Melville Rodrigues argues that reform could free up insurers to help meet levelling-up ambitions
UK insurance companies invest in real estate for the long term, potentially complementing and facilitating the UK government’s levelling up, build back better and net-zero ambitions. Significant investment is needed, for instance, in social and affordable housing and revitalisation of town centres, while also accelerating towards a sustainable investment future.
But the UK’s current Solvency II legislation – largely copied and pasted from the EU’s – has been criticised for hampering well-funded insurers in pursuing these investments on account of the solvency capital requirement (SCR) attached to investment in real estate. This week’s levelling-up white paper recognises that there “are large pools of underutilised capital across the UK that could, in principle, be used to support investment”. The unreasonably high standard model 25% SCR rating for real estate is a reason that contributes to insurers holding underutilised capital.
The UK Treasury is expected early this year to announce a comprehensive package of Solvency II reforms for consultation that takes into account the results of the data collection exercise that the Prudential Regulation Authority (PRA) carried out last summer. The PRA is the arm of the Bank of England responsible for the prudential supervision of insurance companies. In parallel, the PRA will need to respond to Treasury recommendations and review rules where the government considers that it is in the public interest under the Future Regulatory Review. The UK Solvency II reforms can ensure that the domestic regime going forward supports – and is tailored to – the unique features of the UK insurance sector, given that the UK has left the EU.
The UK Solvency II consultation is an opportunity. While the reform objectives understandably include the protection of policyholders, they also extend to supporting insurers in the provision of long-term capital to underpin growth in the economy. Andrew Bailey, Governor of the Bank of England, has stated that “achieving stronger and more sustainable growth in the economy will enhance the primary [regulatory] objectives of safety and soundness and policyholder protection”.
Given the current economic circumstances, delay would be unfortunate. As laid out in a recent report for 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 needs to happen sooner rather than later”.
The Solvency II reform can dovetail with other welcome initiatives designed to stimulate investment, such as those arising from the Treasury’s UK Funds Regime Review. For instance, the long-term asset fund (aimed at facilitating investment in alternatives particularly by DC pension funds) is now available. In addition, the Treasury helpfully has consulted on another initiative: the UK Professional Investor Fund (PIF) that I have been advocating. The PIF will facilitate institutional investment in our social infrastructure.
As part of the package of Solvency II reforms, therefore, the government, working with the PRA, must match the policy intent behind these other initiatives by rectifying the way that real estate is unfairly categorised under the current regime. In 2020, EU policy makers, via the European Insurance and Occupational Pension Authority (EIOPA), without providing an explanation, continued with an earlier determination that the standard model SCR rating for real estate (and real estate funds following the ‘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 investment. For example, MSCI – based on capital risk analysis up to December 2015 – stated that “The appropriate shock factors to use for determining real estate solvency capital requirements need not… be pushed in excess of the 15% mark for all Europe, or 12% for European composites which exclude the UK”.
It is this 25% SCR for real estate that the UK now has the opportunity to adjust (among other things) under the UK Solvency II review. As part of that review, therefore, it should be recognised that real estate – compared with liquid asset classes – is typically a very long-term investment that institutional investors such as life insurers use to meet their long-term liabilities. The December 2019 EIOPA report on ‘Insurers’ asset and liability management in relation to the illiquidity of their liabilities’ helpfully appreciated that insurers hold property-related investments for 14 years on average, the longest of any asset class considered. The high transaction costs incurred in buying and selling real estate make it highly unattractive as a short-term investment.
Insurers and other long-term real estate institutional investors do not typically sell their real estate investments during downturns in the market: they hold them and ride out the downturn while the real estate investments continue to deliver relatively stable income returns. This lack of real estate transaction data in economic crises may perhaps explain why policy makers have regarded real estate as inherently risky and prone to volatility. Going forward, real estate should not be penalised. A lack of real estate transaction data does not support a conclusion of high volatility (with a commensurately high solvency risk charge).
The 25% SCR for real estate is based on UK measures of volatility in a worst-case, one-year downside scenario, when a more appropriate timeframe for measuring downside volatility for long-term assets such as real estate is three or five years: linked to transaction costs, real estate investments are not easily liquidated sooner. Real estate volatility over any period longer than one year is considerably less, in even the most volatile markets. In addition, the benefit of diversification in lowering volatility and risk within insurers’ real estate portfolios is not considered in setting the SCR. If it were, there would be significantly lower portfolio volatility measures.
Institutional real estate investors’ entrepreneurial DNA has much to contribute with investments in productive capital throughout the cycle: a win-win with government that enhances policyholder protection by increasing investment into such capital and makes opportunities more equal across the UK. The real estate industry must prioritise campaigning for this Solvency II reform. Government, please listen, progress with the PRA and enable the industry to make this contribution – and deliver on the package of Solvency II reforms, that includes easing of the SCR for real estate, sooner than later.
