PIC’s RM is significantly higher than would be the case if it was a Standard Formula firm.
24) This does not seem appropriate given that the RM is trying to assess the cost of transferring the risks of the undertaking to a third party. A third party will assess the risks on their own underlying basis and is unlikely to assess the risks differently simply because the undertaking being assessed is currently on an Internal Model or Standard Formula basis.
What is the Matching Adjustment?
25) As noted above, life insurance companies hold technical provisions to ensure they have sufficient funds available to pay their technical liabilities when they fall due. The technical provisions comprise the BEL and the RM.
26) The BEL is calculated as the discounted value of the expected future liability cash flows. The default position is to discount the liabilities using a risk-free rate, but companies with highly predictable cash flows, such as pension annuities, can apply to increase this rate using a Matching Adjustment which reflects the risk-adjusted yield on the assets backing the liabilities. The cash flows of the liabilities and the backing assets must be very closely matched in order for the company to be eligible to apply the Matching Adjustment.
27) PIC fully supports the use of the Matching Adjustment for the valuation of long-term, guaranteed insurance liabilities. However, our view is that the Matching Adjustment is too restrictive in specifying the characteristics that the assets must display in order to be included in the Matching Adjustment calculation.
Responses to specific questions set by the Committee
1. Competitive implications of Solvency II
a) Lord Turnbull suggested in evidence to this Committee that Solvency II makes it more difficult to expand into non-European markets because a European-based and regulated insurance company is at a disadvantage, relative to a Canadian or an American insurance company. What are the competitive implications of Solvency II for UK insurance firms? Please answer within the context of the UK, European and global markets.
As a specialist UK insurer, based in the UK and dealing only with UK pension liabilities, PIC has no comments on this question.
b) What impact is Solvency II having on the development of global regulation? Will we see the development of two-tier regulation as firms attempt to move to less rigorous regulatory frameworks either inside or outside their territories, or reinsure risks to other territories?
Solvency II has had a significant impact on the longevity risk reinsurance market.
Under Solvency II, longevity reinsurance generally plays a more significant role in the business model of many UK annuity writers, as longevity reinsurance enables firms to reduce both their SCR and RM for the longevity risks which have been reinsured, i.e. a double capital benefit is obtained through reinsurance.
Prior to Solvency II, PIC was one of the most active users of longevity risk reinsurance, having first reinsured longevity exposure in 2008. However, in response to Solvency II, a number of insurers active in both the bulk annuity and retail annuity sectors have sought to increase the amount of longevity risk they reinsure. This increase in activity has undoubtedly been driven by the introduction of Solvency II.
Solvency II requires longevity risk to be treated as “unhedgeable” which in turn requires it to be a component of the RM resulting in either (i) substantial additional regulatory financial resource requirements for annuity business; or (ii) the risk being reinsured, often to non-UK reinsurers.
The counterparties to these reinsurance transactions are typically large reinsurance companies which may be based within the EEA, or they can be based in other jurisdictions. In our experience, the most active non-EEA based counterparties are based in North America.
The opportunity to reinsure longevity risk with counterparties based outside the EEA increases capacity in the UK bulk annuity sector, thereby enabling more pension schemes within the UK to divest themselves of risk, securing the pensions of their members and reducing overall systemic risk.
However, there is a risk that Solvency II (in particular the RM requirements) will effectively encourage firms to reinsure longevity risk with counterparties that are based in jurisdictions which have a lighter regulatory regime than current counterparties. Whilst such transactions may superficially seem attractive based on price, overall confidence in the system could be undermined if large amounts of longevity risk are ceded to such jurisdictions.
Fundamentally, we believe that the quantum of regulatory capital required for longevity risk under Solvency I was appropriate and therefore we do not believe that the additional resource requirement (resulting from the longevity risk component of the RM) is justified. The change from Solvency I to Solvency II has led to both higher annuity prices and the search to pass longevity risk to reinsurers outside the UK. In our view, the Solvency II rules should be amended such that longevity risk is no longer a component of the RM, particularly given there is plenty of evidence that it is hedgeable.
c) Could Solvency II create a potential competitive disadvantage for UK insurance firms in relation to firms from outside the insurance industry (including “disrupters” and companies who are not subject to any form of EU or EEA regulation) who may operate substantially in the same market?
PIC does not believe that Solvency II creates a competitive disadvantage within the bulk annuity sector in terms of non-UK based insurance companies competing to insure the pensions of members of DB pension schemes. DB pension fund trustees are inherently conservative and would be unlikely to transact with a bulk annuity insurer which was not authorised and regulated by the PRA. There is however a risk that companies sponsoring UK pension schemes could seek to avoid the costs of insuring under the Solvency II regime by encouraging trustees to invest in products provided through offshore vehicles, putting the pension benefits of UK pensioners at risk.
Solvency II does create disadvantages by making transactions more expensive through the inefficiencies inherent to the RM and Matching Adjustment requirements (for example, difficulties in finding suitable assets to match very specifically annual cash flows for the liabilities can make the difference between a transaction proceeding or being cancelled). These inefficiencies can make transactions uneconomic, thus leaving pension risk with the sponsoring companies, where it drags on productivity improvements.
d) What effect has Solvency II had on product innovation and the ability for new entrants to join the market?
In our sector, Solvency II is likely to have had some impact on product innovation simply due to the internal resource required to meet the launch timetable and the initial uncertainty following launch. However, since then we have been able to develop products to meet specific client needs, albeit sometimes at a higher cost to the customer and with reduced flexibility than was the case under the previous regulatory regime.
What is more obvious is that Solvency II has increased barriers to entry into the bulk annuity sector, and in addition has caused some insurance companies to step away from (bulk) annuities altogether. However, it is our view that enough companies remain in this sector to create price tension and ensure that trustees receive a fair deal in the course of a transaction. We do not therefore see this as the major problem with Solvency II. It should also be noted that actuarial consultants expect more companies to enter this sector over the coming years[2].
2. Development of Solvency II
a) What are the principal developments or adjustments that you would like to see made to Solvency II in an ideal world? Where relevant, please include an indication of timescale, priority, rationale and “real world” constraints.
The principle adjustments that we would like to see in relation to Solvency II relate specifically to the RM and the Matching Adjustment.
We note that the PRA has made clear its view about amending the RM to better manage the volatility we outlined in the introduction to this document and reduce the significant burden that the RM imposes on insurance companies with long-term liabilities. We very much support these comments. We would also support the creation of a more level playing field in the RM calculation between insurers on a Standard Model for longevity risk and those on an Internal Model.
The other development we would like to see is a review of whether longevity risk should be included at all in the RM calculation. It is clear that over the past decade there has been a very active and competitive market in reinsuring longevity risk. In this context we believe that longevity could be considered a hedgeable risk (at least for pensioners in payment) and should therefore be justifiably excluded from the RM calculation.
In terms of the Matching Adjustment, we would like to see amendments to the rules around callability and “make-whole” requirements and to the need to match in annual cash flow buckets. We would also like to see greater leeway in the cash flow matching requirements for the longer dated cash flows (say beyond 40 years) such that they do not need to be as precisely matched as the shorter term cash flows.
We see a number situations where banks wish to sell their PFI / housing association / utility loans as they are no longer capital efficient for the bank to hold. These loans often have very low margins, so offer pre-payment protection implicitly as the funding cost is so low the borrower is not incentivised to repay. However, they do not have explicit “make-whole” clauses so are not eligible for inclusion in the Matching Adjustment Fund under Solvency II.
Similarly, we see a number of project finance / infrastructure transactions which have cash sweeping mechanisms whereby if the project outperforms, excess cash is used to pay down debt. This improves the quality of the asset (due to the deleveraging), but the cash sweep mechanism creates difficulties with Matching Adjustment Fund eligibility because repayment is at par.
Prior to Solvency II, pre-payment protection in the form of “make-whole” clauses was typically a given for institutional transactions. However, as it is now mandatory for insurers to have pre-payment protection (whereas pension funds and banks don’t need to have it), the insurance industry is at a competitive disadvantage in the lending market, and borrowers can use this as a negotiating tool, in a way they couldn’t before.
A more pragmatic approach to callability / pre-payment protection would therefore be welcomed, whilst appreciating that stability of cash flows is an important requirement for liability matching. It is worth noting that the Solvency I regime had a well understood approach to callable bonds, where cash flows were taken into account on a “call to worst” basis.
It should be noted that the treatment of callable bonds within the Matching Adjustment has created unintended consequences in the bond market. In particular, one of our fund managers observed that between October 2015 and April 2016, the yields on Solvency II eligible bond tightened by 6bps, whereas the yields on non-Solvency II eligible bonds widened by about 20bps – a stark difference in performance driven entirely by the current specific rules applied to Matching Adjustment eligibility.
A review of the specific rules applied for Matching Adjustment eligibility and the capital treatment of different asset classes could increase the supply of capital to some important areas of the economy. For example, the ability to invest efficiently in whole infrastructure projects (not just the debt), or indeed to invest in the equity of key infrastructure projects, is precluded by Solvency II, due to the significant capital requirements that currently apply to such investments.
If the Government is to meet its ambitious infrastructure targets with the help of UK institutional investors then the Matching Adjustment and capital rules current in force need to be refined.
b) Given the potential increased flexibility that may be available following the UK’s exit from the EU, should the UK seek alternatives to Solvency II for insurance regulation (such as a regime similar to the old ICAS regime, or a differentiated regulatory regime which varied according to an insurer’s size or customer base)?
We do not believe that the UK should look at alternatives to Solvency II. As noted above, there has been a lot of time and effort invested to ensure that the system works. It is still bedding down, and this is an ongoing process.
What we need is some degree of regulatory stability, even within a system that is acknowledged as imperfect, and would therefore prefer to see refinements to the RM and to the Matching Adjustment to meet the needs of the customers of the UK insurance industry, and those of the wider UK economy.
Going down the route of designing and implementing a brand new regulatory system, even one designed specifically for the UK insurance sector, would create years of uncertainty for customers and load additional costs onto UK insurers.
c) Lord Turnbull said in evidence to this Committee that “it will actually help insurance companies if we can leave the [Solvency II] arrangement” which “treats insurance companies as though they were banks” 3. Should the UK Government seek to withdraw from Solvency II?
Lord Turnbull is correct that the Solvency II regulatory regime does to a certain extent treat insurance companies like they are banks. The Recovery and Resolution plans require insurance companies to have a “living will” similar to that required by the banks.
However, we do not agree that we should leave Solvency II, for the reasons stated in our answer to Question 2b, above.
In theory, a complete exit from Solvency II may allow the UK to develop a regulatory regime that increases the competitive position of UK companies abroad. However, our ability to dramatically alter regulation may be constrained by any desire to achieve equivalence with EU regulations. Bermuda found this out in their equivalence negotiations, where they needed to implement an RM and other parts of the regime that they originally left out.
d) Sam Woods said in evidence to the Committee that there were elements which he would like to change – he said that the calculation of the risk margin (projecting forward insurance and capital grants until they run off and then discounting them back at the risk-free rate, so that the risk margin increases as the risk-free rate drops) “is the most obvious one” and “I would like to have some more macroprudential flexibility in the regime”. Should the UK seek to amend, or withdraw from, these, or any other elements of Solvency II?
See response to question 2a and 2b.
e) Is Solvency II a price worth paying for the passporting of insurance services across the EEA?
As a specialist UK insurer, based in the UK and dealing only with UK pension liabilities, PIC has no comments on this question.
3. Implementation of Solvency II
a) What lessons have we learned from the implementation of Solvency II in the UK?
At the UK level, we were broadly happy with the implementation process. In particular, the PRA has demonstrated an appropriate degree of pragmatism where required in the context of bedding in the new rules.
b) With the benefit of hindsight, how well has the implementation of Solvency II met its stated objectives?
Solvency II has increased the security of existing policyholder benefits compared to the ICA regime as a consequence of the broader corporate governance requirements introduced. However, the benefits derived from Solvency II are at this time outweighed by the need for reform of the RM and Matching Adjustment.
d) Solvency II has a number of transitional provisions (for up to 16 years in some circumstances). Are these provisions effective, practical and flexible enough?
We welcomed the transitional provisions and have made full use of them for our in-force book. However, we believe they are not flexible enough and as such can lead to unnecessary volatility in an insurer’s capital ratio. They should be reformed such that they better reflect actual market conditions and that consequential adjustments to the amount of transitional provisions can be incorporated closer to the actual event. This would help to better manage reporting requirements.
4. Safety and soundness
a) How effective has Solvency II been in increasing the safety and soundness of the UK insurance industry? b) What are its principal strengths, both technically, and in its influence on Boards?
The UK life insurance industry coped very well with the financial crisis which started in 2007. So the starting point for Solvency II was to gold plate an already safe and secure regulatory framework. It is unlikely that we will definitively know the answer as to how effective Solvency II has been in increasing the safety and soundness of the UK insurance industry until we have been through a significant financial crisis, although as noted in the introduction, there are potential weaknesses inherent to Solvency II.
We believe that the Committee should review the unintended consequences of Solvency II, in particular the potential for pro-cyclicality, asset herding, Solvency II balance sheet volatility caused by the RM, excessive RM requirements for bulk annuities leading to unnecessarily high premiums, and unnecessarily restrictive eligibility criteria for Matching Adjustment assets.
c) What are its principal limitations?
As noted above, the principal limitations of Solvency II relate to the design and implementation of the RM and Matching Adjustment.
d) What are your views on the concept of internal and standard models and does the concept work well in practice? If not, what refinements could be made?
We believe that the Internal Model concept works well and we welcomed in particular the focus on a more appropriate measure of longevity risk, tailored to each individual company.
e) Is the new regime flexible enough to withstand another financial crisis?
The calibrations of the RM and Matching Adjustment mean that certain market events can have significantly greater impacts on the solvency of the company than were probably intended. Sharp falls in interest rates increase the RM significantly. Downgrades (not defaults) have the potential to be very expensive. The PRA is limited in what it can do in response to particular financial crisis events by what is and is not in the delegated acts. This could act as a limiter on the ability of the Regulator to respond to particular events. The PRA has highlighted its desire to amend the RM calculation, but is unable to “tweak” the RM due to inflexibility in the rules.
f) Can you think of any circumstances where Solvency II would not operate effectively or could increase the risk to the UK insurance industry?
As noted above, the incentives within the Solvency II regulatory framework which encourage herding and pro-cyclicality should be reviewed, as well as the excessive and volatile RM requirements. Examples of this might include the penal capital treatment of lower risk quasi-government debt which has been designated “corporate” under the regulations. Insurers have to treat local authority debt largely the same as debt issued by large multinationals due to rating equivalency.
5. Proportionality
a) Do you consider that the ongoing regulation under Solvency II is cost effective and proportionate with regards to the areas below?
i. Pillars I and II
ii. Pillar III
iii. Solvency II’s requirements to identify key function holders as implemented in the UK’s new SIMR regime
Pillar III reporting is extensive and frequent. Consideration should be given to rationalising this, either the frequency (perhaps moving from quarterly to annual full QRT’s) or the content.
b) Has the implementation of Solvency II allowed sufficiently for the different sizes and types of firms?
The implementation of Solvency II has encouraged larger, well-resourced insurers to develop Internal Models to quantify and understand their risks and hold capital based on this basis. This is in contrast to smaller insurers which have typically used the Standard Formula approach which prescribes the level of capital they need to hold.
PIC has developed and utilised an Internal Model. Under PIC’s Internal Model a significantly higher level of capital is held in respect of longevity risk than would be the case if longevity risk capital requirements were assessed under the Standard Formula. This could mean that an insurer which had not developed an internal model for annuities would be able to hold significantly less capital than those insurers which have developed their own Internal Models. This does not seem appropriate or in the interests of the wider financial system.
6. Financial reporting
There are a number of international developments (e.g. IFRS and EEV) attempting to clarify and simplify financial reporting and valuation for insurance entities. How does Solvency II factor in to this debate?
Our view is that it would be beneficial if Financial Reporting (IFRS), Embedded Value (EV) and solvency reporting were fully aligned. The multitude of reporting and valuation metrics that currently exist are at times confusing for investors and a more simplified and consistent approach would be beneficial for encouraging investment into UK life insurers.
7. Wider implications of Solvency II.
What are the implications of Solvency II for:
As noted in our introduction, the design of Solvency II contains flaws which could become systemic risks:
December 2016
[1] PRA Solvency II Internal Model approvals, 5 December 2015 http://www.bankofengland.co.uk/pra/Documents/solvency2/imapprovals051215.pdf
[2] Professional Pensions, 1 September 2016: Four insurers set to enter bulk annuity market by 2021 http://www.professionalpensions.com/professional-pensions/news/2469494/four-insurers-set-to-enter-bulk-annuity-market-by-2021