Changing risks and the search for yield on Solvency II capital
Speech given by
David Rule, Executive Director of Insurance Supervision
Association of British Insurers, London
6 July 2017
1
All speeches are available online at www.bankofengland.co.uk/speeches
Regulatory change has dominated our insurance supervision agenda for the past few years. Today I want to
talk mainly about risks. Our supervisory work is similarly shifting gear. As Solvency II becomes business
as usual, we will spend more of our time understanding the risks that insurers are taking and, where
necessary, responding to them.
I do though want to make a couple of initial points about Solvency II. First, we are making good progress,
working with the ABI, in identifying improvements to our implementation of it. This follows up the
commitment made by Sam Woods to the Treasury Select Committee in February. Amongst the areas we
are working on are our processes around model changes and the matching adjustment; and regulatory
reporting. We are working within the bounds of the EU legislation and I do not anticipate any headline-
grabbing initiatives. But I am confident that we will identify a number of practical changes that will make a
difference to insurers and supervisors on the ground.
Second, we will continue to update our approach in the light of new information. For example, it does appear
that the rate of improvement in life expectancy of older people has slowed in the United Kingdom1. Annuity
writers should be cautious in changing their longevity assumptions. For example, the annual data can be
volatile because of factors such as the failure of flu vaccines. Moreover, the slowdown in the rate of
improvement in life expectancy appears less marked amongst wealthier people, who are represented
disproportionately in annuity portfolios. Nonetheless, we have concluded that we should make some
changes to our quantitative indicators in the light of recent longevity experience. These indicators are used
by supervisors as one input into our review of whether insurers' models meet Solvency II tests and
standards.
Third, we will soon complete the first full cycle of Solvency II reporting. Later this year, I plan to hold
roundtables with insurers, investors and analysts to discuss Solvency and Financial Condition Reports
(SFCRs). We are also reviewing whether an ongoing requirement for audit of every year's SFCR is
proportionate for the smallest insurers. It would be unhelpful for the PRA to be too prescriptive about the
depth of content of SFCRs. But it strikes me that some areas could be made more consistent. For example,
changes in Solvency Capital Requirement coverage could be broken down to show what is attributable to
changes in capital, to changes in modelling and to changes in risk assumptions. Insurers need to explain
fully to policyholders, investors and others what lies behind their Solvency II ratios. This is particularly true in
more complex areas like internal models and the matching adjustment. Otherwise we run the risk of a loss
of confidence in those numbers in a crisis.
Now I will turn my attention to risks in the life and general insurance sectors. I will also describe the
supervisory work we are doing in response. In different ways, both life and general insurers are adapting to
1
Source: ONS statistical bulletin: National life tables, UK: 2013-2015
https://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarriages/lifeexpectancies/bulletins/nationallifetablesunitedking
dom/20132015
a world with lower returns on capital. They are also learning how to optimise their activities for the new
constraints of Solvency II. Put the two together and we can think of a search for yield on Solvency II capital.
General insurance risks and supervisory priorities
In the general insurance sector, underwriting returns remain soft. On 22 June, I wrote to Chief Executives
with the results of our latest 'Monitoring the Market' survey of general insurers. One unsurprising finding was
that premium rates had declined in most lines of business. A perhaps more surprising finding was that, on
average, London Market insurers thought rate adequacy had improved slightly. They appear to be
incorporating a more benign view of future losses into their technical pricing. Many insurers raised concerns
about distribution channels, particularly in the wholesale markets. More generally, our supervisory concerns
in the current market include:

Insurers may be tempted to release too much from prior year reserves to bolster current profits.
Across the market, reserve releases continue to run at high levels by historical standards.
 Insurers may be underestimating risks, particularly on new business. For example, they may be too
sanguine about catastrophe risks, such as significant weather events.
 Terms and conditions are loosening.
 Insurers may be tempted to expand into new lines of business with apparently more attractive
returns. But these may fall outside their knowledge and expertise.
Over the course of 2017, we will carry out a number of supervisory initiatives to deepen our understanding of
how individual insurers are being affected by these conditions. Our overall expectation remains that firms
(and their Boards) are the first line of defence and accountable for the risks written on their balance sheets,
regardless of distribution channel used. Where insurers participate in delegated underwriting arrangements,
we will expect them to retain the ability to understand the impact of business written through these channels
on their overall risk profile.
Our specific work this year includes:

Reviews of underwriting and exposure management for selected lines of business at a number of
large London Market insurers. In the course of these, we will seek to understand how changes in
terms and conditions are carried through to planning, reserving and capital assessment. Where
these insurers delegate aspects of underwriting through broker facilities, managing general agents or
other arrangements, we will also assess whether they have sufficient information and control to
manage their risks effectively.
 A thematic review across a number of smaller Lloyd's managing agents, to assess how distribution
channels are changing.

Reviews of underwriting and risks around pricing at a number of motor insurers. For example, we
will assess how insurers protect themselves against the risk that under-pricing leads them to take on
a large number of policies quickly, particularly through price comparison websites.
Life insurance risks and supervisory priorities
In the life sector, the search for yield on Solvency II capital is taking insurers in different strategic directions.
Some are taking a approach, focused on
'capital-light' unit-linked liabilities and asset management. Others
are growing their annuity books, particularly by taking on the liabilities of defined-benefit company pension
schemes.
One of the most direct and notable consequences of Solvency II has been growth in reinsurance of longevity
risk. On average, between 2015 and 2016, longevity risk transfer increased by nearly 25% across UK
annuity writers. Long-dated insurance risks, such as longevity exposures, attract a high risk margin. We
have been clear that we think the Solvency II risk margin is too sensitive to the level of market interest rates2.
It is therefore too high at current low levels of interest rates, encouraging insurers to transfer longevity risk
through reinsurance. The risk margin is our first priority as part of the Solvency II review. We are working in
EIOPA to achieve a sensible outcome.
To be clear, though, we are not opposed to use of longevity reinsurance, including to non-UK counterparties,
provided risks are properly managed. We set out our expectations in a Director's letter more than a year
ago. It asked insurers to pre-notify the PRA of new longevity risk transfer and hedging arrangements,
including the insurer's proposed approach to risk management. We consulted on the content of the letter and
published Supervisory Statement 18/16 on 'Solvency II: longevity risk
transfers'3. This allowed us to track
activity and has been a source of useful information to supervisors. Our supervisory approach has not
changed since. Through a programme of in-depth supervisory reviews, we are gaining assurance on
insurers' risk management. We will then review
our expectation to be notified ahead of transactions.
With insurers transferring more longevity risk and the associated returns, the profitability of writing annuities
depends increasingly on the mix of assets chosen to back them. Yields on government bonds are low and
spreads on corporate bonds narrow. Insurers are therefore searching for yield in less liquid, direct
investments. These include equity release mortgages, commercial property and infrastructure financing.
Based on supervisory information, around 25% of annuities are backed by such direct investments currently.
But insurers have plans for that proportion to increase to 40% by 2020. These assets can be a good match
for long-term annuity liabilities. Moreover, increasing investment in real assets may have wider economic
benefits. However, they often lack observable market prices and external credit ratings. It is therefore more
2
Source: Record of the November 2016 Financial Policy Committee Meetings published 6 December 2016
http://www.bankofengland.co.uk/publications/Documents/records/fpc/pdf/2016/record1612.pdf
3
http://www.bankofengland.co.uk/pra/Pages/publications/ss/2016/ss1816.aspx
difficult for insurers to assess credit and other risks. Investing in and managing these assets also requires
different skills. For example, when bonds are downgraded, an insurer may expect to be able to sell them.
But when a direct investment begins to go wrong, the insurer will probably only be able to sell at a fire-sale
price. It needs the capability to renegotiate and restructure the debt.
One particular area of growth has been equity release mortgage lending. Life insurers take on almost all of
the flow of new equity release mortgages in the UK. This now stands at around £13 billion or 1.4% of
non-linked assets.
We published a discussion paper on Equity Release Mortgages last year. A typical such mortgage is a loan
to an older borrower that does not require regular interest payments. Instead interest accrues over time and
is repaid, together with the principal, from the proceeds of the sale of the house when the loan becomes
Borrowers have a 'no
due. That is usually when the borrower either dies or goes into long-term care.
negative equity guarantee'. It protects them from being required to pay back any more than the value of their
property. In economic terms, the insurer has sold the borrower a put option on the house.
Equity release mortgages can be a valuable product for borrowers, allowing them to unlock the equity in their
homes. They can also be an appropriate asset to back annuities as part of a diversified portfolio. But they
are a more direct exposure to house prices than conventional mortgages for which the lender's primary
source of repayment is the borrower's income.
Insurers are protected by low loan-to-value ratios. However
these will tend to increase over time as interest is rolled up, particularly if the interest rates exceed house
price appreciation. And the Solvency II Matching Adjustment increases the effective loan-to-value ratio by
allowing insurers to bring forward a portion of the expected income on the loan into current capital.
The Matching Adjustment allows an insurer to reduce the value of long-term liabilities, such as annuities, by
discounting them using a spread in excess of risk-free rates. The idea is that if long-term liabilities are fully
matched by long-term assets, the Matching Adjustment captures the excess market returns in relation to
risks to which such a buy-and-hold investor is not exposed. It is calculated as the remainder after subtracting
two components of the market yield on an asset: first, the equivalent risk-free rate; and second, the so-called
Fundamental Spread, which is mapped from the credit rating of the borrower and used as a proxy for risk.
desirable effect of the Matching Adjustment is to insulate an insurer's capital position from volatility in
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market prices. In its November Financial Stability Report4, the Financial Policy Committee concluded that
the Matching Adjustment reduces potential instability across the financial system. Another effect is to bring
forward part of the future yield on an insurer's assets into current capital. A bigger Matching Adjustment
therefore improves an insurer's return on Solvency II capital.
4
http://www.bankofengland.co.uk/publications/Pages/fsr/2016/nov.aspx
II, Matching Adjustment assets need to be "bonds or other assets with similar cash flow
Under Solvency
characteristics"5. They also need to have cash flows that are "fixed and cannot be changed by the issuers of
the assets or any third party". UK insurers can
restructure assets through internal securitisations in order to
produce senior tranches that meet the Solvency II tests for the Matching Adjustment. A material amount of
illiquid direct investments by annuity writers have been transformed in this way. The Matching Adjustment
benefit is capped at the level of BBB-rated assets. Insurers are therefore targeting a Matching Adjustment
in order to maximise the return on Solvency II capital. Market contacts have described to us an
'sweet-spot'
excess of funding for infrastructure projects near that sweet spot.
Given the potential impact on an insurer's capital position, we are taking a close supervisory interest in this
area. First, we will consider whether insurers are taking an appropriate Matching Adjustment in calculating
their base balance sheets. Put another way, the Fundamental Spread must fully reflect the risks the insurer
has retained. Restructured direct investments typically have neither market prices nor external ratings. An
appropriate Matching Adjustment therefore depends on an insurer's own valuations and internal ratings. We
will verify that internal ratings capture the full range of risks. They should not have a persistent bias
compared to those from regulated External Credit Assessment Institutions (ECAIs). Yesterday we published
Supervisory Statement 3/176. It sets out how we will seek to obtain assurance on the exposures which
present the greatest risk to our objectives. It also explains how we may use independent reviews to obtain
on insurers' internal ratings of those assets.
an opinion
Second, we will review whether insurers have the appropriate governance and risk management to make
and hold illiquid, direct investments. This includes expertise across all three lines of defence. For example,
where internal ratings reflect in part what actions the insurer would take to recover value if the asset became
distressed, that insurer should have appropriate credit work-out capabilities.
Third, we will consider whether insurers' capital requirements properly reflect the risks to which they are
exposed when holding illiquid direct investments in a Matching Adjustment portfolio. In particular, Solvency II
internal models should capture effectively all the risks in a 1-in-200 stress. We are currently doing thematic
work on 'the Matching Adjustment in stress' that will influence our future thinking in this area.
Risk concentrations
A broader concern is that the search for yield on Solvency II capital could lead insurers to take excessively
concentrated risks. In general insurance, we are currently running a stress test designed to identify
concentrations of exposure to a number of possible natural and man-made catastrophes. Perhaps more
worrying is the potential for hidden concentrations. More than 25 years after asbestos-related claims
contributed to the near collapse of the Lloyd's of London market, insurers continue to face related losses.
5
http://www.bankofengland.co.uk/pra/Documents/solvency2/matchingadjustmentletteroct2014.pdf
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http://www.bankofengland.co.uk/pra/Pages/publications/ss/2017/ss317.aspx
A peril with potential for hidden exposures is cyber7. Sizing cyber exposures across the industry is therefore
difficult. But it is clear that the risk is growing. To give one estimate, the Lloyd's Business Blackout scenario
- -
analysing the implications of a cyber attack on the US power grid puts global insurance losses to
$US40bn.
Yesterday we published a supervisory statement setting out our expectations for the prudent management of
or 'silent' exposures, where the
cyber underwriting risks8. It distinguishes affirmative from non-affirmative
insurer has not explicitly included (or excluded) cover. We expect insurers to take steps to bring
non-affirmative exposures within risk appetites agreed by their boards. Possible ways of achieving this
include: introducing robust wording exclusions, offering explicit cover with additional premium and attaching
specific limits to cover. Finally, we have also been considering how we might respond to a large loss
affecting many insurers that could change market conditions. We have worked closely with the industry and
Lloyd's over the past few months
following our consultation last year.
Turning to life insurance, a potential concern is that the shift towards direct investments might in future lead
business, UK insurers'
to a concentration of exposure to UK property. Excluding unit-linked property-related
exposures grew significantly over the course of 20169 to stand at 11% of non-linked assets. The most rapid
growth has been in mortgages and loans secured on property, particularly equity release mortgages. Our
analysis of insurers' equity release exposures suggests that a stress roughly aligned to the FPC's banking
system stress test (a 30% fall in house prices and 0-0.5% growth per annum thereafter) could lead to
industry-wide losses of £2-3 billion (see table and chart below).
The Prudent Person Principle in Solvency II is an important safeguard against concentration risk10. It
requires insurers to invest only in assets whose risks they can "properly identify, measure, monitor, manage,
control and report". Moreover, assets must be "properly diversified" so as "to avoid excessive reliance on
any particular asset, issuer or group of undertakings or geographical area and excessive accumulation of risk
in the portfolio as a whole". Assets not admitted to trading on a regulated financial market are
required to be
kept to "prudent" levels. The illiquid direct investments I described earlier would typically fall into this
category. Later this year, we plan to set out in a supervisory statement our expectations of how UK insurers
should invest their assets in accordance with the Prudent Person Principle.
7
These include losses as a result of both malicious acts (eg cyber attack, infection of an IT system with malicious code) and
non-malicious acts (eg loss of data, accidental acts or omissions); and involving both tangible and intangible assets.
8
http://www.bankofengland.co.uk/pra/Pages/publications/ss/2017/ss417.aspx
9
From around £84 billion to nearly £99 billion. Data are taken from Solvency II returns. They include direct property holdings, loans
and mortgages secured on commercial and residential property and real estate investment funds. Some of the change may be due to
reclassification of reporting by insurers.
10
Source: Article 132 of the Solvency II Directive https://eiopa.europa.eu/regulation-supervision/insurance/solvency-ii
Conclusion
In conclusion, the search for yield on Solvency II capital is changing insurer behaviour. In response we are
spending more time understanding how risks are changing, including through more in-depth supervisory
reviews. Our approach to supervision remains forward looking and judgment based. We will use all the
supervisory tools available to us to ensure that UK insurers are adequately capitalised and managing their
risks prudently.
8
All speeches are available online at www.bankofengland.co.uk/speeches
Speed of recovery Discount assumption £ billion
in house prices
12
Undiscounted
0% p.a.
Risk-free rate
1% p.a.
10
Risk-free rate
2% p.a.
+ 100bps
8
Faster recovery
in house prices
6
4
2
0
25 30 35 40 45 50
Initial house price fall (per cent)
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All speeches are available online at www.bankofengland.co.uk/speeches