Turning to life insurance, a potential concern is that the shift towards direct investments might in future lead to a concentration of exposure to UK property. Excluding unit-linked business, UK insurers’ property-related 9  exposures grew significantly over the course of 2016 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 £ billion (see table and chart below). 10  The Prudent Person Principle in Solvency II is an important safeguard against concentration risk . 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.

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 6  Supervisory Statement 3/17 . 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 an opinion on insurers’ internal ratings of those assets. 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.