David Worsfold
As 2016 gets underway, the Bank of England is taking its microscope to the connections between insurers’ asset allocation decisions, Solvency II, movements in asset prices and the wider economy.
At the recent Insurance Investment Exchange seminar in London, the Bank of England presented its thoughts on ‘Insurance and financial stability’ from the Q3 2015 Quarterly Bulletin. The presentation cited that procyclicality is a key risk for the BoE and with good reason. There has been a sustained shift from UK equities to fixed income since 2005 in the UK concentration exposure amongst insurers. And this is not an isolated example, with Dutch financial institutions selling peripheral sovereign debt after yields increased sharply in 2012-13, and the very strong correlation of allocation decisions by American and French institutions to equities in the S&P 500 as other powerful examples of the potential problems.
On the Bank’s radar screen in the UK are the growing proportions of insurer assets that are going into the CDS market and commercial real estate as well as the growth of insurance linked securities which are still largely untested by a catastrophe event. All of these risks are the subject of a “deep analysis” investigation into how insurers could contribute to financial stability risks.
This shouldn’t really be a surprise to insurers as the Bank flagged up many of these issues last year in its Financial Stability Reports, in particular in its report on Financial stability risk and regulation beyond the core banking sector (July 2015) issued mid-year.
Product sustainability is not such a priority concern in the UK as there is little concentration and plenty of alternatives for consumers. This is more of an issue in other countries such as Germany and Belgium where many products have guarantees fixed by law which are now under strain in the low return world.
These concerns surfaced recently in an article in the Wall Street Journal by Allianz SE’s chief economist Michael Heise in which he warned of the consequences of the European Central Bank’s new found enthusiasm for quantitative easing and negative interest rates. It doesn’t take much reading between the lines to see that the German life assurance sector is starting to check where the panic button is located in case its ability to deliver on the guarantees comes under serious pressure.
It is the potential for the £1.6tr of assets invested by the UK life companies to cause instability in financial markets and the real economy that remains one of the Bank concerns, especially when it looks at the interconnectivity of assets held by banks and insurers. The significant proportion of bank-issued corporate bonds held by insurers is but one example.
On this side, we note two concerns that are bubbling to the surface now.
One is the enthusiasm of insurers for investing in the plethora of insurance linked securities and collateralised reinsurance vehicles that are now available. This is linked to the huge amount of reinsurance being written outside the EU to lay off guarantees in products which are heavily penalised under Solvency II. It is just the sort of inter-connectivity that worries policymakers.
The other is the potential for Solvency II to drive procyclicality. The Bank of England has acknowledged this as a risk. But Solvency II has also limited the scope for speedy or tailored action. Any deviation from the rules has to be approved by the rest of the Euro market, necessitating lengthy negotiations. It is a far cry from the forbearance provisions of the previous regulatory regime, which allowed national supervisors to move far more swiftly when they saw a problem emerging.
With the first amendment of Solvency 2 due in 2018, there will be an opportunity to review these issues– assuming, of course, that markets haven’t turned nasty in the next 18 months and proved the fears of policymakers all too well-founded.