Reforming European Union insurance rules to free up billions of pounds of capital is a key part of the UK government’s program to boost the economy. The market turmoil triggered by the mini-budget could make such ambitions harder to achieve.
The combination of rising interest rates and jitters triggered by the near explosion of liability-driven pension funds could undermine government efforts to roll back European-era Solvency II rules, making more difficult to achieve its growth objectives, according to several financial and regulatory experts.
There could be “small tweaks” to Solvency II, but the scope will likely be limited, according to Huw van Steenis, a former adviser to Mark Carney when he was governor of the Bank of England. “More of a moan than Big Bang 2.0,” van Steenis said. Two other regulatory experts who did not want to be identified discussing government policy agreed that pressure to loosen insurance regulation may have been weakened by market turmoil.
The Treasury said it would go ahead.
“We are absolutely committed to making reforms to Solvency II which could unlock tens of billions of pounds of investment in UK infrastructure over the long term,” a government spokesman said. Kwarteng said he would announce “an ambitious set of regulatory reforms” this fall to achieve a growth target of 2.5%.
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Even if the changes are imposed, higher interest rates could anyway dilute the expected benefits of the Solvency II reform. Such an environment reduces the amount of capital that can be freed up and reduces the relative attractiveness of the returns offered by infrastructure projects, which the government hoped would be the main destination of the funds freed up.
A technocratic regulation introduced in 2016 to harmonize insurance rules for 28 countries, Solvency II has become a top target in Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng’s campaign to cut red tape and create a Brexit dividend.
While there is broad support in the financial community and across political parties for a Solvency II reform tailored to UK businesses and to unlock capital for investment in areas such as infrastructure and climate transition, there is also had warnings that deregulation could increase risks.
The Prudential Regulation Authority, the branch of the Bank of England responsible for the soundness of the financial system, supports changes to part of the Solvency II regime. But he wants tougher, not lighter, standards for the so-called equalizing adjustment, which balances long-term assets with liabilities in the form of promises to pay pensions to policyholders until they die.
The PRA did not comment.
The scare of pension funds
The distress of liability-focused pension fund investments, which was triggered by falling gilt prices forcing the Bank of England to announce a £65bn ($74.2bn) program to support the market, has focused minds on the risks of situations where financial firms become forced sellers of relatively illiquid assets, van Steenis said.
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That likely reinforced the PRA’s caution about allowing insurers to invest in a wider range of assets, he said.
“The government-signed Solvency II reform to ‘free up tens of billions’ to green infrastructure is extremely unlikely after last week,” said van Steenis, co-chair of the World Economic Forum’s financial services board. The BOE will be encouraged to maintain corresponding adjustments for “illiquid infrastructure” and insurers “will also act cautiously” following the market disruption, he said.
Still, there are several differences between LDI’s problems and insurers, analysts said, including the large amounts of liquid assets insurers operate with.
The current interest rate environment could also mitigate the impact of the Solvency II reform. Rising rates reduce the amount of capital insurers will be able to free up due to the way their risk margin is calculated. The PRA said in July that the Solvency II reforms could generate £45-90bn from insurers’ capital to invest in the economy, which would be lower in a high rate environment.
Another factor is improving yields on corporate bonds and other assets, which may make insurance companies and pension funds less inclined to channel funds into infrastructure investments, further undermining plans. of the government. “I think as yields rise, pension fund managers are likely to feel less enthusiastic about investing in alternative assets like infrastructure projects,” said Kevin Ryan, analyst at insurance at Bloomberg Intelligence.
Many in the City of London expect the Treasury to add more on Solvency II to its Financial Services and Markets Bill, its framework for post-Brexit rules for banks, insurers and asset managers. ‘assets. But the government’s sweeping plans to deregulate the City of London may be more difficult to achieve since Kwarteng’s speech.
“It’s a big problem we face now over the government’s proposals for Big Bang 2,” said Richard Portes, professor of economics at London Business School. “The events of the past week suggest that financial markets are fragile and that you are deregulating with some risk.”
Photograph: A commuter walks past the Bank of England in the City of London, UK, Monday October 3, 2022. The pound posted a two-day gain and UK government bonds fell as the Prime Minister Liz Truss was defending her package of sweeping tax cuts. , stoking investor concerns about the country’s fiscal credibility. Photo credit: Carlos Jasso/Bloomberg
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