Aviva – Written Evidence (FRS0032)

The future of financial regulation and supervision following Brexit

The Committee’s inquiry into financial regulation and supervision following Brexit is welcome and we are pleased to submit a response. 

Current regulatory regimes

1. What is your overall assessment of the EU’s financial services regime, in light of its current application to the UK? To what extent is it effective, and for whom?

1. While the EU has been responsible for a very significant proportion of legislation affecting the UK financial services sector, the EU’s financial services regime was developed broadly in line with an international consensus on the necessary response to the financial crisis. The EU subsequently carried out an important review of the post crisis financial regulation in its “Call for Evidence” exercise. This was a welcome acknowledgement that given the pace and volume of reform, it was inevitable that there would be unintended consequences or legislation could be improved once its effect on the market were observed.

2. Given the volume of legislation and the need to incorporate 28 different markets, it is predictable that not all EU legislation matches the specific characteristics of the UK market. The insurance sector is diverse with different business models operating in the EU. The UK is one of the very few markets where customers purchase an annuity to fund their retirement for example. Further, few firms offer cross-border services. Combined with the various regulatory discretions available to national competent authorities, this means that Solvency 2 has not achieved its intended effect of creating a fully level playing field in insurance. 

3. The negotiation of Solvency 2 was a highly political process with the final rules representing a complicated compromise between Member States, each seeking to protect the business model of their national insurers. For UK businesses, the final rules included a number of shortcomings, including:

        An imperfect matching adjustment: since the UK is one of the few markets in which annuities are offered, there was a general lack of understanding of the business models of UK insurers and the importance of being able to hold assets for very long periods. While a workable compromise was finally agreed in large part due to the efforts of UK Government and HM Treasury, the final rules were better but still overly prescriptive and deter certain long term investments.

        The risk margin: the risk margin is not appropriate for an insurance business that holds long term assets, is unduly sensitive to interest rates and does not recognise the existence of a mature reinsurance market.

        A constraint on investment in infrastructure: the capital treatment of infrastructure investments does not currently reflect the long term nature of these investments.  As part of the review of post-crisis financial regulation, the EU rightly concluded that Solvency 2 was hindering insurers’ ability to invest in infrastructure. However, their remedy in the form of legislative amendments to amend the calibrations for infrastructure assets and later, for infrastructure corporates, was relatively limited and only applied to firms using the standard model. The effect was to deprive a number of prominent UK insurers the opportunity to benefit from more attractive capital charges, to the detriment of the European economy.

2. Are current EU proposals on banking and financial services in your view positive for financial stability? How do you expect the EU’s regulatory framework to evolve in the coming years?

4. We have limited our comments to Solvency 2. We would not claim Solvency 2 to be a perfect piece of legislation but the UK industry has invested heavily in it and the implementation of the regime has been a relatively smooth process. The directive does introduce measures that can be expected to promote financial stability. However, it was estimated by the Treasury to cost the industry £2.5bn to implement the rules and ongoing annual costs of £196 million[1]. Given the resilience of insurers during the financial crisis, there is a question over the extent to which the highly prescriptive rules within Solvency 2 have been a proportionate tool for promoting stability.
5. Regarding the future evolution of legislation, as noted in our answer to the previous question, Solvency 2 consists of a set of compromises that reflect the different insurance markets across the EU. Perhaps more so than in any other piece of legislation, the absence of the UK from future discussions can be expected to result in insurance legislation becoming increasingly unsuitable for the UK market. Important elements of Solvency 2 to the UK, such as the matching adjustment, cannot be expected to be maintained in a way that works for the UK, if at all. The matching adjustment provides a crucial function for UK insurers by allowing them to hold assets that fund annuity liabilities for long periods, rather than having to sell them during a short term market downturn. This allows insurers to operate with less volatility and to use their capital more effectively. Without the matching adjustment, the increased volatility in the value of assets would lead to customers seeing the value of retirement incomes fall.
6. For this reason, we strongly advise against the UK adopting a future arrangement with the EU that would require the UK to follow EU rules without the ability to help draft them or the flexibility to adapt them to the domestic market.  

3. What are the key differences between financial regulation as agreed at the international, EU and UK levels, and where are the gaps? How important is it to maintain a level playing field for regulation?

7. The insurance sector differs from the banking and markets sector in that Solvency 2 is an EU-driven process rather than originating at an international level. Subsequent to the introduction of Solvency 2, international regulators are examining the need to develop an International Capital Standard (ICS). While it is too early to tell if the ICS will be adopted globally, clearly any measure at this level will need to reflect the nature of the UK market. Insurance markets – and particularly life insurance markets - differ significantly by jurisdiction, due in part to domestic tax systems and pension structures. As such, it is very difficult to design a regulatory framework that truly reflects a number of different markets. This challenge was clear during the development of Solvency 2 and will be even more present in the design of an international standard.  

4. Are there any particular legal or practical challenges related to incorporating the existing body of EU financial services legislation into the UK’s domestic law, for example the PRA rulebook?

8. Solvency 2 and the associated implementing acts are very substantial and technical pieces of legislation. It contains detailed provisions for the cross-border supervision of insurance groups, cross-border activity and numerous references to EU bodies and their powers. All of these references will need to be reviewed and updated. The government will also need to decide where to allocate the powers currently attributed to EU supervisors, such as the role of EIOPA in publishing the risk free rate term structures or setting the methodology to derive the ultimate forward rate. It will also need to give thought to how to establish the supervisory cooperation structures that currently exist between national supervisors. These are important mechanisms for the sharing of expertise and pooling of supervisory responsibilities that help support risk management.

9. The government will also need to decide if the UK Parliament should be given similar powers to the European Parliament in scrutinising and providing consent to implementing legislation.

10. Given the complexity of the issues, government should be clear and transparent in how it intends to incorporate EU law into the UK. This should include consulting in advance with industry.

Transition, equivalence and alignment

5. What would be the key priorities for a transitional arrangement, and how much continuity would you expect to see under such an arrangement?

11. The immediate priority should be to provide an early commitment that there will be a transitional arrangement. Businesses with cross-border interests have been required to develop contingency plans to maintain customer/counterparty relationships. In the insurance sector, the relevant adjustments – e.g. moving customers to different entities or securing approval for new licences - must be made under the Solvency 2 framework and therefore need to be completed before March 2019 if a transition is not secured. Securing the relevant legal approvals and authorisations, and facilitating these changes is expected to take at least 12 months. This means that negotiators must be able to confirm the detail of a transition period in early Q1 2018 at the latest or firms will be forced to start implementing their contingency plans to ensure that they can continue to serve their customers from a stable legal footing.

12. The government will also need to use the transition period to establish the necessary supervisory structures and systems, such as supervisory colleges. In many cases, this will involve cooperation with international partners, including the EU. Such structures can be expected to take time to establish. 

13. Regarding continuity during the transition period, given the scale of change that firms will be preparing for in the new relationship with the EU, we would prioritise providing industry with stability and consistency during this period. While it may be a necessary condition of the transitional period for the UK to be effectively a 'rules-taker' during this period, we would emphasise the importance of the UK not remaining a rule-taker in the medium term if its wants to have regulation that is fit for purpose for the UK's own market.

6. In practical terms, how and when could a transitional arrangement be agreed and put in place? How long would such a transition need to last?

14. As noted above, the government should seek to confirm that there will be a transitional period as soon as possible to prevent firms having to execute contingency plans that will take at least a year to implement.

15. It is important to note however, that while businesses, and the UK economy, will benefit significantly from this being confirmed early, it does not follow that there is no value in a transition period if it is only agreed late in the process. The anticipated scale of change means that firms will benefit from a transition period regardless of when it is agreed.

16. Regarding the length, we believe that a period of at least two years to give time for businesses to adapt.

7. What are the benefits and drawbacks of seeking equivalence? What conditions are likely to be attached by the EU to any equivalence decisions?

17. The extent to which equivalence is important varies by sector, activity and business structure.  For example, within Solvency 2, there are three different types of equivalence, none of which give passporting rights. 

18. One of the most critical areas where the UK should seek equivalence is on the sharing of data (known as 'adequacy' in this instance). A priority for government must be to ensure that it is deemed ‘adequate’ under European data protection rules and data sharing can continue following Brexit. A failure to do so would cause considerable disruption across many sectors of the economy. 

19. The insurance industry is structured differently from some other parts of the financial services sector, such as wholesale banks or market infrastructures, in that some of the firms that operate in a number of different EU markets tend to do so through separately capitalised subsidiaries. This means that there is less reliance on a ‘passport’ to provide services consumers across borders. However, the equivalence regime does allow for firms with entities located outside of the EU to operate more efficiently in some areas. In particular, firms that are headquartered outside of the EU can rely on the third country supervisor to conduct group supervision if the third country regime has been deemed equivalent. This could become a useful provision for UK headquartered firms who would avoid a potentially costly process of restructuring their business to create a new holding company within the EU for the purposes of meeting Solvency 2 requirements.

20. The benefits of being equivalent under Solvency 2 would need to be balanced against the cost of seeking equivalence. As noted in our answer to question 10, we believe that there is a degree of flexibility afforded to third country jurisdictions when being assessed for equivalence. Should the EU require that Solvency 2 was mirrored precisely in order for the UK to be equivalent, the cost of compliance would far outweigh the benefits.     

21. More broadly, the equivalence in its current form is not a viable basis for a lasting relationship with the EU. The shortcomings have been well documented but can be broadly summarised as:

        It is subject to political interference: in most cases, the European Commission is solely responsible for determining if an equivalence assessment should be started and subsequently, if an approval should be given. The European Parliament and Council must then both approve the decision. All of these processes include an element of political decision-making and judgement, which would be a source of uncertainty for UK based firms who are seeking to make long term business decisions. 

        Lack of flexibility: equivalence decisions would be granted subject to criteria set in European legislation. This could require UK authorities to adapt the domestic regime in order to comply with priorities set by the EU. It could also be subject to political interference.   

        Lack of stability: EU rules are reviewed and updated over time. At each juncture, the UK may need to be assessed again to check if the domestic regime is still equivalent. Over time, the EU and UK markets may deviate, meaning that the UK would need to adapt its domestic regime to an increasingly unrecognisable market. 

        Threat of revocation: equivalence decisions can be revoked at short notice, meaning that firms will not be provided with the certainty that they need to make long term business decisions. In some cases, it can be withdrawn with as little as 30 days’ notice at political discretion.

8. What alternatives may exist for maintaining alignment between the UK’s and EU’s regimes? What options could be considered for resolving disputes or arbitrating on such matters? What would be the barriers to a more bespoke arrangement?

22. The government should seek a balance between maintaining close relations with the EU while preserving sufficient flexibility to adapt the domestic regime to meet the needs of the UK economy. A solution should be sought that builds on the equivalence framework but provides additional stability and flexibility, addressing the shortcomings outlined above.

23. The UK is expected to remain committed to the international financial regulatory agenda and it can be assumed that the UK will embark on similar financial reforms to those undertaken in the EU. Therefore, the main improvements to the equivalence regime should focus on process since the requirements of an equivalence assessment to have rules in place that achieve similar outcomes is less likely to be an issue.

24. A focus on process over substance could include seeking to establish a presumption that the UK will be equivalent if they have already implemented rules stemming from the same international initiative (a similar approach was included in the EU Benchmarks Regulation[2] where temporary equivalence is granted to countries that had implemented IOSCO standards), confirming that UK regimes will automatically be assessed for equivalence when new EU laws are drafted rather than this being at the discretion of the Commission, making an equivalence assessment permanent rather than subject to review and building close cooperation mechanisms through which any future changes to law are reviewed so as to avoid an equivalence status being compromised or easily revoked.    

25. A number of industry bodies have developed proposals for a mutual recognition regime that provides mutual access to markets based on similar rules being in place and strong cooperation mechanisms between regulators. The government should advocate such an arrangement with European counterparts as a model for a future relationship in financial services.

The future environment

9. What effect will the loss of the UK have on the development of the EU financial services framework and its capital markets?

26. The UK government and financial services sector has traditionally played a very significant role in the development of the EU financial services framework. The UK government has been able to ensure that EU legislation very often incorporates UK ideas and is reflective of the UK market. 

27. There is a substantial amount of expertise and experience within the UK that is often incorporated into the EU’s approach to financial services regulation. UK financial and professional services firms have actively participated in regulatory debates and forums in the EU and have been an important source of expertise during the development of policy. This can be seen in the contribution that UK firms make to EU consultations: 36% of the public contributions to the Commission’s Green Paper on Retail Financial Services came from UK firms, as did 26% of responses to the Commission’s Call for Evidence on the EU Regulatory Framework for Financial Services and 22% of responses to the Commission’s consultation on Building a Capital Markets Union. This UK-oriented input will clearly be lost after Brexit, which will have some impact on the content of future policy.

28. From an insurance perspective, as noted in our response to questions 1 and 2, the diverse nature of insurance markets in the EU means that we would expect future insurance policy to deviate from the UK’s policy interests. In particular, we would expect changes to the matching adjustment on the grounds that very few other countries make use of it, which would be detrimental to people receiving private pension payments in the UK. The absence of the UK’s voice on the risk margin, internal models and reporting to name but a few, would likely result in future reviews of Solvency 2 resulting in a regime that is increasingly unsuitable for the UK market.

29. Beyond the insurance sector, we can anticipate that EU policymakers’ interests will turn towards expanding the Capital Markets Union for the EU27, which will likely be accompanied by an expansion of the powers of the European supervisory authorities. We hope that as part of this reform, the EU will continue to be outward looking and seek close cooperation with other global financial markets.

10.                     Where is there scope for the UK to amend its regulatory regime? What precedents exist under current equivalence decisions for divergence to occur?

30. The EU’s equivalence assessments tend to be outcomes based and seek to ensure that a firm authorised in a third country meets the same standards as those in the EU. In its review of the equivalence regime, the European Commission describes equivalence assessments as follows, “It is the equivalence of regulatory and supervisory results that is being assessed, not a word-for-word sameness of legal texts.”[3] In the same paper, the Commission states that an equivalence assessment will usually review third country rules under the following three criteria:

        the comparable requirements being assessed are legally binding,

        they are subject to effective supervision for compliance and enforcement by domestic authorities,

        they achieve the same results as the corresponding EU legal provisions and supervision[4].

31. The structure and scope of the equivalence assessments suggests that the UK as a third country would have a degree of flexibility in how it drafted domestic legislation that was intended to be tested for equivalence with EU law. One challenge would be to coordinate the timing of legislation to ensure that EU law agreed at a later date (because of the slower nature of the co-decision process), does not subsequently include criteria for testing equivalence that would rule the UK regime incompatible.

32. Notwithstanding the above, the equivalence assessment provides scope for third countries to develop their own regimes. The criteria for the three equivalence assessments is set out in articles 378-380 of the Commission’s delegated regulation on Solvency 2[5] and while detailed, it does not amount to requiring that a third country has an identical regime to Solvency 2. Further, the adjustments that could be made to ensure that Solvency 2 functioned better for the UK, such as adapting the matching adjustment or risk margin, can be made without undermining Solvency 2’s objectives of supporting financial stability and protecting policyholders.

11.                     What challenges will expected innovations in financial markets, for instance in the FinTech sector, present in respect of regulation and supervision post-Brexit? How can these challenges be overcome? Can the UK maintain a competitive advantage while adapting to a new regime? If so, how?

N/A

12.                     Will leaving the EU affect the way that the UK represents itself in international fora? How can the UK continue to maintain influence when dealing with organisations such as the FSB and IOSCO in setting international standards?

33. The UK has played a very active role, and has often led the agenda, in international fora. This is a function of the size of its financial services industry and strong commitment to the global financial regulatory agenda. As long as the UK remains committed to a having in place a robust regulatory regime that is aligned to international standards, there is no reason why the UK should not continue to play a prominent role in international fora after leaving the EU.

Supervision

13.                     The Commission is currently conducting a review of the European Supervisory Agencies. What, in your view, are the key areas where reform should be pursued and what might be the impact of such reform on UK supervision?

34. We believe that EIOPA has been given broadly appropriate powers both in terms of its responsibilities under Solvency 2 as well as within the EU regulatory framework. One of the questions considered in the consultation on the review of the ESAs was whether EIOPA should be merged with the EBA to form a single prudential supervisor under a ‘twin peaks’ model. We would not support this since we believe that it could lead to a loss of insurance industry expertise as well as the risk that the insurance sector is seen as secondary within a prudential supervisor that is also covering the banking sector. It is also important to clearly distinguish between insurance and banking models. There is a risk that a single authority would be more inclined to apply supervisory practices for the banking sector to insurance to promote consistency without fully acknowledging the fundamentally different business models.

35. Finally, we believe that EIOPA has been given the correct powers and the focus of the review should be on ensuring that these powers are used effectively rather than expanding the tools available. For example, EIOPA does not need to take over responsibility for approving internal models, which can continue to be carried out by national supervisors with support from EIOPA.

14.                     How could an enhanced role for ESMA and the ECB in respect of euro-denominated clearing work? What are the options for the UK to retain euro clearing in the light of the European Commission’s recent proposals?

N/A

15.                     How would supervisory cooperation (as envisaged for CCPs) work in practice? Are there any precedents? What are the potential risks?

N/A

29 September 2017