UK Solvency II reform must ease real estate requirements – and quickly | News
UK insurers invest in property for the long term, potentially complementing and facilitating the UK government’s efforts to level, rebuild better and achieve net zero targets. Significant investment is required in areas such as social and affordable housing and the revitalization of city centers, while accelerating the path to a sustainable investment future.
But the UK’s current Solvency II legislation – largely copied and pasted from the EU – has been criticized for preventing well-funded insurers from making these investments because of the Solvency Capital Requirement (SCR) associated with real estate investments . This week’s leveling-up white paper acknowledges that there are “large pools of idle capital across the UK that could, in principle, be used to support investments”. The standard model’s unreasonably high 25% SCR rating for real estate is one reason that helps insurers hold underutilized capital.
The UK Treasury is expected to announce for consultation earlier this year a comprehensive package of Solvency II reforms, taking into account the findings of data collection carried out by the Prudential Regulation Authority (PRA) last summer. The PRA is the branch of the Bank of England responsible for the supervision of insurance companies. In parallel, the PRA must respond to Treasury Department recommendations and review rules when the government believes it is in the public interest to do so under the Future Regulatory Review. The UK’s Solvency II reforms can ensure that the future domestic regime supports – and is tailored to – the unique characteristics of the UK insurance sector given the UK’s exit from the EU.
The UK Solvency II consultation is an opportunity. The goals of the reform understandably include protecting policyholders, but they also extend to helping insurers provide long-term capital to support economic growth. Bank of England Governor Andrew Bailey has stated that “achieving stronger and more sustainable economic growth will improve primary energy [regulatory] Objectives of safety and soundness and protection of policyholders”.
Given the current economic circumstances, a delay would be unfortunate. As pointed out in a recent report for the Pension Insurance Corporation by WPI Strategy (Investment Unleashed: How reforming Solvency II can Improve the life chances and financial security of millions of people across the UK), “reform must come sooner rather than later”. .
Solvency II reform can be dovetailed with other welcome initiatives to stimulate investment, such as those emerging from the Treasury’s UK Funds Regime Review. For example, the long-term asset fund (aimed at facilitating investment in alternative investments, particularly by DC pension funds) is now available. In addition, the Treasury has helpfully consulted another initiative: the UK Professional Investor Fund (PIF), which I have campaigned for. The PIF will facilitate institutional investment in our social infrastructure.
As part of the Solvency II reform package, the government, in cooperation with the PRA, must therefore live up to the political intent behind these other initiatives by correcting the way real estate is unfairly categorized under the current regime. In 2020, EU policymakers, via the European Insurance and Occupational Pensions Authority (EIOPA), followed up on an earlier finding without reasoning that the standard model of SCR ratings for real estate (and “look- though” principle) should be 25%.
The industry has consistently argued that this 25% SCR is too high and does not reflect the real and lower risk associated with real estate investments. For example, based on a capital risk analysis up to December 2015, MSCI stated that “the appropriate shock factors to determine solvency capital requirements for real estate need not be raised … above the 15% mark for the whole of Europe, or 12%. for European composites excluding the UK”.
It is this 25% real estate SCR that the UK can now adjust (among other things) under the UK Solvency II review. As part of this review, it should therefore be borne in mind that real estate is typically a very long-term investment, compared to liquid asset classes, that institutional investors such as life insurers use to service their long-term liabilities. The December 2019 EIOPA report on “Insurers’ asset and liability management in relation to the illiquidity of their liabilities” helpfully acknowledged that insurers hold real estate-related investments for an average of 14 years, the longest of any asset class considered. The high transaction costs involved in buying and selling real estate make it highly unattractive as a short-term investment.
Insurers and other long-term institutional real estate investors typically do not sell their real estate investments during market downturns: they hold them and weather the downturn while the real estate investments continue to deliver relatively stable returns. This lack of real estate transaction data during economic crises might explain why policymakers have viewed real estate as inherently risky and prone to volatility. In the future, real estate should not be penalized. A lack of real estate transaction data does not indicate high volatility (with a correspondingly high solvency risk fee).
The 25% SCR for property is based on UK volatility measures in a worst-case one-year downside scenario, when a more appropriate timeframe for measuring downside volatility for long-term assets such as property is three or five years: with transaction costs, property investing cannot be done without Liquidate more earlier. Real estate volatility over a period of more than a year is significantly lower, even in the most volatile markets. Furthermore, the benefit of diversification in reducing volatility and risk in insurers’ real estate portfolios is not taken into account when setting the SCR. If that were the case, there would be significantly lower portfolio volatility measures.
The entrepreneurial DNA of institutional real estate investors has much to contribute by investing in productive capital throughout the cycle: a win-win with the government improving policyholder protection by increasing investment in such capital and making opportunities more even across the UK. The real estate industry must give priority to this Solvency II reform. Government, please listen, move forward with the PRA and enable the industry to make that contribution – and deliver the Solvency II reform package, which includes the relaxation of the SCR for real estate, sooner rather than later.