The Solvency II Directive and its impact on the UK Insurance Industry Contents

4Financial stability and market distortions

Procyclicality and Regulatory Forbearance

91.It is generally accepted that the insurance industry poses much less systemic risk to the UK financial system than the banking industry, and historic evidence supports this view, (see, for example, the analysis of insurance company failures in Chapter One). However, it is important to note one risk, which arises because insurers must hold additional capital against higher risk assets such as equities and property which can fall in value. If their solvency is threatened insurers may choose, or be required, to sell these assets and buy lower risk assets such as gilts, thereby releasing most or all of the capital charge. Because a typical cause of reduced solvency is falling markets, there is a danger of a vicious circle: markets fall, insurers are forced to sell, which causes markets to fall further, in a process known as “procyclicality”. As insurers are such big market players, this effect could exacerbate an emerging economic storm. It would also cause insurers to sell at the bottom of the market, crystallising losses for policyholders.

92.Solvency II incentivises insurers to act in the way described above when their solvency is threatened. This was a feature of the previous ICAS regime too; however, under ICAS the UK regulator had the ability to take overall market conditions into account when reviewing solvency. This included the ability to override normal capital requirements for the benefit of market stability. In particular, the requirement to test for a 1-in-200 year fall in equity markets (say 45%), could be relaxed if a significant fall had already occurred.

93.The regulator used this freedom in the recent financial crisis, and it is widely believed to have helped market stability. This facility, often referred to as “regulatory forbearance”, has been removed in Solvency II.

94.The consequence of applying Solvency II’s standardised framework across the entire EU insurance industry’s €10 trillion of assets is that insurers across the EU are “likely to react to market events in tandem…reducing the natural offsets that have historically existed between national systems”.97 This increases macro-economic risks, as noted by the International Monetary Fund in their Financial Stability Report:

“Pension funds and insurance companies are less able to play a countercyclical role in financial markets because of tighter requirements to minimise asset-liability mismatches”.98

95.The Basel Committee on the Global Financial System also notes that:

“Ongoing accounting and regulatory changes…limit the scope for taking long-term or illiquid assets on balance sheet, particularly during times of elevated market volatility”.99

96.The desire for regulatory forbearance “or temporary rule amendments in the event of a severe financial crisis”100 was expressed by a number of respondents101 including Unum, who noted that “it is not currently envisaged under Solvency II”.102 Regulatory Forbearance would “help avoid the unnecessary resolution of an insurer during a period of short-term distress, instead allowing it to recover”.103 This in turn would deliver a “better outcome for customers and higher market confidence in the insurance sector”.104

97.The IFoA noted that a key political compromise in agreeing Solvency II was the Long-Term Guarantees Package containing various measures to support long-term investment and combat procyclicality. “It will be important that similar mechanisms are maintained (with enhancements) in any successor UK regime.”105 However, the key element of this, the Matching Adjustment, is over-engineered and restrictive as to what assets it covers, meaning that regulatory forbearance is still sought after. The IFoA also noted that “[I]n the event that the UK leaves the EU this presumably results in EIOPA having no UK-specific role which may then be an opportunity for the PRA to apply discretion.”

98.In developing a post-Brexit regulatory model, it is recommended that efforts are made to accommodate regulatory forbearance, where it can be shown to improve macroeconomic stability and improve consumer outcomes. The Committee would expect to see some work on how this is being progressed. In parallel with this, the PRA should develop contingency plans that it can adopt if and when necessary in emergency circumstances, as soon as it is no longer constrained by EU law.

97 SOL026

98 IMF, April 2015, cited in SOL026

99 Cited in SOL026

100 SOL008

101 SOL008, SOL009, SOL019, SOL023, SOL032, SOL026

102 SOL019

103 SOL032

104 Ibid

105 SOL026

25 October 2017