This was originally published in FN. Read it here.
The government’s claim that reforming Solvency II regulations that govern the multi-trillion pound insurance industry will “unlock tens of billions of pounds of investment” is not only misleading; it also hides how risky the reforms are.
First, the misleading part. The reforms are complicated, but mean that insurers can reduce the capital they put aside to protect the system from the risks of a big insurer collapsing through a reduction in what is known as the risk margin.
It is true that this will free up capital that insurers can redirect elsewhere. But there is nothing in the reforms to ensure this would be invested in the UK.
While the reforms do mean insurers can broaden the range of assets they can invest in, they have no mechanisms to direct that investment. The freed up capital could equally well be used to reward shareholders with higher dividends, or be used in any other way the companies see fit.
Let’s turn to the risky part, given that the Solvency II framework is explicitly about reducing risks. The first problem is that, while reform of the risk margin may have been warranted, any reduction in risk-protection capital of this scale is bound to increase systemic risks.
Solvency II is not the “EU red tape” the government has portrayed it as; it is a way of managing risks to the British public and UK economy should a big insurer collapse.
This is why the Prudential Regulation Authority had been fighting the government to stop the rules being watered down.
The regulator has now lost this battle. It had proposed reforms to the ‘matching adjustment’, which would have the effect of offsetting the increased risk caused by the reduction in risk margins. The matching adjustment is a mechanism that allows insurers to improve their balance sheet by adjusting the value of certain long-term liabilities where they are offset by matching assets.
In a sign that the government is willing to override the independent regulators, and side with the powerful insurance industry lobby, the PRA’s proposals were dropped in the final reform package.
The most concerning part of the reforms, however, is that they ignore the biggest risk of all for insurers: the increasing impacts of climate change. For example, the recent floods in Australia broke records for insured flood losses, and this trend will only get worse.
There were sensible proposals to integrate climate concerns into Solvency II by, for example, excluding fossil fuel assets from the matching adjustment. But despite Prime Minister Rishi Sunak’s promise that the UK would become the world’s first net-zero financial centre, climate was not part of the discussion during this reform round.
These failures matter because the risks are all too real. The Bank of England had to intervene this autumn to save the pensions industry, showing how fragile the financial system can be, particularly during times of major economic change. Pressures on the insurance industry from climate change are rising and will, sadly, only get worse.
Solvency II reforms did not free up billions for investment. Instead, unfortunately, they watered down protections against risk put in place after the global financial crisis, and ignored the mounting climate crisis.