The Eumaeus mailbox was buzzing late last week after the publication of a speech by Deputy Governor Sam Woods 1 on proposed reforms to the Insurance capital regime. The general mood was surprise.
My first thought is that we should not be altogether surprised, as the PRA has been expressing concern about the abuse of the capital regime for some time. Sam mentioned “wide disagreement on this amongst academics” about the size of the illiquidity premium, but this is nothing new – on 29 April 2021 my former colleague Charlotte Gerken said there are “several schools of thought” on whether illiquid liabilities should be discounted at a higher than risk free rate, while reiterating the PRA line that a ‘component’ of the credit spread represents an illiquidity premium. Sam also said that MA is effectively a way of recognising as capital up-front a part of the income that insurers expect to earn on their assets in the future, and therefore if the PRA allows such an arrangement it must operate it “with a very high degree of confidence that those future returns will in fact materialise”. Again, there should be no surprise here. In a speech published on 22 September 2021, Gareth Truran expressed concern that “some of the returns which are currently treated as an illiquidity premium might, in fact, reflect compensation for variability around future credit losses. If so, in adverse scenarios, these profits might not materialise.”
So, say it again, Sam.
That said, the tone seems to have changed. For the first time, Sam used the word ‘prudent’, suggesting that allowing such early profit-taking “is not common in other bits of regulation” – you don’t say – and hinting that “it would be more prudent to make insurance companies wait until those returns (for instance, interest payments on corporate bonds) are actually paid to them before recognising them as capital which could be paid out to shareholders”, lest those returns not actually materialise (my emphasis). He added that “Based on the analysis and evidence we have reviewed, we think we need to take some steps now to guard against these problems with the MA leading to an insurer getting into trouble in the future.” (My emphasis again.)
There was also a strong suggestion that the regime was being abused. He said that if you plot the MA against the range of views from academics “then you find that the MA is either towards the most generous end of that range or well outside it. This is a topic on which reasonable people can differ, but given the very important role the MA plays it is concerning that the regime is not more consistently well within the range of views offered independently by others.” (My emphasis). In other words, independent academic opinion has not been entirely supportive of the PRA’s view on the MA.
There was even a dark hint about the failure of previous regulation –
Perhaps we should not put 100% faith in the fact that the bonds have the same credit rating, given how spectacularly wrong ratings have sometimes been in the past – and noting that for many assets only an internal rating, performed by the firm owning the asset, is available. (Again, my emphasis)
– and of perverse and unintended consequences:
The MA incentivises insurers to seek out assets which have the highest return relative to the regulatory benchmark used to estimate future losses – these may or may not be productive or indeed UK assets. To give just one example, one of the most MA-generative assets our team has come across so far is a 100-year bond issued by a Latin American country, which surely has nothing to do with the government’s investment objectives for the UK. It’s simply an asset that happens to pay a high return relative to the rating it has managed to secure. Indeed, looking at insurers’ assets six years into the regime it is notable that the MA currently tilts incentives towards assets like ground rents – and that infrastructure fares relatively less well. (My emphasis).
He also stressed that the PRA must curb the incentives to gaming and regulatory arbitrage, given the incentives the regime currently creates “simply to seek out those assets which have a high return relative to the expected losses set out in the rules”.
This is particularly important because the competitive nature of the market for moving corporate pension schemes over to insurers means that even if firms have the best intentions to invest in productive UK assets, they will still be compelled to invest in the most MA-producing assets they can find or risk losing the business to other competitors.
Goodness.
Finally, Sam underscored the issue of materiality.
This question might not matter much if this part of our insurance regime didn’t provide capital relief equivalent to two thirds of the entire capital base of our life insurance industry, and didn’t underpin the livelihoods of millions of pensioners. But as it does both of those things, we don’t think “maybe” is a good enough answer. The current set-up does also lead to some odd results, such as a group of assets sitting on insurers’ balance sheets today for which the capital banked up-front (in the form of MA) was in fact greater than the entire cost of the assets themselves. Further, data provided by firms suggests that over 20% of BBB exposures have an MA benefit that exceeds a reasonable estimate of a 1 in 200 year capital requirement, resulting in firms effectively creating capital by taking on more risk. We need to learn from our experience over the last six years and make changes to get this part of the regime onto a firmer footing.”
The ‘odd result’ is intriguing. No one I have spoken with has a clue how it is possible to create, in the form of MA, an amount of fake capital greater than the entire cost of the assets themselves, but the PRA has spoken. In the weird world of financial regulation, what is impossible can also be true.
What next? PRA analysis indicates that the combined effect of the proposed reforms (“loosening the risk margin while tightening the MA”) would free up 10-15% of the current capital held by life insurers, potentially supporting between £45b and £90b in additional investment in the economy. However, no indication was given of how the reforms would impact firms which already make heavy use of MA. The firms which benefit would include non-life as well as life insurers, but non-life insurers do not make heavy use of MA – it is typically only annuity writers who do so. Will any firms lose out? Logic suggests so.
To select one firm entirely at random, Rothesay Ltd at the end of 2021 had a (2021) Risk Margin of £2.2bn, MA of £6.9bn, with own funds (i.e. capital) of £8.3bn. Clearly, any loss of the MA ‘benefit’ would far outweigh the benefit of any loosening of the Risk Margin. Most of its reported capital therefore stands to be wiped out. But let’s not worry! Its actual capital position would be largely unaffected, because the capital wiped out did not exist in the first place.