Clifford Chance

The Bank of England (BoE) raised interest rates by 75 basis points to 3% at the beginning of this month, the biggest increase in 33 years. The BoE provided unusually direct guidance on the UK's economic prospects in the press conference that followed, stating that the outlook was "very challenging" and that additional interest rate hikes might be required for inflation to sustainably return to the target 2%. The BoE also noted that market forecasts for November's interest rate peak were excessive. While the BoE's forecast assessment may have been meant to reassure the UK housing market, the pound fell immediately because of the warnings of recession that accompanied the BoE's announcement. UK bonds and stocks on the London Stock Exchange also suffered, with listed UK insurers among the most affected.

LDI strategies

The Prudential Regulation Authority (PRA) is particularly interested in how interest rates affect an insurer's balance sheet. This is because an insurer's profitability and solvency fluctuate along with changes in interest rates, with variations mostly caused by the sizable amounts of interest-sensitive assets, such as bonds, that insurers hold. Given the uproar that the mini budget produced just a few weeks ago, the BoE's statement had a much smaller effect on the financial market than it might have had. The market instability that followed was mostly linked to an increase in interest rates on long-term UK government bonds and the effects that this had on the leveraged liability-driven investment (LDI) strategies utilised by UK defined benefit (DB) pension plans.

Like pension funds, life insurers use LDI strategies to back their annuity business. The rise in gilt yields caused a significant fall in the net asset value of leveraged LDI funds, which then raised short-term liquidity issues for investors, like UK DB pension funds. Margin calls were made on investors, who then struggled to sell gilts in time to enable them to post more collateral to support the LDI strategies.

UK insurers were not as exposed to these margin calls as pension funds. Stricter Solvency II regulation, including the requirement to comply with the Prudent Person Principle, resulted in more modest exposure, with life insurers more likely to have hedged their positions with physical financial instruments, than with derivatives. Asset liability matching, as required under the Solvency II Matching Adjustment, as well as increased oversight by the PRA also played its part. The PRA has worked closely with life insurers on their liquidity risk management capabilities in the past few years. For example, the PRA have required insurers to put in place more rigorous liquidity stress testing, which the Pensions Regulator does not require of pensions funds.

Solvency II reform

Government efforts to reform Solvency II for the life sector may have been hindered by rising interest rates and the LDI issue. One of the aims of the reform was to make more capital available to invest in infrastructure and green initiatives but recent market events have led to insurers having less capital available. Similar concerns were seen in HM Treasury's response to the last Solvency II consultation published last week, where respondents indicated that the current interest rate increase as well as historic Transitional Measures on Technical Provisions would temper the capital release that would result from a reduction in risk margin of 60–70 percent.

The Treasury's ambitious plans to reform the fundamental spread also appear to have also been derailed by recent events, with the government confirming that the design and calibration of the fundamental spread will remain as it is today. This might result in less erratic annuity prices and, in the end, more predictable income for UK pensioners. The government has also decided that the eligibility criteria for the matching adjustment should be widened to include assets with highly predictable cashflows, subject to several safeguards that the PRA will put in place. This change was welcomed by the Association of British Insurers (ABI) who said that industry would now be able to invest in a wider array of assets.

Call-in power

The confirmation of Solvency II reforms follows reports of internal differences between the Treasury and the PRA, with PRA worrying that some reforms might adversely affect policyholders. Tensions between the UK regulators and the Treasury have persisted since the announcement of a new secondary international competitiveness objective but have been exacerbated after the government made clear its support for a "call-in" power, which would allow the Treasury to order the UK regulators to make, amend, or repeal rules in situations where there are significant public interest considerations.

Sam Woods, the CEO of the PRA, and Nikhil Rathi, the CEO of the FCA both expressed concerns about the effect of the call-in power on regulatory independence. After having initially announced a delay in the introduction of this power and much to the relief of the UK regulators, the government announced on 23 November that it would no longer be proceeding with this power.

General insurance sector

General insurers too are impacted by increasing inflation – in times of rising costs and uncertainty, they may reduce or stop offering insurance. Reduced market capacity can result in less competition, higher rates, and higher renewal costs, to the detriment of policyholders.

Inflation will impact on all claims expenses, making underwriting less profitable. This can particularly impact long tail liability business, where long term reserves may need to be significantly increased to reflect increasing inflation.

Outlook

The outlook for the UK insurance sector remains mixed. With household incomes expected to fall further, spending on non-essential goods and services will be weaker, and people will be increasingly tempted to self-insure. Instability in the housing market will also have a negative impact on insurers' balance sheets, as will a decline in bond prices.

Due to the recent crisis, there may be a considerable decrease in demand for LDI solutions, with pension scheme liabilities more likely to be transferred to insurers. The bulk annuity pipeline is likely to remain active.

Should solvency issues arise, then insurers have several options, including raising additional capital, either through equity or qualifying debt (as we have recently seen Beazley do, raising £350m in equity), the use of ancillary own fund items or reinsurance solutions which provide capital relief or other capital efficiency benefits.