Written evidence submitted by Prudential
We welcome the opportunity to respond to the Treasury
Select Committee's inquiry on financial regulation and outline
below some important issues for our business in relation to European
developments.
We would like to draw your attention to the broad
changes in European regulatory reform and then invite you to consider
our concerns and potential solutions with regard to some specific
policy areas.
EU REGULATORY REFORM
1. New European Supervisory Authorities
1.1 The European Commission issued in September
2009 a legislative package to create new European Supervisory
Authorities (ESAs)—the European Banking Authority (EBA),
the European Securities and Markets Authority (ESMA) and the European
Insurance and Occupational Pensions Authority (EIOPA) to replace
the existing Level 3 Committees[1].
The proposal also included a European Systemic Risk Board (ESRB)
to provide macro-prudential oversight. The new European bodies
will start operating from 1 January 2011.
2. Role of the new Authorities
2.1 ESAs will not be responsible for day-to-day
supervision of firms. We support this outcome, as we believe that
regulation is best implemented by national supervisors with a
strong understanding of their local markets. However, we will
be closely monitoring the use of the ESAs' binding technical standards,
which add significant new regulatory powers to the existing supervisory
role of EU regulatory authorities.
2.2 We also support the recognition of the specific
characteristics of the insurance sector outlined in the proposals
for the creation of the European Insurance and Occupational Pensions
Authority (EIOPA). For example, we support the EIOPA Regulation,
recognised in Article 12b(2), that EIOPA must take into account
relevant international approaches to systemic risk posed by insurance,
re-insurance and occupational pensions institutions when setting
the criteria for systemic risk and stress testing.
2.3 We remain concerned, however, that the European
Systemic Risk Board (ESRB) will be overly focused on the banking
sector and, as a consequence, might not be able to lend full attention
to the distinctive role of the insurance model and other parts
of the financial services industry. The ESRB will be represented
by over 60 institutions, including 27 Central Banks.
2.4 In view of EIOPA Article 12b(2), the ESRB
and EIOPA should take account of the conclusions of the IAIS statement
on financial stability: "The insurance sector is susceptible
to systemic risks generated in other parts of the financial sector.
For most classes of insurance, however, there is little evidence
of insurance either generating or amplifying systemic risk, within
the financial system itself or in the real economy".[2]
2.5 As the policies of the new authorities take
shape, we would look to the ESRB and EIOPA to take into account
the comments of FSA Chairman Lord Turner in his Dubai speech to
the International Association of Insurance Supervisors (IAIS)
on 27 October 2010. While recognising the need for consistency
in applying regulation across the sector to avoid arbitrage and
the importance of taking into account the interconnectedness of
the financial system, Lord Turner stressed that regulation created
for banks should not automatically be applied to the insurance
sector: "…insurers and banks are, in some quite fundamental
ways, different. And that clearly implies that we cannot simply
read across regulatory reforms designed for banks and assume that
they should apply to insurers".[3]
2.6 In particular, insurers differ from banks
because:
- 2.6.1 Insurers do not have a financial, structural
or liquidity mismatch between assets and liabilities;
- 2.6.2 they are not key participants in the
payment systems which act as critical infrastructures in the economy
and potential channels of contagion effects in cases of bank failures;
and
- 2.6.3 they are not typically subject to the
sort of short-term counterparty risks that some banks became exposed
to due to banks' high dependency on inter-bank lending.
3. Post financial crisis measures
3.1 We do not support the European Commission's
proposals published on 7 October for the future taxation of the
financial sector.[4]
The insurance industry was not the source of the financial crisis
and should not therefore be subject to any new tax instruments
that aim to ensure that the financial sector contributes to post-crisis
fiscal consolidation.
3.2 The Commission's proposals include support
for a Financial Transaction Tax at a global level. It also includes
support for a Financial Activities Tax at a European level, which
would target the profits of, and remuneration in, financial services
companies.
3.3 We believe that penalising insurers as part
of a financial services industry-wide tax would be unhelpful to
our key role—particularly in the current economic climate—of
investing in long-term infrastructure; acting as a potential source
of non-bank lending; and reducing the burden on the state through
private provision (eg pensions).
3.4 Similarly, we would oppose the move towards
a pre-funded insurance guarantee scheme put forward in the European
Commission's Insurance Guarantee Scheme White Paper, as the long-term
nature of insurance products means that an immediate call on funds
is unlikely to be required in the event of financial failure.
3.5 Where insurers do become insolvent, claims
will be paid over many years rather than being paid out in full
at the beginning of the insolvency. We therefore believe that
the building up of a substantial pre-fund is unnecessary and that
it is possible for the scheme to meet claims from post-funded
levies.
4. Relationship with the UK
4.1 We are concerned about the potential implications
due to the split of representation between the new Prudential
Regulation Authority (PRA) at the Bank of England and the Consumer
Protection and Markets Authority (CPMA).
4.2 It is vital that the PRA and CPMA are given
sufficient expertise and resources, as regulation is increasingly
set at an EU level. In particular, there must be adequate representation
with regard to macro-prudential issues on the European Securities
and Markets Authority (ESMA). It is also important that the UK
continues to devote appropriate resources at Ministerial level
to influence EU legislation at this critical juncture.
POLICY AREAS
5. Solvency II
Introduction
5.1 Solvency II is a new risk-based economic
regulatory framework for European insurers. It will replace with
a single Directive the Solvency I framework (30 years old and
made up of 14 different directives), and is designed to ensure
companies are able to take a "whole-company" view of
their risks, eg across different sectors and geographies.
5.2 The framework Directive was agreed in 2009
and implementing measures are now being developed. These are expected
to be finalised in late 2011 with the Directive entering into
force on 1 January 2013.
Key issues for UK insurers
5.3 Liquidity premium:
- 5.3.1 The liquidity premium represents part
of the yield on corporate bonds. It is the compensation paid to
investors to make up for the fact that corporate bonds are not
as liquid as other investments.
- 5.3.2 However, as many annuity providers
buy corporate bonds and hold them to maturity, the liquidity premium
represents extra value to them, compared to say, gilts. Non-recognition
or inappropriate recognition of the liquidity premium could therefore
mean annuity providers having to hold more capital to back their
annuity liabilities and could, in turn, lead to consumers paying
more for annuities. However, there has not, so far, been an agreed
method of measuring the liquidity premium, and it varies with
market conditions.
- 5.3.3 CEIOPS led a taskforce, which included
industry representatives and reported in early 2010, which set
out a formula for measuring the liquidity premium and determining
the stressed market conditions when it should apply.
- 5.3.4 For new annuity business following
the introduction of Solvency II, we would like to see the formula
included in the Level 2 implementing measures. This will provide
insurers with certainty as to its application.
- 5.3.5 However, for existing businesses, the
most appropriate solution would be transitional measures, allowing
insurers to continue to use current liquidity premium treatments
for a set period of time. We understand that transitional measures
are being considered and we welcome this development; the ABI
has suggested this should be 20 years.
- 5.3.6 More generally, it is important that
the liquidity premium is appropriately recognised, to ensure that
annuities remain an attractive pensions product, and to ensure
that insurers are able to continue to hold corporate debt to back
these liabilities. If not, there is a risk that the availability
of medium and long-term credit to businesses in the UK and the
EU could be restricted, which, in turn, could hamper economic
growth.
5.4 Third countries: EU-based insurers
will have to apply Solvency II across their businesses globally.
This places EU-based insurers at a potential disadvantage if Solvency
II capital requirements are higher than local requirements. However,
where a regime has been deemed to be equivalent, local capital
rules may continue to be used, subject to regulatory approval.
CEIOPS has been asked by the European Commission to undertake
assessments for equivalence of Switzerland and Bermuda (and Japan
for reinsurance business). This will be the first wave of equivalence
assessments; we welcome the recognition by the European Commission
that transitional measures may be appropriate for some countries
that will not be considered in the first wave, including the US.[5]
5.5 Overall capital requirements: Industry
remains concerned that these are rising, unnecessarily—however
we note Commissioner Barnier's recent comments that the Commission
does "not expect the entire European insurance industry to
increase their capital by virtue of the changeover to Solvency
II".[6]
6. OTC Derivatives (European Market Infrastructure
Regulation—EMIR)
Introduction
6.1 The European Market Infrastructure Regulation
(EMIR) was launched on 15 September 2010. The Regulation will
implement in the EU the G20 commitment to mandate central clearing
and reporting of over-the-counter (OTC) derivatives.
Concerns
6.2 The central clearing initiative is about
reducing risks and improving market stability. We support the
general concept of central clearing, but we believe managing unintended
consequences is crucial.
6.3 We believe the current proposal would not
result in a fair outcome for end investors, as the clients, such
as pension schemes, which present an extremely low default risk
are treated the same as clients presenting high default risk (such
as a leveraged hedge fund).
6.4 As a result, we are concerned that insurers,
managers of Undertakings for Collective Investment in Transferable
Securities (UCITS) funds, mutual and pooled funds as well as pension
funds are likely to incur significant costs as a result of the
current proposals.
6.5 Long term savers and pension schemes were
not the cause of the financial crisis. Measures to constrain irresponsible
trading and speculation are required, but should be implemented
in a way that does not penalise stable, long-term investors.
6.6 Pension funds or long-term savings funds
use OTC derivatives to hedge long-term market risks, such as interest
rate movements, on behalf of their investors. They will face a
performance penalty due to the need to hold large sums of low-yield
instruments, such as cash, as collateral in their portfolios.
6.7 To the extent that legitimate OTC derivatives
activity is made prohibitively costly or effectively prohibited
then end investors will suffer.
6.8 We do not think the current EU approach delivers
the market stability sought by the G20, nor is it fair to investors
and their clients. Insurance groups and pension funds are low
risk counterparties, and should not be equated with speculators.
This should be acknowledged in any mandatory central clearing
framework. We would be looking for flexibility for long-term investors
in terms of what kind of instruments they can post as collateral.
7. Investor Compensation Schemes Directive
(ICSD)
Introduction
7.1 The Commission launched a legislative proposal
to review the Investor Compensation Schemes Directive (ICSD) in
July 2009 and it is now undergoing the co-decision procedure.
7.2 The proposal would extend compensation to
investors for claims relating to the failure of a third party
custodian, UCITS depositary or sub-custodian. It would harmonise
the level of compensation to €50,000 and introduce ex-ante
funding of ICS rising to a minimum target fund level of 0.5% of
the value of assets managed with a ten year collection period.
The Commission also proposes to allow ICS to borrow from other
Member States' ICS.
Concerns
7.3 We support the main objectives of the review,
which are to:
- increase the protection provided to investors
and strengthen their confidence in the use of financial services;
- improve the practical functioning of the schemes,
and
- adapt the Directive to the evolution of the regulatory
environment in Europe.
7.4 However, we have major concerns regarding
the proposed extension of the benefit of the investor compensation
schemes to UCITS unit holders in case of the default of a depositary
or sub-custodian. These provisions are premature as there is as
yet no clarity on the outcome of the ongoing review of the UCITS
depositary regime. It is only when the outlines of the depositary
functions and liabilities are clearly defined that it will be
possible to assess objectively if, and to what extent, an extension
of the scope of the ICSD to UCITS unit holders is needed.
7.5 Nor is there a level playing field with other
non-UCITS retail schemes, such as UK authorised unit trusts, that
would appear to be out of scope.
7.6 Moving ICS to pre-funding will also entail
important additional costs that are very likely to be ultimately
borne by UCITS unit holders and which are disproportionate in
comparison to the benefits they would bring in terms of increased
protection. Such costs are always likely to be borne by the end
investor. Nor is there recognition of how UCITS unit holders are
structured—for example UCITS holders include institutional
investors that are not normally eligible claimants.
7.7 Data gathered by the European Fund and Asset
Management Association (EFAMA) at end of June 2010 indicate that
the total assets under management in UCITS are €5.49 trillion.
Setting the target level at 0.5% would require a total contribution
of approximately €27 billion, potentially taken out of UCITS
assets over a 10 year period. In comparison, the total loss for
UCITS in the wake of the Madoff scandal was approximately €1.7
billion.
7.8 There is not a sufficient cost-benefit analysis
or appropriate market failure that justifies the amount above.
We are also concerned that this target is not ring-fenced from
contributing to schemes for other parts of the financial services
industry, such as banking.
7.9 It is essential that the costs to the end
investor are borne in mind when these proposals are being decided
by the European Parliament and Council in the months ahead.
I hope you find these points helpful and we look
forward to continued engagement with the Committee and with HM
Treasury as the regulatory reforms continue to take shape—both
in the UK and EU - over the next few years.
1 The Level 3 Committees are advisory committees in
the old Lamfalussy supervisory structure. The Level 3 Committees
are the Committee of European Banking Supervisors (CEBS), the
Committee of European Insurance and Occupational Pensions Supervisors
(CEIOPS), the Committee of European Securities Regulators (CESR). Back
2
Position statement on key financial stability issues, International
Association of Insurance Supervisors (IAIS) (4 June 2010)
For full statement: http://www.iaisweb.org/view/element_href.cfm?src=1/9364.pdf
Back
3
http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2010/1027_at.shtml Back
4
http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2010_0549_en.pdf Back
5
Letter from Jonathan Faull, Director-General of Internal Market
and Services DG, to Gabriel Bernardino, Chairman of CEIOPS, 29
October 2010. Back
6
Commissioner Barnier speech to Public Hearing on Solvency II,
Brussels, 4 May 2010. Back
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