Andrew Bailey: Reforming Solvency II - delivering policyholder
protection
Speech by Mr Andrew Bailey, Governor of the Bank of England, at the Institute and Faculty of
Actuaries, London, 1 December 2021.
* * *
It's a great pleasure to be here today. For me, it's a pleasure to be able to speak in person in the
room as it were. I am going to speak today about financial regulation post-Brexit, and especially
Solvency II.
For five and a half years, I have prefaced speeches by saying that as a public official I take no
position on the substance of Brexit. To be clear, I'm not changing my position. It has happened,
and we must get on with building the new world. The past is important for understanding where
we are and should go to, but we don't live in it.
That is not, however, to deny that some things act as what I would call timeless anchors. One
such thing is that we intervene in private markets only where there is a sufficiently strong public
interest case for doing so. Regulation therefore must be anchored in public interest objectives.
There are, of course, many potential such objectives. Moreover, we should expect that the public
interest will be advanced as an argument for offical action in a wide variety of contexts, some
stronger than others in terms of the public interest. I will come back to the point of relative
strength of public interest arguments.
Leaving the European Union provides an opportunity to review the framework of financial
services regulation. Prior to leaving, the body of EU law and regulations was transferred into the
UK - or "on-shored" to use the more technical phrase. In other words, it was shipped over and
copied out with little change, a necessity in view of the time available for the task. But, we can't
leave this position unchanged. There are at least two reasons for this in my view.
First, public policy must be dynamic, in the sense that it must change and adapt to the world
at large, which is itself constantly changing. Covid is a good example of the need for change
in many areas. Public policy has, of necessity, had to adapt to a world in which a global
pandemic is a reality. I would emphasise this point in the post-Brexit world, because the
meaning of the UK-EU equivalence of regulation cannot for either party mean unchanging
regulation. Indeed the EU has itself set about making changes to Solvency II.
The second reason that makes a position of no change in regulation post-Brexit unrealistic is
that it is not a matter of controversy to say that rules designed to straddle a union of 28
countries may not be optimally suited to any one country. Solvency II is an omnibus type
regulation which seeks to cover many different national markets in which the product mix is
different. UK life insurance is a good case in point. It is quite heavility annuity focused in
terms of products. But that is not the case in many EU markets.
This might sound like a recipe for a free-for-all, in fact it is anything but that. The public interest
objectives across countries have a lot in common, even where the products used do not. In the
case of insurance, the essential public policy objectives for prudential regulation are the safety
and soundness of insurers, and the protection of policyholders. These are the bedrock of public
policy in terms of prudential insurance regulation. However, two further important points need to
be made here. First, stating the objective doesn't tell us how much or what levels of safety and
soundness and policyholder protection should be delivered, in what form and how. Nor does it
preclude other secondary or subordinate objectives which also meet a suitable public interest
test.
With an audience of actuaries, I am going to develop the theme of how much protection should
society expect. Let's wind the clock back to 1862 for a moment. Arthur Bailey - not a relative as
far as I am aware - who would go on to become the President of the then Institute of Actuaries
published the first actuarial paper on asset-liability management and investment strategy,
pioneering the idea that insurers should be able to benefit from an illiquidity premium on
nonmarketable assets. His paper described the "security of the capital" as the first "consideration" to
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guide a life insurer's investments.
If Arthur Bailey started to lay the foundations for the concepts of protection for policyholders and
thus safety and soundness of insurers, a lot of the substance has had to be filled in since then,
and the answers to the questions of how much protection continue to be debated.
In one sense, the answer is at least conceptually simple, although anything but so in practice.
Society should choose a level of protection guided by the distribution of outturns in history, and
set the capital and thus protection accordingly. Let's call that the ability to withstand a 1 in X
event, where X is a means of calibrating a probability distribution of outcomes based on history.
We can then decide where X should be set, and thus how far into the tail of the distribution of
outcomes we want to set the level of protection.
So far so good you might say, although I'm probably chancing my arm as a non-actuary. But,
here goes. The world doesn't quite look as simple. Let me take a very recent example namely the
UK economy last year. In GDP terms, on the current data, we had a 1 in 100 event least year.
Just to explain the context a bit: last spring, we were predicting the largest fall in UK GDP since
1706 - I'm going to leave aside the measurement challenge of the 18th century GDP data and
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stick to the one estimate we have. That would have made it a 1 in 300 event. Today, we think it
was the largest fall in GDP since 1921, which is what makes it a 1 in 100 event. But look at falls
in household income, unemployment or credit losses. These were much more benign, with
changes which were smaller and shorter lasting than we observed during the financial crisis
which was just a little over ten years ago.
I draw two important conclusions from this experience. First, even on the published data, the
answer to the question of how much policyholder protection is not straightforward. Second, let's
dig under the surface of these data for a moment. Why was one set of measures more benign
than another? One reason is Government intervention - the furlough and loan guarantee
schemes for businesses for instance.
But, can we assume that a pandemic will always be associated with substantial public
intervention? Moreover, government interventions in crises are often only temporary - a bridge
that allows more time for permanent policy responses. I'm not going to offer a view on this one,
beyond saying that a prudential regulator may not take it as a given because no government can
bind its successors. But I can imagine some voices saying that we should assume that outcome
because we have one case at least where it happened.
I use this digression to illustrate an important point. Public policy objectives like safety and
soundness and policyholder protection are the bedrock of prudential insurance regulation. But
let's not assume that the answers to the question of how much of it should we have are obvious.
That said, I cannot emphasise enough that we must come up with well considered answers to
the question of how much protection, in order to allow prudential regulation to do its job
effectively.
I mentioned earlier that there are likely to be multiple public interest objectives to take into
consideration in a regime such as insurance. Moreover, they will have different degrees of
relative importance. Put like that, I would suggest the statement is uncontentious. As I will come
to, this is not the case in the real world, as Solvency II illustrates.
To illustrate this state, let me briefly summarise the PRA's objectives as set out in the most
recent so-called remit letter sent to me by the Chancellor earlier this year - such a letter must be
sent at least once each Parliament. The purpose of the letter is to make recommendations to the
Prudential Regulation Committee (the governing committee for the PRA) about aspects of the
economic policy of the government to which the PRC should have regard when considering how
to advance the objectives of the PRA.
The legislation specifies a simple general objective for the PRA, covering banks and insurers, for
promoting the safety and soundness of the firms it regulates, through ensuring that firms avoid
adverse impacts on the stability of the UK financial system. There is an additional insurance
objective of contributing to the securing of an appropriate degree of protection for those who are
or may become policyholders. These are the so-called primary objectives, they take pole
position.
There is a secondary competition objective - for insurers and banks alike - which requires the
PRA when discharging its so-called general functions (think of that as making policy) to act as far
as reasonably possible in a way which facilitates effective competition in the markets for services
provided by regulated firms.
Next, the PRA must have regard to the so-called regulatory principles set out in the legislation.
These tell the regulator to use its resources efficiently and effectively; impose burdens which are
proportionate to the benefits; that sustainable growth in the UK economy is desirable; that
consumers should take responsibility for their decisions; that there is a responsibility of senior
management of regulated firms to comply with regulatory requirements; that the regulator should
recognise differences in the nature of regulated firms, notably mutuals; and that the regulator
should act transparently including when it takes formal regulatory action.
That's enough you might say. Not quite. The Treasury can also make recommendations about
aspects of current economic policy to which the PRA should have regard when doing its job. As
set out in the letter this March, government economic policy is to achieve strong, sustainable and
balanced growth, and the PRA should have regard to see more competition in the economy; to
ensure financial services make a positive contribution to levelling up the country and supporting
sustainable economic growth in the UK; that the UK remains an attractive domicile for
internationally active financial institutions, and that London retains its position as the leading
international financial centre and hub for green finance; to see innovation in the financial services
sector and how this can support the wider economy; to encourage trade and inward investment
to the UK that can help to boost productivity and growth across the economy; to see financial
services work in the best interests of the consumers and businesses they serve; and to deliver a
financial system which supports and enables a net-zero economy by mobilising private finance
towards sustainable and resilient growth, resilient to the physical and transition risks that climate
change presents.
Simple then. And, I should be clear that what I have just set-out is the current regime not the one
that might emerge from the post-Brexit regulatory reform process, though to be very clear there
is no suggestion that the basic structure of what I have just described will change.
Let me draw out two important points from all of this for the reform of Solvency II.
First, achieving only the primary objectives requires multiple elements to the regime, and a
careful balance of these elements which takes into account how they interact. Solvency II is
a particularly complex example of this need for multiple elements, as I will come on to.
Second, balancing the various elements of the objectives and remit can give rise to intense
discussion and strong opinions. Reforming Solvency II illustrates this well. I don't think it is
out of order to say that today's Solvency II is far from perfect in form, and the desire for
harmonisation across the EU (in order to support the deepening of the Single Market) meant
that it took the form of a maximum harmonising regulation with a high degree of prescription
in the rules and little flexibility to apply judgement when supervising firms. A more flexible
approach may help to balance the elements of the objectives, but let's be under no illusion
that it can also lead to apparent tensions, for instance between policyholder protection and
insurers playing their important part as investors in the economy, particularly for less liquid
longer-term assets such as infrastructure.
I said that these tensions are apparent, because I am not sure they are real, or at least whether
they should be. The structure and hierarchy of the objectives is clear. Within that, we need to
calibrate the appropriate tolerance of risk and thus our approach to safety and soundness, and
policyholder protection. Moreover, for a number of reasons it is also not always obvious that
weakening policyholder protection would in any case increase productive investment in practice
- to give one example, insurers may transform existing assets rather than create new
investments. And, we need to consider how these objectives interact with the important societal
objectives - as set out in government policies - of sustainable growth, climate transition etc.
I will give two high-level examples here. First achieving stronger and more sustainable growth in
the economy will enhance the primary objectives of safety and soundness and policyholder
protection. Second, achieving the transition to net zero through financing the green transition will
likewise enhance the primary objectives. But, this must all be done in a transparent way which
enhances the public interest of the primary objectives. Policies that seek to enhance sustainable
growth and transition to net zero by compromising the policyholder objective are not within the
scope of the clear hierarchy of objectives that I set out earlier. So, please don't be surprised that
at the Bank and the PRA we pull the debate back to the anchors of the primary objectives. That
is, after all, our job. That said, I am an optimist - I think we can reform the rules if there is a
genuinely open engagement and spirit which respects the regulatory objectives and is
transparent in how this is done.
Before I finish, I want to say something about what this means for the reform of Solvency II. What
is the debate really about here? Wet towels are being handed out now.
There are two particularly material items under review - the Risk Margin and the Matching
Adjustment. By, the way, to those of you who don't regard Solvency II as your special subject, it
has a language all of its own.
The Risk Margin is part of the balance-sheet value of a firms insurance liabilities. It is added to
the best estimate of those liabilities to ensure that in total they equal an estimate of "transfer
value" - the amount that a firm would need to pay a third party to take over its insurance
obligations. Think of this as equivalent to the process currently going on in the energy supply
markets in the UK, except that where financial products are concerned it is harder to value the
transfer, hence the need for a margin to take account of risk.
The current calibration of the Risk Margin is too sensitive to interest rates, and in particular is too
high when rates are low. The case for reducing it is well made, though I should caution that doing
so has elements of both art and science to it, in other words there isn't an unambiguous answer.
The Matching Adjustment is an addition to the discount rate for certain long-term illiquid
insurance liabilities, where these are closely cash-flow matched by a pool of eligible assets. It
allows insurers to recognise upfront as-yet unrealised returns on these assets, effectively
bringing forward the recognition of profit that would otherwise only emerge over time. This
illustrates the point that insurers have an inverted production cycle, meaning that they collect
premiums up-front for services that are provided over years to come. This comes with a number
of risks. The insurer might under-estimate the cost of these future services, and so-under
reserve for them. It might not invest policyholder premiums as prudently as it ought to. Or, it
might under-price the risk of the policy. There is little that policyholders can do to protect
themselves from these market failures.
The Matching Adjustment is relevant here because it reduces the value of the liabilities on the
balance sheet, and smooths balance sheet volatility that would otherwise arise mechanically as
spreads on the matching assets move.
The Matching Adjustment is a significant benefit for annuity writers, and as such Solvency II has
rules to govern its use. The primary purpose of these rules is to ensure that the firm's expected
asset and liability cash flows are matched and that the liquidity risk arising from forced asset
sales is therefore greatly reduced. The critical assumption here is how the spread on an asset
decomposes between:
1. an allowance for illiquidity, which buy-to hold investors might reasonably be expected to
earn, and so are permitted to capitalise upfront (the Matching Adjustment) and
2. an allowance for other risks such as credit risk, to which all investors, including well-
matched long-term investors, are subject (the Fundamental Spread). There are a wide
range of views on this decomposition - it has elements of art and science.
There is a concern that Solvency II as a negotiated compromise has created risks to our primary
objectives. The Fundamental Spread does not include explicit allowance for uncertainty around
defaults and downgrades, and appears low compared with ranges implied by academic literature
for the credit risk portion of spreads. Second, the Fundamental Spread is not sensitive to
changes in credit market conditions and changes little as spreads change over time. This means
that any increase in spreads not accompanied by a downgrade is assumed to be entirely due to
increased illiquidity of the assets, and therefore taken credit for as Matching Adjustment. Finally,
the Fundamental Spread is not sensitive to risk and spread across asset classes, and thus
assets that have the same rating but higher spreads will attract a higher Matching Adjustment
despite what can appear to be a higher level of credit risk. This creates a risk of adverse
selection based around the regulatory rules.
The task is to come to a landing zone for both the Risk Margin and the Matching
Adjustment/Fundamental Spread. I can assure you that the PRA is working intensely on these
issues, as are HM Treasury, which has the rule making power transferred from the EU until the
regulatory reform legislation is passed and comes into effect. To be clear, we will work, engaging
with the industry, to come up with solutions which respect the statutory objectives. This is
crucial. At the same time we are working on a range of other reforms in order to promote other
aspects of the public interest - in particular reforms to remove unnecessary bureaucracy from
the regime and to widen the sorts of assets which can benefit from the Matching Adjustment.
Conclusion
Regulation must be based on an identified public interest or interests which the market acting on
its own cannot be relied upon to satisfy. Any debate on or change to regulation must be anchored
in the public interest, something that can sometimes get out of sight. Where there are multiple
public interests involved it is important to identify and then respect the hierarchy of such
interests. In other words, some of them are most important. This is true for prudential insurance
regulation. The UK regime, as set out by the FSMA legislation, has done a good job of enabling
that hierarchy of public interests to be identified.
Regulation does not stand still, if for no other reason than that the world around us does not
stand still. A mistake of some of the rhetoric in the EU equivalence debate is to presume that the
world does stand still (if that is not the assumption, then the only other possible explanation is a
belief in rule taking, about which I am not going to say more today beyond repeating what I have
said before, that it is a non-starter). Reforming Solvency II is sensible because the world moves
on, and because it was never well suited to some aspects of the UK market. There are important
issues to be resolved in doing so, which must be tackled within the public interest framework.
Finally, I have not spent time today on another critique of Solvency II, namely that it is
cumbersome and therefore slow moving in practice, combined with the operational costs
involved. I think we can all agree that sorting this out should be a common objective.
Thank you.I am grateful to Francesca D'Urzo, Manuel Sales, Sadia Arif, Dean Minot, Karen Jude,
Vicky Saporta, Alan Sheppard, Anna Sweeney, Sam Woods, Charlotte Gerken, Cassandra
Archer, Gareth Truran, Dan Georgescu, Anthony Brown, Ruth Hendon, David Humphry and Ali
Moussavi for their assistance in helping me prepare these remarks.
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On the Principles on which the Funds of Life Assurance Societies should be Invested. By Arthur Hutcheson
BaileyOpens in a new window
2
Broadberry, Stephen, Bruce M.S. Campbell, Alexander Klein, Mark Overton and Bas van Leeuwen (2015), British
Economic Growth, 1270-1870, Cambridge: Cambridge University Press