How insurers are navigating persistent market volatility and Solvency II
The arrival of the Solvency II regulatory regime in Europe on 1 January 2016 triggered a paradigm shift in asset allocations among Europe’s insurance firms. This trend is gaining traction as the industry grapples with an uncertain market, while navigating changing financial regulations in the UK and Continental Europe.
It is 18 months since we published our awardwinning European Insurance Survey, based on interviews with chief investment officers and chief risk officers of leading insurers across the UK and the Continent. The key themes we identified have continued to resonate. These are:
- Historically low interest rates
- Expectations of large strategic asset allocation shifts as a consequence
- Solvency II places limits on the design of investment portfolios
- An expectation that insurers would outsource more assets to third-party asset managers
- Traditional insurance business models are under extreme pressure and in decline.
The changes that we have observed continue to hold true. Our forthcoming Asia Pacific Insurance Survey will identify the key themes that chief investment officers and chief risk officers in the region told us are front of mind for them at present.
Historically low interest rates remain
The challenge of low interest rates remains in place. Although we have seen some slight increases in bond yields across many markets, the fundamental problem remains that interest rates are at levels where insurers find it difficult to generate sufficient investment returns to support their business models – and to generate meaningful returns for their customers.
Even as economic developments in the US and the UK offer hope of higher growth – and so higher investment returns – this has yet to materialise in any meaningful way. In fact, we expect low interest rates will persist globally.
Political uncertainty across Europe has heightened market volatility, increasing the challenges of managing market-consistent balance sheets (valuing both assets and liabilities at market values).
Asset allocation and outsourcing
We have seen four key themes emerge on asset allocation that are consistent with the conclusions of our European survey.
- Increasing risk appetite – most notably, taking on more credit risk. However, these allocations are often constrained by new risk-sensitive solvency regimes that require additional capital to back risk exposures.
- Use of diversification to manage explicitly risk through the use of new asset classes or strategies, such as modern approaches to multi-asset investment.
- A rotation from public to private market assets as insurers attempt to increase returns using the illiquidity premium. However, this rotation is being hampered by the limited supply of appropriate investments. It is also constrained by the enhanced modelling requirements needed by supervisors and regulators before they will allow insurers to invest in what are relatively new asset classes for the insurance industry.
- A re-structuring of traditional asset exposures, and improvements in asset and liability management, aimed at improving capital efficiency.
Overall, insurers are trying to generate additional returns and improve capital efficiency, as had been predicted by the findings of the survey.
We have also seen evidence of insurers making further moves to outsource investment management, a trend that was identified by the survey. We have seen this in fixed income and high-yield fixed income, as well as smaller shifts in other asset classes such as infrastructure debt, absolute return and global equities.
There are definite signs of a bigger trend emerging, as insurers come to terms with the consequences of low interest rates and risksensitive solvency regimes like Solvency II. We expect that insurers will accelerate the proportion of assets that they put out to thirdparty asset managers, and specifically to those with expertise and operational capability in insurance. Often it is an asset manager’s knowledge and knowhow of insurance issues that can prove most compelling when an insurer decides to place assets with that manager.
Regulation and its impact
Solvency II was successfully implemented in January 2016. Risk-sensitive solvency regimes continue to evolve and move towards broader implementation across global insurance markets, with North America being the notable exception. The framework for a global Insurance Capital Standard1 is being mapped out by the International Association of Insurance Supervisors, and is expected to be implemented in 2020. Still, this plan is subject to great uncertainty, both in relation to the timeline and the underlying methodology.
While the new regulatory regime is in place, many European insurers are still striving hard to implement aspects of their own strategy. The scope of change is broad, including internal model approvals and subsequent change approvals, reporting, and the strategic asset allocation adjustments needed to optimise balance sheets and business models.
For example, the internal model improvements needed before supervisors and regulators will allow insurers to invest in relatively new asset classes such as infrastructure debt are ongoing. This can be a lengthy process, especially if supervisors and regulators use their full sixmonth approval window.
Moreover, Solvency II remains a moving target. The Standard Solvency Capital requirement and other aspects are currently under review by the European Insurance and Occupational Pensions Authority, and will be amended by the European Commission in 2018.
The UK market has its own specific challenges. Brexit has obviously increased regulatory uncertainty – beyond just Solvency II. For example, while there is appetite to alter (and perhaps even remove entirely) the risk margin, the UK industry does not want to go so far in amending Solvency II that equivalence of any subsequent UK regime is jeopardised – this could result in the perception of a weakened regulatory environment. British insurers are beginning to set up subsidiaries in places like Brussels and Dublin to allow them to continue operating freely in the European Union.
For the UK annuity business, the risk margin (the cost of capital for non-hedgeable risks) is a particular problem in the current low interest environment. There is now general agreement that it is inappropriately calibrated and is causing too much volatility in insurers’ balance sheet as a consequence of its design. The risk margin has had a very large and unintended impact on the UK annuity market.
We have seen some interesting themes and trends emerge in the European insurance industry in the 18 months since our survey, and as far as broader business consequences are concerned. These themes include:
- A more competitive landscape is emerging. A few smaller and less well-prepared insurers have either closed or been acquired by larger and stronger insurers.
- European insurers have been surprised by how volatile the post-Solvency II balance sheet has turned out to be in practice. They have an increasing focus on managing this volatility – and its impact on financial strength – over the planning cycle.
- We have seen insurers continuing to withdraw from offering traditional long-term guaranteed savings products. Unless interest rates increase markedly, this is expected to be the start of a much larger trend in many European and global insurance markets. Based on our experience, many insurers are examining their business models and trying to understand where their future lies.
- In the UK, we have seen many insurers withdraw from both the individual and bulk annuity markets as a consequence of the high risk margin and Solvency II capital requirements. Longevity risk transfers out of the EU and the emergence of non-EU consolidators of UK annuity businesses have also been themes.
More changes in the global insurance market are underway, driven by new technologies. For some insurers this is a challenge. For others, it provides a competitive advantage.
There has already been a huge amount of change in the European insurance industry in the 18 months since we launched our survey. We believe the pattern of change in the insurance market will continue, and may well accelerate. The shockwaves of these changes are expected to be felt beyond UK and Continental Europe, in Asia and across the world.