Aviva head on insurers grappling with complex regulation

As insurance firms face an increasing regulatory burden, expert explores the implications for their business models

Aviva head on insurers grappling with complex regulation

Insurance News

By Gabriel Olano

In recent years, insurers have faced increasingly stringent regulatory regimes, including increased capital requirements, to ensure solvency and protect clients.

According to Iain Forrester (pictured), head of insurance investment strategy at Aviva Investors, in response to these regulatory developments, insurers have re-evaluated the assets on their balance sheets. Also, in many cases, they have shifted to business models that are less capital-intensive.

“Yet while countries agreed a common international regulatory framework for banks, with the adoption of Basel III, the tightening of insurance regulations has been piecemeal,” Forrester said. “European insurers have seen the most sweeping changes following the introduction in 2016 of the European Union’s Solvency II directive.”

He noted that the rules take a risk-based approach to regulation: the riskier an insurer’s business, the more capital it requires.

“Perhaps most significantly, the shift to valuing both their assets and liabilities on a ‘mark-to-market’ basis when determining their regulatory capital position has meant the sensitivity of their assets to changes in interest rates has to be much more closely aligned with that of their liabilities,” Forrester said.

The same is happening in Asia, Forrester said, with several countries implementing, or working to implement, risk-based capital regimes similar to Solvency II. As in Europe, these actions will lead to changes in investment allocations, and drive Asian insurers to modify their product mix.

“One challenge for the industry is that it is not always clear in which direction the regulations are heading,” Forrester said. “For example, in Europe, insurers are awaiting revisions to Solvency II next year. Perhaps not surprisingly, they are putting pressure on regulators to ease back, at least in terms of the capital treatment applied to certain types of investment.”

Capital-lite environment
According to Forrester, due to the regulatory changes and low interest rates, insurers are now hesitant to offer investment-linked products with guaranteed returns. The shift to mark-to-market valuations, he said, has made it much more expensive for insurers to offer products with long-term guarantees.

Some insurers have responded by realigning their business’s mix towards more sustainable products that are more suitable for the prevailing low interest rate climate.

“For example, according to the Geneva Association, insurers are reducing their reliance on savings products with high interest-rate guarantees and replacing them with unit-linked and hybrid products with more sustainable guarantees,” Forrester said.

Others, he said, have sold off their guaranteed businesses, with various reinsurers, private equity firms, and specialist consolidation vehicles eager to snap up these insurers’ unwanted lines of business. Some examples he enumerated were Generali selling businesses to the likes to Athora and Monument Re, and Standard Life Aberdeen selling its UK and European insurance business to Phoenix.

Picking up annuities businesses is of particular interest to such investors, Forrester said. Citing a study by global consultancy firm EY, he said that UK annuities in particular offer long-term investors attractive returns relative to traditional asset classes, and these can be further enhanced by shifting longevity risk to countries with softer regulatory regimes than Europe, such as the US or Bermuda.

“Bermuda, for example, uses a scenario-based approach to asset-liability matching, which provides Bermudan insurers more investment freedom to generate returns rather than the onerous Matching Adjustment rules under Solvency II,” he said. “Furthermore, in both Bermuda and the US, insurers allocate as much as 20% of their investment portfolio to alternatives – with as much as half going to hedge funds, private equity, and other equity-like products. Given the capital implications of investing in such assets can be high, insurers in Europe overwhelmingly avoid them.”

The future of regulation
As pension schemes consolidate and compete with insurers that are taking on company pension schemes, Forrester said that there is an increasing gap in regulation between the two for what are likely to be a very similar set of assets and liabilities.

“This could be a future target of regulators,” he said. “Indeed, the Bank of England’s Prudential Regulation Authority has been calling for consistency in the rules, warning against the dangerous of unscrupulous owners and managers taking excessive risks or misusing policyholder funds.”

One attempt to resolve the variations in regulatory regimes is the global Insurance Capital Standard (ICS), developed by the International Association of Insurance Supervisors (IAIS), which measures and compares the riskiness of insurers operating in different regimes.

According to Forrester, such rules should allow firms to operate more efficiently across borders, reducing costs and bringing benefits to consumers, as well as promoting co-operation between national authorities and limiting the potential for regulatory arbitrage.

“However, it is far from clear that all countries will adhere,” he said. “For example, while US authorities accept the idea of capital being risk-based, they are far less keen on converging the way in which liabilities are valued. This reluctance could lead to a global framework that is implemented differently around the world.”

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