The European insurance sector’s growing interest in assets with environmental, social and governance (ESG) characteristics is likely to get a further boost from the European Commission’s proposal to lower Solvency II (S2) capital charges for longer-term business, Fitch Ratings says.
Fitch’s report showed that insurers are well-placed to invest in longer-term assets, including environmentally sustainable infrastructure and renewable energy projects, given their long-term investment horizon.
However, insurers are constrained by what they view as high capital requirements.
This is set to change through reforms in order to reduce a risk margin provision, which insurers hold against certain long-term business and to lower the capital charges for equities that are treated as “long-term”, therefore these will be unlikely to be sold quickly.
Insurers and their policyholders could benefit from the higher returns that may be available on longer-term, but often illiquid, assets.
The European Commission published its proposals on 22 September, highlighting that the review of S2 was an opportunity to ensure that the regulatory framework was conducive to long-term investment by the insurance sector.
It also considered whether the sector could contribute to the EU’s political priorities, including climate and environmental targets under the European Green Deal.
The Commission estimates that the risk-margin reduction could release up to EUR90 billion of capital and that the lower charges for long-term equities could release about EUR10 billion.
The rating agency believes the main capital impact would be for life insurers with a high proportion of business with long-term investment guarantees, particularly in Germany, Italy and the Netherlands, where such business is prevalent.
However, the net capital release would, in practice, be tempered by other parts of the commission’s proposals, in particular a rise in provisions due to a phase-in of slightly lower long-term discount rates.
While the proposed changes are likely to encourage more longer-term investments, we expect the impact to be gradual as it will take time for insurers to source investments they consider suitable. Some insurers may initially use the extra capital freed up by the reforms to purchase more readily available shorter- or medium-term assets, to invest internally or to support shareholder distributions.
A shift into longer, less-liquid assets should not affect an insurer’s rating unless it generates a material asset-liability liquidity mismatch or significantly weakens the credit quality or diversification of the insurer’s investment portfolio.
Fitch’s main measure of insurers’ capital strength is the Prism Factor-Based Capital Model (Prism FBM), although Fitch also considers S2 ratios and other capital metrics.
The proposed changes to the S2 risk margin and long-term equity charges would not directly affect insurers’ Prism FBM scores as Prism FBM does not use the S2 risk margin, and its equity risk charges are set independent of S2.
However, Prism FBM scores would reflect any changes that insurers make to their asset allocation as a result of the reforms.