The realities of Brexit for UK insurers

Published in: Risk, Risk management, Corporate strategy, Capital management, Financial results, Regulation, Solvency II, Investment, Investment risk - strategy, UK, Brexit

Companies: Standard & Poor's, Moody's, Scottish Widows, Legal & General, Royal London, Standard Life, Aviva, Prudential, OAC, Llloyd's, PwC, KPMG

Market volatility should erode capital ratios, the possible loss of passporting rights may force restructuring and relocation – and regulation could well be tightened. Hugo Coelho reports

Britain's decision to leave the EU has dramatic implications for the financial sector, not least for the insurance industry. At this moment, it is difficult to find the positives.

In the short term, market volatility will hit insurers' solvency ratios. Uncertainty is higher about the medium- and long-term consequences, as they depend on the outcome of discussions with the EU.

The loss of passporting rights would force insurers to restructure, especially in the London market, and could prompt foreign companies to relocate to continental Europe.

As far as regulation is concerned, few believe that the rules facing the industry would be eased. Solvency II, in particular, is here to stay. If anything, UK regulators are expected to tighten up its requirements.

Volatility to hurt capital ratios

The FTSE 100 index tumbled more than 8% within the first minutes of trading on Friday morning. The yields on the benchmark 10-year UK government bond fell by 35 basis points, despite rating agency Standard & Poor's warning that the UK is likely to lose its AAA-rating.

Collapsing equity markets and widening credit spreads will reduce the value of insurers' assets, and bring down capital ratios. According to Moody's, the most affected groups should be UK domestic life insurers, as a result of their high asset leverage and their exposure to UK investments, given their policy to match sterling-denominated liabilities with sterling-denominated assets.

The equity and bond market moves are not all that extreme, compared to the stress tests that insurers' routinely perform

"In our rated cohort, some of the most exposed groups are Scottish Widows, Legal & General, Royal London and Standard Life," the rating agency said in a report published last week. "Aviva, the largest UK life insurer, and Prudential are also exposed, but to a lesser extent thanks to their more geographically diverse business, which means that a meaningful portion of their assets are invested outside the UK."

As of 11.00 BST, the insurers suffering the worst hits to their share price were Aviva and Legal & General (both down by around 16% on the previous day's close).

Actuarial consultancy OAC said the equity and bond market moves are not all that extreme, compared to the stress tests that insurers' routinely perform, and advised firms to "ride through" the short-term volatility and think carefully before making fundamental change in asset positions.

Passporting rights at risk

EU legislation gives insurers in a member state the ability to carry out business and sell services throughout the bloc without obtaining a licence in each individual country. This concept is known as passporting. If the UK does not retain its membership of the European Economic Area, insurers would lose passporting rights, and would be required to set up a subsidiary in the EU.

This would be painful, especially for the Lloyd's and London market and general insurance market, which make extensive use of it, explains Jonathan Howe, UK insurance leader at PwC. "The loss of these rights could see insurers being forced to restructure and facing large operational, regulatory and tax costs as they adapt to such a change," he says.

Howe adds there is a risk that US and Asian insurers that currently use the UK as their European headquarters and as a gateway into Europe will consider relocating.

Regulatory burden increased

Brexit supporters have repeatedly blamed the EU for saddling the financial industry with cumbersome regulations. Yet, leaving the bloc is unlikely to bring much relief to the industry.

Experts point to the massive costs of implementation to argue that the much-criticised Solvency II regime is here to stay. The scope for tinkering with the rules is limited even if Britain becomes a third country, as that would undermine its chances of securing equivalence status. Furthermore, UK regulators have a history of gold plating insurance regulation, so if anything the Prudential Regulation Authority (PRA) is likely to use any flexibility to tighten up the current rules.

"The loss of these rights could see insurers being forced to restructure and facing large operational, regulatory and tax costs" Jonathan Howe, PwC

Janine Hawes, director at KPMG's European insurance regulatory centre of excellence, in an interview with InsuranceERM in March, warned that a departure from the Solvency II regime might result in higher capital requirements for insurers. "You could have the PRA moving back to a world of giving extra capital buffers," Hawes said, adding that the supervisor could adopt principles similar to the ones applied under the previous individual capital assessment regime." (IERM, 1 March, PRA handcuffed by equivalence in brexit scenario)

Hugo Coelho