Written evidence submitted by Legal & General Group plc (SOL0047)

Thank you for the opportunity to give evidence to your Committee yesterday.  As requested, this letter sets out our response to the following two questions that you asked us to answer:

• Legal & General to set out competitive issues where Solvency II has a disproportionate effect on British firms, illustrated with (a) numerical example(s).

• Legal & General to provide an illustration of what a balanced regulator might consider to be the right amount of regulatory capital.

As we outlined yesterday, to deliver a strong post-Brexit economy, the UK needs the support of a competitive and vibrant insurance sector underpinned by a regulatory framework which works more effectively than the current model. Solvency II was designed at a time when the market was very different, relying too much “built out” of a regime designed for the banking sector.  As you know, insurers are not banks.  We write business with long-term liabilities, with minimal liquidity risk, no maturity transformation and, as a sector, have a strong economic and social purpose which drives us forward.

Reforming SII provides us with the opportunity to deliver our global ambitions.  As we set out below, the SII framework as currently implemented means we have to hold higher than required levels of capital and lack capital efficient access to certain asset classes.  This makes us less globally competitive and unnecessarily drives up prices for consumers.  We believe all the changes that we have discussed can be delivered without impacting equivalence.

The UK is already a great place to invest, but we believe that through adjustments to the current regime we can deliver even more, without impacting financial stability.  Many of our clients (we have over 3200 pension and sovereign wealth funds) are keen to co-invest with us.  This could help realise even further growth and innovation in infrastructure investment, house building, re-equitising our society, provision of venture capital, lifetime mortgages, commercial mortgages etc. 

As a firm, we have committed to deliver £15bn of infrastructure investment with £8bn delivered already. We could do this even more quickly than we currently are if the regulatory regime supported this.  £15bn equates to almost 1% of GDP, with new real assets creating real jobs and growing the economy.  This will support driving higher productivity.  Your inquiry can help ensure that the market failures resulting from the regulatory framework that SII has delivered can be addressed.

Numerical Example:

For clarity, the following statements regarding capital include the Risk Margin as part of the total financial resources insurers are required to hold under Solvency II. The goal of the Solvency II project was stated at the outset as not leading to an increase in capital for the industry. This has not been borne out in practice – there are a number of areas where we believe the capital requirements are above the standard set out in the Directive (i.e. a 1 in 200 stress occurring over a 1 year period).

Clearly the “right” amount of capital, particularly in the context of a 1 in 200 event is a matter of judgement; there is no one right answer, rather judgements may lie in a reasonable and justifiable range. Additionally the “right” amount of capital will vary by product and by firm depending upon its business mix.  In our example below we have focussed on annuity business; as a product that offers long term guarantees annuities are particularly impacted by Solvency II, for other products the outcome is less severe.

To provide a numerical example, we set out below the example of a customer giving us a lump sum of £100 to purchase an annuity.  In this example, the firm retains the longevity risk and invests in Matching Adjustment eligible assets.  The table below sets out the total amount of capital resources we have to hold which is made up of policy reserves, risk margin and capital requirements. The table shows that, under current market conditions, an insurer would have to fund £27 of capital resources in addition to the £100 of premium received, compared to a third of this amount under the “reasonable”

requirements, i.e. £8.  This ratio will vary with market conditions – as many of the firms noted in their submissions the Solvency II capital requirements are market sensitive, in particular, to interest rates.

The total is shown for Solvency II, the previous Solvency I regime and a “Reasonable View” where the capital requirement is based on L&G’s own Economic Capital model. In addition to the Solvency 1 requirements, the UK operated the Individual Capital Assessment (“ICAS”) regime; the capital requirements under ICAS, including the PRA’s capital guidance, were much more closely aligned to those shown under the “Reasonable View”.

Like Solvency II, our Economic Capital Model is calibrated to a 1 in 200 one year “value at risk” (VaR) but removes some of the constraints that we believe Solvency II unnecessarily imposes e.g. Matching Adjustment eligibility, and uses what we consider to be a more appropriate calibration of longevity risk; the long term nature of longevity risk does not lend itself well to a calibration over a one year time frame.

Notes:

1. Solvency II and the Reasonable View assume a best estimate liability.  Under the reasonable view we have removed some of the unnecessary prudence in the Matching Adjustment (MA).  This could potentially be reduced further as relaxation of the MA rules would allow investment in assets that provide a better return to the customer for the same premium.  The reduction is illustrative.

Solvency I Pillar 1 requires prudent rather than best estimate reserves.  For some time L&G’s reserves have been approximately 100% of premium.

2. The Solvency II Risk Margin is sensitive to interest rates. The 15% quoted here is consistent with current conditions.  A 2% increase in rates would reduce the Solvency II Risk Margin to 10%.

There is no Risk Margin under Solvency I.  The Risk Margin under the Reasonable View is consistent with the cost of reassuring the risk to a third party based on our view of currently observable market pricing.  This approach is consistent with the management action proposal discussed with the PRA in late 2016.

3. As discussed above the level of capital that represents a 1 in 200 one year VaR is a matter of judgement.  For Solvency II we have estimated the Solvency Capital Requirement based on L&G’s Group SCR at June 2016 as a proportion of annuity reserves.  For the Reasonable View we have used the ratio of L&G’s Economic Capital Requirement to the Solvency II SCR, again as at June 2016.

Solvency I Pillar 1 capital requirements were not risk sensitive and for annuity business were set at 4% of reserves.

As you can see, SII requires us to hold substantially more than either SI or our own Economic Capital model.  In return this has a competitive impact on both us and the sector more broadly. 

Impact on competition:

Building on our original response to your inquiry, there are five key areas that were highlighted in our original submission and where we think that UK firms are put at an un-necessary competitive disadvantage.  With the exception of Spain, the UK is the only country to use the Matching Adjustment.  Similarly, every country in Europe has a slightly different implementation of the Solvency II directive; it is the totality of the requirements from the UK implementation that we believe should be revised.  Our suggestions would lead to a decrease in complexity and improved efficiency of the regime, with a small number of uneconomic features reviewed.  We do not believe EU legislation needs to be reformed to deliver these measures.  The five below are listed in priority order:

1. Risk margin: The risk margin as formulated under Solvency II is demonstrably out of line with the market price for transferring risk. Based on current reassurance pricing and using the approach outlined to the PRA, we estimate that the Group’s risk margin would fall to around 5% of reserves, compared with the risk margin of around 15% currently.  The size of the Risk Margin means that it is uneconomic to retain longevity risk in the UK causing business to be transferred to, amongst others, the United States, Canada and Switzerland. In the short term, without reform to SII, we expect over 90% of the UK’s longevity reinsurance will be undertaken by non UK insurance companies, whilst in the longer term we expect the whole business activity to be transferred out of the UK.

Alternatives would be: (i) a provision representing the insurer’s cost of recapitalising themselves, following a 1-in-200 stress event, which would, conceptually, deliver the same outcome as the risk margin, but allow for a more evidence-based and economically rational calculation. (ii) modify the existing risk margin rules to make them more principles-based and future-proof. As we discussed during the evidence session, the industry has been discussing proposals on the latter with the PRA.

2. Increased capital requirement: As demonstrated above, the Solvency II capital requirements for UK life insurers are calibrated in such a way as to increase the capital held by firms well above that under the previous regime, and indeed to a level that we believe is above the intention of the Solvency II regime.

As a sense check against the Reasonable View above, we estimate that the total capital resources for the same business written under, for example, the US regulatory regime would be c.105.  The US statutory regime is deemed to provide an equivalent capital standard to Solvency II.  The US capital requirement aligns more closely with Solvency I, ICAS and our Reasonable View rather than the 127 under Solvency II.  This places many other firms, particularly those with a US parent, at a significant advantage over a Solvency II firm, as the UK annuity risk could be reassured to the US parent and lower capital held.

3. Matching Adjustment changes: We recommend a more principles-based approach to the Matching Adjustment, resulting in considerably less operational complexity and a less binary split between eligible and ineligible assets. We agree that assets should demonstrate the characteristics that make them suitable for matching annuity liabilities, but that any risks arising from assets should be allowed for via an appropriate allowance in capital requirements rather than resulting in complete ineligibility of a particular asset class.

We have worked with the PRA to seek to find structuring solutions for some ineligible assets e.g. equity release mortgages, but these structures add considerable complexity and cost.  We estimate that we spend in excess of c.£3m pa in maintaining the MA structures and spent over £3m setting up a solution to make equity release assets eligible for the matching adjustment.  These costs are a

considerable barrier to entry to the annuity market and ultimately would be passed on to customers.  Similarly, we are unable to invest in certain infrastructure assets that would not automatically be eligible for matching adjustment, for example without appropriate prepayment protections. These would require costly and complex structures which are not required by other market participants such as banks and pension schemes. Further, some sectors are targeting BB credit debt structures such as on-shore wind which attracts a prohibitive capital charge despite exhibiting high levels of operational and financial stability. For projects with large upfront capital costs, the level of support through regulation and stability of income is critical to investment.

This is an issue unique in Europe to the UK annuity business.  We believe that the principles based approach could be adopted whilst still complying with the Directive.

4. Balance sheet volatility & definition of Solvency Capital Requirement: The current formulation of the Solvency II balance sheet results in significant volatility in regulatory surplus. This is partly due to the risk margin, but also due to the strict use of a 1-year horizon for the capital assessment, which may be inappropriate depending upon the position in the economic cycle. We recommend calibration such that the total capital resource requirements are less sensitive to the economic cycle.

5. Pillar 3[1]: The disclosure requirements under Solvency II are excessive and many of the disclosures are of limited use to regulators, investors, intermediaries and policyholders. This produces a significant on-going cost to insurers of producing the required information. Solvency II also requires quarterly reporting by insurers. The general trend for disclosures across global markets is to reduce the frequency of reporting to prevent short-termism. We recommend annual detailed reporting of relevant data with more limited half-yearly updates. For the L&G Group this creates the requirement to fill in over 400 forms a year, running to thousands of pages with an additional cost of at least £5m per annum together with the additional management time that this absorbs.

February 2017