Investors appear to have mixed views on the impact of post-Brexit Solvency II (S2) reforms on UK insurers’ credit quality, according to Fitch Ratings.
At a recent Insurance Insights event in London, that was attended by investors, issuers, as well as other market participants, an audience poll showed that 30% thought the reforms would make insurers “more attractive” to credit investors, while 16% thought the opposite and more than half (54%) said that they see no impact.
Fitch explained that it expects the reforms to lead insurers to gradually invest slightly more in illiquid assets.
As a result, this could wind up improving asset diversification and investment returns.
However, it could also increase the credit risk in investment portfolios and liquidity risk, Fitch warns.
“We do not expect the reforms to make a material difference to insurers’ credit quality, sharing the view of just over half the poll respondents. Changes in insurers’ investment allocations are likely to be limited and gradual due to regulatory constraints and insurers’ generally prudent investment risk appetite, and we expect the credit positives and negatives to be broadly in balance,” Fitch said.
Moreover, one of the major aims of the reforms is to incentivise insurers to invest more in long-term illiquid assets, such as infrastructure projects, to boost the economy.
Fitch noted that insurers have called for more favourable treatment of illiquid assets backing annuities since before S2 came into effect in 2016.
The two most significant reforms are a reduction in the ‘risk margin’ when calculating technical provisions and increased scope for ‘matching adjustment’ (MA) credit when calculating best-estimate liabilities for long-term illiquid liabilities backed by assets with similar duration and cashflows, Fitch explained.
The agency also noted that the lower risk margin – which took effect at end-2023 and affects life and non-life insurers – has led to a reduction in capital requirements, which has freed up some capital, which could potentially motivate insurers to take on more investment risk in search of higher returns.
The MA reforms, which are set to take effect at end-1H24, will predominantly affect annuity business.
In addition, a wider range of illiquid assets will be eligible for MA credit, including investments in infrastructure projects still in the construction phase before they generate stable cashflows.
Fitch explained that it does not expect an increase in annuity firms’ holding of illiquid assets to generate material liquidity risk, given that the assets are buy-and-hold and their cashflows are well-matched to the annuity cashflows.
However, Fitch highlighted that the main credit negative that could potentially result from the reforms could be a slight decrease seen in the average credit quality of annuity firms’ investment portfolios due to increased holdings of illiquid assets with lower, and in some cases SIG, credit quality.
The agency warned that this would raise the risk of downgrades, which push up capital requirements, and defaults.
But, Fitch stated that it does not expect to see a dramatic shift in investment allocations, as the organisation largely expects insurers to stay within their existing risk appetites and not to take on a level of risk that would potentially jeopardize their ratings.
