From the Treasury Committee hearing, Wednesday 23 June 2021. Steve Baker (SB) questions deputy governor Sam Woods (SW).1
This one will run for a long time, and more later.
SB: Can I just go back to Harriet Baldwin’s question about MA? So I understand correctly, you said it’s about capital set against expected cashflows. But could you just tell me something about the risk profile of those expected cashflows?
SW: Yes, so the way the MA works, crudely, is that if insurance companies can prove to us, to a fairly high – well very high – standard, that they have achieved a fixity of cashflows coming in from the assets, which maps onto what they have got to pay on the other side on the liabilities, we then allow them to use a higher discount rate for their liabilities.
SW: What we do not allow them to take over into that higher discount rate is something called the fundamental spread, because the fundamental spread is meant to capture the risk that those bonds ‘go wrong’. Now there is a lot of work that went into calibrating the fundamental spread when S2 was set up.
SW: The point that I was making was that under the construct that we currently have, there is not an allowance for uncertainty around that going forward, and I think in the context of, if we were looking at broadening elegibility somewhat, if we were looking at de-bureaucratising somewhat, if we were reducing the capital strength and the risk margin, I think in the mix of all that it would make sense to look at that question and I think that there is probably a way of making that work better, which leaves the whole thing square.
SB: So obviously there are, you know, people concerned about MA, some of them experienced in the field of prudential regulation. So the rules that you apply are in public I take it.
SW: Yes
SB: But presumably the application of those rules to individual firms is a matter that is commercially in confidence?
SW: (Pause) Yes, although you know we give you of course the aggregate figures, and the firms themselves I think to various degrees disclose how their capital figures come together and it’s plain, basically, that firms in the annuity business and with heavy credit exposures will be heavy users of the MA.
SB: So I find myself listening to various figures, and they seem to be quite alarmed at the capital position that some firms might be in, because of the MA. What would your advice be to them if they wish to bottom out this argument? What argument would you want to listen to in order to try and bottom this out?
SW: Well I think they should consider the question of, I mean, their argument is essentially – and I am glad that people make that side of the argument because the insurers make the opposite and its good to be attacked on both sides. (laughter) No honestly I think it is a good thing, because I think there should be a debate about this given how important it is. I think the argument I would make to them is, if their contention is basically that you should only ever discount liabilities at the risk free rate, now that is a perfectly respectable world view. That is a world view that in my opinion would have two negative aspects.
SW: One is I do think that that would significantly increase the pricing of annuities, and I don’t know if you have looked around but the annuity you get for £100k is not particularly appetising. But there is just a trade off in there between the degree of risk that we choose to run and the amount of benefit that consumers can get, that’s inevitable. They have a corner solution view on that. So that is one obvious downside of what they suggest.
SW: But the other big downside is that the thing that the MA does which I think is genuinely very helpful and risk reducing is the incentive it provides for them to match. It is actually a very good thing as we go through something like last year with markets going all over the place, [that] insurers can actually ride that out because they have achieved that matching. That is a good thing.
SW: So I think that those are the counterpoints to them, but I think it’s a good thing that they push us around on it.
- Transcript now available here, Q69 ff