I just discovered the fabulous Commons TV feature that allows you to link directly to the time you wanted, rather than fumble about with the cursor all night.
So here is Nicky Morgan giving a light grilling, and tbh it’s very light, to David Rule, director of insurance at the PRA. In which David coins a new verb ‘to dividend’.
My transcript below for those who lack the patience to watch it through.
[EDIT] Full transcript is now here.
Morgan: To move on to Equity Release Mortgages. The PRA made an announcement in December on this issue, um, and the shares of one of the insurance companies – Just Group – rose by more than 20% in response to that announcement. Have you analysed why the market response was favourable to Just Group. The announcement was described as ‘industry friendly’. Do you think that was a fair description?
Rule: I’m not going to go too much into one firm, but I think that the reason that their share price was particularly responsive just reflects that they have the biggest concentration of their business in Equity Release Mortgages. So, just to take a step back to what we were trying to achieve with our changes. Our key objective was that insurers adequately reserve and hold appropriate capital against the risks. If they understate the risks then they would hold too low reserves.
The key risk here in our view is the no negative equity guarantee which is very beneficial to a borrower, in that it says that a borrower will never pay more than the value of their home, but it does expose the insurer to property risk – house property risk over a very long period. What we’ve done is set out a common framework that sets a minimum standard for how insurers assess that risk and what reserves they then have to hold against it. The key issue for us is that insurers shouldn’t be able to assume the risk away, effectively by modelling it assuming house price inflation in excess of the risk free rate, because that’s a risk to which they are exposed. If house price inflation is lower than their assumption then they will be exposed, and the matching adjustment in effect delivers day one profit, so goes into capital and will be dividended1 away, so it should never reflect risks to which firms remain exposed.
If I go back to why there was a stock price reaction, it was largely to do with, er, a slightly arcane issue around the transitionals in Solvency II. So around … the Equity Release Mortgage market is about £20bn, around £13bn of that was written before Solvency II was introduced so a significant chunk, although the market has grown very rapidly over the last three years. And part of our interest in this market is that it has grown so rapidly and more firms have come into it. But there was a sizeable chunk that predated Solvency II and was therefore being reserved on our previous regime, under Solvency I. Part of Solvency II is that if you have had lower reserves under the previous regime than Solvency II requires, you can transition that increase in over 16 years, and it runs off 1/16th every year.
We had taken the view that we wanted to apply the same approach that we are applying under Solvency II under Solvency I when we consulted, because we took the view that the Solvency I regime is still a living regime effectively and we could update it if we saw the risk was changing and therefore it wouldn’t be eligible for that transitional. Following the consultation we were persuaded that a better legal interpretation of the Solvency II transitional is that it relates to the actual way that Solvency I was being applied by the firms just before Solvency II was introduced, and so if we were to change the interpretation under Solvency II then they would be eligible under transitional. So for firms – including Just, including Aviva – that have quite large back books, the impact on them is much less because of that transitional is now being recognised by us.
Morgan: Now you mentioned house prices, and I think Just Group mentioned a house price growth of four and a quarter, 4.25% a year. Perhaps you won’t want to comment on their particular assumption but others, and I think we were talking earlier on, about house price growth having slowed particularly in London, is that something that you, the PRA, keep an eye on, the house price growth assumption that the company is making?
Rule: Yes that’s the key thing that we’re targeting here. Effectively, if your risk is the level of house prices in 20 years time, if you assume four and a quarter [per] year increases, you’re assuming house price growth in excess of the rate that borrowers are accruing interest, so your risk doesn’t exist in your model. If you do as we require, which is now to assess that house prices don’t grow any faster than risk free rates, then you recognise that you’re at risk.
It doesn’t mean that you’re assuming that that’s what will happen, but it recognises that house price growth is a risk to which you’re exposed, and therefore you shouldn’t be taking the future profits of that business straight into your day one capital. You should be reserving against that risk. And fair enough, if house prices do increase, then you will not be exposed on the no negative equity guarantee and you will be able to make profits in the future, but you shouldn’t assume those on day one. That’s the key part of our reform.
Morgan: And then, I think you gave a speech, a couple of speeches, one in July 2015 and one in April of last year. In the first speech you signalled that Equity Release Mortgages, commercial property, infrastructure financing, could be a good match for long term annuity liabilities, and clearly I think you mentioned that companies who – they think it’s good business – and actually, given where we are in terms of demographics and ageing population, this is a sector that is going to grow, would you agree with that, and does that mean that the PRA is going to [devote] more resources to this if you could see potentially the appetite amongst home owners growing in this market?
Rule: So, yes, we think it will grow, and just to put it into context though, although it has grown quite rapidly, it’s still relatively small in the context of insurers overall books, I think it’s about £20bn of about $500bn of business that they write where they’re at risk – exclude unit linked – and it’s only about 1.4% of the overall mortgage market, so it’s still small in the general scheme of things, but part of the reason we wanted to tackle all of this now, and it’s been very controversial in the industry, is that we wanted it to grow on a properly reserved basis, going forwards. And we also wanted a level playing field, because we saw firms making different assumptions and actually, from our competition objective-perspective, we saw that as distorting the market. So part of this was about having a level playing field across the firms and the market.
But we do think it’s appropriate to back annuities, because it’s a long term asset suitable to back a long term annuity book, as part of a diversified portfolio of other assets – infrastructure, corporate bonds, government bonds, so we do think that’s right. These things do have to be restructured to meet Solvency II requirements for the Matching Adjustment, and that’s a complexity that we somewhat regret, but that’s part of Solvency II – so they have to be restructured to create fixed cashflows through internal securitisation.
Morgan: So where are you with this, having put the document out. Is that it, or would you expect to make further announcements, looking at the Matching Adjustment that you have talked about, is it an area that you might expect to return to, or do you think that things are set up for the time being, given how the sector is developing?
Rule: So on equity release, the new approach phases in, so that it will be fully implemented at the end of 2021. We’ve also got some further pieces that we need to give clarity on to the industry, particularly around how often they should update these valuations, some of the parameters that we set we think should vary with, if there are significant movements in interest rates, and will set out how that will work. We also need to set out how firms should model the risks on these things for their capital. So far we’ve focused on the reserving, not the capital.
More generally on matching adjustment, this is a key part of our supervisory work for annuity writers. Insurers are taking a lot of the defined benefit pension risk out of corporate pension schemes and into the insurance sector so they’re growing largely for that reason. There are still some individual annuity businesses but the large growth is coming out of the corporate sector, with pension scheme liabilities moving to insurers, and we need to focus on the assets backing those risks because this is high impact business, annuity business, and the operation of the Solvency II regime, the matching adjustment, under which that business is reserved
Morgan: Thank you very much indeed.