The industry's opportunity to recommend changes to EU regulation in a post-Brexit world has delivered a comprehensive criticism of the MA. David Walker and Asa Gibson report.
Following the UK's vote to leave the European Union in June, the UK parliament's Treasury Select Committee invited feedback from the industry about how Solvency II rules could be changed for UK firms in a post-Brexit world.
The Committee began collecting the industry's comments and finished taking responses last month. Criticisms of the new regime were wide and covered several aspects of the framework, but over-engineering of the matching adjustment (MA) leading to artificial investment strategies was one of the more prominent, along with barriers to real economy investments, such as infrastructure.
Real economy investment barrier
Life insurer Prudential argued in its submission to the committee that the regulation is hampering insurers' attempts to look for "real economy" investments. The company has about £60bn ($76bn) invested in UK infrastructure and housing, but said its concerns that Solvency II is not built to promote this activity "have only deepened with the continuing impact of long term low interest rates."
The rules "effectively ensure there is a decreasing level of capital available over time to finance the 'real' economy," it said. The rules "ensure that there is less capital available to finance credit risk, [because] when credit spreads are tight firms are encouraged to transfer into risk-free assets, whereas when credit spreads widen or there are significant market events, it is not clear that the regulations enable [insurers to] transfer out of risk free assets."
The life insurer said it was of "fundamental importance" that solvency rules let underwriters continue investing in concrete assets "in a manner which does not engender pro-cyclical risk".
"[The MA] acts against the public interest by potentially limiting insurers' flexibility to add value through asset selection," - IFoA
Systemic risk
The industry can act as a counter-cyclical buffer when market stress leads banks - without long-term liabilities to match - to offload assets. This makes underwriters safer hands than credit institutions for real-world assets, Prudential said.
But Solvency II "ignores the systemic impact which could arise from all insurers de-risking at the same time" from less creditworthy instruments, it said, such as infrastructure debt. This "would likely be pro-cyclical and worsen liquidity to the point that asset sales are not possible.
"The framework could also result in a greater interconnectivity between the insurance and banking sectors, therefore running counter to policymakers' attempts to reduce systemic risk."
Prudential added that Solvency II treats "particularly harshly" the BBB rating band that agencies often assign infrastructure projects and property finance that entails development risk.
MA engineering faults
The insurer also criticised financial engineering to make assets qualify for the MA, which is meant to grant insurers relief for buying certain longer-term assets to match pre-defined life liabilities.
The engineering "does not lead to any reduction in investment risk, indeed the additional complexity adds operational risk, creates asset valuation challenges, reduces transparency and adds cost.
"Large pools of money sitting in annuity funds are restricted from such investment activity due to Solvency II MA eligibility/capital efficiency," Prudential said.
The institute and faculty of actuaries' (IFoA) submission argued the MA is "over-engineered and unnecessarily constraining" and that "it acts against the public interest by potentially limiting insurers' flexibility to add value through asset selection."
Risk and capital management consultancy Willis Towers Watson (WTW) noted that insurers' investments have been heavily influenced by MA eligibility, which could "potentially cause unhelpful distortions [in asset classes] given the scale of investments made by insurers".
Distorted markets
WTW said insurers had already favoured some assets that qualified to sit within Solvency II's MA; shunned some assets ineligible for the MA; and had made more swap market investments, because Solvency II uses a risk-free rate based on the asset class.
The consultancy said it knew of some insurers that had sold a "significant proportion of their government bond assets, and instead purchased a swap-based asset portfolio in order to improve matching with their liabilities". As a key example, Aviva voluntarily made a transition to swap discounting in 2012 and, on the back of that, halved the gilt holdings in its with-profits funds to £4bn ($6.1bn).Conversely, the sector has shown diminished demand for callable bonds, credit and lifetime mortgages, which WTW said were "previously attractive and suitable for matching annuity liabilities, but are not eligible under the MA other than [by] using costly and complex structuring techniques".
Prudential said that the imperative to make assets qualify for MA portfolios could lead it, perversely, "to argue to remove bondholder-friendly provisions, [such as] extensions, coupon steps and payment acceleration, in order to gain eligible status.
"This reduces the capacity within the UK market to raise flexible finance," the insurer added.
It argued the Prudential Regulation Authority should take a "more flexible approach" to MA applications, to help boost infrastructure investing, including relaxing asset eligibility and matching requirements.
Throughout all submissions, the message for the Treasury Select Committee is loud and clear - relax the MA eligibility criteria and insurers will avoid systemically risky herd-like behaviour and boost the real economy with investments in infrastructure.