The U.K.’s investment rules for insurers and reinsurers have become particularly interesting due to recent proposals for reform relating to U.K. sovereignty and the ESG movement.  

In this episode of “The Standard Formula” podcast, host and Skadden partner Rob Chaplin is joined by colleagues Ben Lyon and Verena Mengis. Tune in as Ben and Verena delve into a wealth of topics, including the prudent person principle (PPP) in the context of the U.K.'s Solvency II investment rules. Discover the key aspects of PPP and how it applies to insurers' and reinsurers' asset portfolios. Learn about investment rules specific to derivatives, securitizations and assets held to cover linked policies, along with related regulatory changes and their impact on the insurance sector. The episode concludes with a critical discussion on sustainability risks and the integration of ESG concerns into investment rules.

💡 Meet Your Host 💡

Name: Robert Chaplin

Title: Partner, Insurance at Skadden

Specialty: Rob primarily focuses on transactional and advisory work in the insurance sector. He advises on mergers and acquisitions, disposals, joint ventures, and strategic reinsurances. He also counsels on regulatory issues, with an emphasis on Solvency II. 

Connect: LinkedIn  

💡 Featured Guest 💡

Name: Ben Lyon

What he does: Ben is a counsel in the Financial Institutions Group at Skadden, where he focuses his practice primarily on transactional and advisory work in the insurance sector. He has extensive experience working on insurance and asset management-related public and private mergers, acquisitions and joint ventures, reinsurance transactions, regulatory matters and investigations, corporate governance issues, debt and equity capital markets transactions and other corporate matters in the U.K. and internationally.

Organization: Skadden

Words of wisdom: “The PRA expects that an insurer's response to financial risks from climate change be proportionate to the nature, scale, and complexity of their business, and that their approach to managing the financial risks from climate change will mature and will develop over time.”

Connect: LinkedIn 

Name: Verena Mengis

What she does: Verena is a trainee solicitor in the Financial Institutions Group at Skadden. 

Organization: Skadden

Words of wisdom: “Since Solvency II came into force, a less prescriptive, but more market favored regime applies to investment rules, to which the prudent person principle is central.”

Connect: LinkedIn 

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The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP, and Affiliates. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.

From Skadden, the Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner, Robert Chaplin, leads conversations with industry practitioners and explores Solvency II developments that matter to you.

Welcome back to the Standard Formula Podcast. Today, we'll be talking about the UK's investment rules for insurers and reinsurers. This topic is particularly interesting due to recent proposals for reform relating to Sovereignty UK and the ESG movement. I'm joined by my colleagues Ben Lyon and Verena Mengis who will be discussing this topic. Ben, to start us off, please run us through what we mean when we talk about the prudent person principle, which is a key concept when we talk about investment rules.

Thanks, Rob. It's great to be here to discuss relevant solvency to investment rules. And maybe we start with a prudent person principle, PPP, which refers to the general standard of prudent investment, which insurers and reinsurers must comply with, with respect to their entire asset portfolio. The principle which sets out objective standards for prudent investment as developed in Solvency II as adopted in the UK's PRA handbook. The principle requires that an insurer's asset portfolio must only include assets whose risks the insurer can, first, properly identify, measure, monitor, manage, control, and report on; second, such investments take into account the insurer's overall solvency needs; third, which entire portfolio security, quality, liquidity, and profitability; fourth, which are localized where relevant; and last, which in the context of conflicts of interest are held in the best interests of policy holders generally.

For all assets other than those held in respective life insurance contracts where the investment risk is born by policy holders, which we will discuss later on in this podcast, it is also a requirement that investments are properly diversified and that there is not excessive risk exposure to a particular issuer or group. Assets held to cover a firm's technical provisions, the topic of our next podcast, must be invested in a manner appropriate to the nature and duration of the insurer's liabilities, and in the best interests of policy holders generally. Regarding the requirement that investment risks be properly monitored, as mentioned earlier, the PRA in its September 2023 consultation paper has proposed a new requirement, which is that in monitoring investment risks, firms should also consider the impact of concentrations on the overall solvency position, including concentrations on the amount of matching adjustment benefit that is claimed. Let's take a look at what pre -Solvency II looked like as it helps us inform our views on the current regime. Over to you, Verena.

Thanks, Ben. Before Solvency II, UK insurers were subject to stricter restrictions on the types of assets in which they could invest with investments only being allowed to be made in a set number of admissible asset categories if the insurer wanted the investments to count towards its capital requirements. Another example of how the regime was stricter before Solvency II was that investments in unlisted securities such as equities have to be capped at 10%, whereas now they must just be kept at prudent levels. Since Solvency II came into force, a less prescriptive but more market favored regime applies to investment rules to which the prudent person principle is central. Given the regulatory change, the principle is accompanied by a prohibition on EU member states from requiring insurers to invest in only a particular category of asset or seek pre-approval for investment decisions.

Nonetheless, despite the more flexible regime, it is important to note that different categories of investment will attract different capital charges when calculating the SCR, the solvency capital requirements. In addition, as Solvency II refers to the whole portfolio of assets, the prudent person principle applies to an insurer's or reinsurer's entire portfolio of assets and investments, including assets covering technical provisions, minimum capital requirements, and solvency capital requirements, and any other assets. This is different from the pre-Solvency II regime, which only control the types of assets held to cover capital requirements. Let's now talk about some of the guidance from EIOPA and the PRA on how the PPP should be applied in practice. Ben, why don't you start with the guidance from EIOPA?

Sure. To begin EIOPA notes that there should be regular reviews of a firm's investment portfolio, which includes, for example, considering the relevant liability constraints and the level of nature of risk that an insurer is willing to accept. This guidance is reflective of what Solvency II requires, namely that the entire portfolio is monitored on a continuing basis for compliance with these requirements. Where an investment is of a non-routine nature, EIOPA also states that additional due diligence should be conducted, and that makes sense. And that includes an assessment of the associated risks of that investment, the insurer's internal liability constraints, and its ability to manage the investment properly. In addition, where an investment is complex, not admitted to trading on a regulated market or is otherwise difficult to value, it really should be monitored closely by a firm. While there is further guidance from EIOPA that should be closely followed, I think it's important to also explore the guidance issued by the PRA on today's podcast. Verena, can you take us through that?

Yes, of course, Ben. Thanks. In its supervisory statement, the PRA covers specific topics such as investment strategy, investment risk management, and outsourcing of investment activities amongst others. The PRA sets out requirements relating to the content of firms as investment strategies, which should include consideration of the investment objectives and asset allocation, the board's risk appetite, risk tolerance limits, investment risk return objectives, as well as alignment of the investment strategy with the insurer's business model. The PRA also requires that any investment made by an insurer or reinsurer is aligned with the firm's risk appetite, policies, and their general business model, as well as the profile of the firm's products and their policy holders.

Additionally, where an insurer or reinsurer chooses to outsource its investment activities to an external party, it must be subject to appropriate due diligence, and the outsourced entity must equally be able to comply with the requirements of the supervisory statement. Now that we've discussed the prudent person principle and considered some of the guidance around how it should be applied in practice, let's talk about specific investment rules for specific asset classes, namely derivatives, securitizations, and asset held to cover linked business liabilities. Over to you, Ben.

Thanks, Verena. As you rightly mentioned, there are specific investment rules that apply to derivatives above and beyond the requirements for investments generally. For starters, say in relation to linked business, which we'll discuss later on, derivatives are only permitted in so far as they contribute to a reduction of risk or facilitate effective portfolio management. So for instance, a hedging derivative is more likely to be compliant than a purely speculative derivative dressed up as a hedging strategy. Regulators in continental Europe have focused on life insurers using derivatives for portfolio management, especially as there is a risk of derivatives being used as a tool to mask underlying investment exposure. EIOPA's guidelines provide further detail here, namely that insurers should monitor its derivative exposure in line with its risk management policy, should demonstrate how the portfolio is improved by the use of these derivatives, and where derivatives are used as a risk mitigation technique. The insurer should document the rationale for this and be able to demonstrate the risk transfer and the benefits obtained from such derivatives. Verena, there are two other asset classes we haven't touched on yet, securitizations and assets that are held to cover linked policies. Why don't you run us through securitizations?

Thanks, Ben. To begin, what we mean when we say securitizations are securities or other financial instruments which are based on repackaged loans, bonds, or notes. The regime that an insurer or reinsurer must comply with varies depending on whether the instrument is in a securitization issued before or on or after the 1st of January 2019. For securitizations issued before 1st of January 2019, insurers and reinsurers must comply with several rules. First, the originator sponsor or original lender of the position must retain a 5% economic interest in the securitized portfolio and must disclose this to the investing insurer or reinsurer, subject to a few exceptions. Second, the insurer or reinsurer must be satisfied that the position is of sufficiently high investment quality, taking into account certain qualities of criteria which are set out in level two delegated regulation. Third, the insurer or reinsurer must establish written monitoring procedures appropriate for the risk profile of the position, ensure that there is internal reporting to the administrative management or supervisory board, perform regular stress tests, and be able to demonstrate to its supervisory authorities that it has a deep understanding of the product and its underlying exposures, and that it has written policies and procedures in place for risk management.

Finally, if an insurer or reinsurer becomes aware of the above requirements that I just mentioned not being complied with, it must inform the supervisory authority immediately, and this may result in an increase of the insurer or reinsurers solvency capital requirements. And this remains the case in the post-2019 regime, which I'm going to go onto now. So for securitizations issued on or after 1st of January 2019, requirements can be found in the securitization regulation. The risk retention requirements on originator sponsors and original lenders are largely unchanged from the previously discussed regime. Most of the due diligence requirements that insurers and reinsurers must undertake in relation to securitizations are also similar to the requirements of the pre-2019 regime. There has, however, been a change in some of the criteria which the insurer or reinsurer must assess to be satisfied that the position is of sufficiently high investment quality, which I'll briefly go through now.

Before becoming exposed to a securitization, a firm must first identify that the structure is risk compliant, which includes verifying that assets were originated on the basis of high credit rating standards and verifying that the originator, sponsor, and/or securitization SPV comply with the disclosure obligations under the securitization regulation. Second, insurers must carry out due diligence considering the relevant risk characteristics and the structural features of the securitization that can affect its position. There is an additional regulatory framework that applies for high quality securitizations, which I won't dive into now, but I think our listeners would love to know about the requirements for investment in linked assets, as well. Ben, would you take us through those please?

Yes, of course. Linked insurance contracts are effectively where the investment risk is born by the policy holder rather than the insurer. For assets held to cover linked business, certain elements of a prudent person principle don't apply. This means, for example, that there is no requirement on investments and unlisted securities being kept at prudent levels, and there's also no requirement that investments be properly diversified. The natural hedge for the firm is holding the underlying linked securities and hence the term linked policies. Where those linked policy benefits exist, member states are allowed to impose certain restrictions on the type of assets or reference values to which policy benefits may be linked. In the UK, the FCA handbook sets out similar limitations requiring that an insurer may only provide benefits under linked contracts, which are determined by reference to a list of permitted linked assets such as bonds or real estate. So I think that wraps up our discussion on the specific investment rules that apply to certain assets. Next, we will discuss the sustainability movement on the application of the Solvency II investment rules, and perhaps, Verena, you could start us off with a discussion of the types of sustainability risks relevant here to the insurance sector.

Sure. Thank you, Ben. The PRA has identified three types of sustainability risks that the insurance sector is particularly exposed to: physical risks, transition risks, and liability risks. Physical risks are risks that occur as a direct result of climate change. For instance, insured losses arising from floods or fires or the value of an agriculture investment decreasing. Transition risks are those arising from human responses to climate change, such as changes in law or policy as a result of an increased pressure from customers, shareholders, and activists. This means, for example, that an insurer's investment portfolio could fall in value as a result of the devaluation of equity and debt holdings in carbon intensive industries. Liability risks arise from parties who have suffered loss or damage from physical or transition risk factors seeking to recover losses from those who they hold responsible. Let's go through how our sustainability risk interplays with the prudent person principle and how ESG concerns impact the investment rules. Over to you, Ben.

Thanks, Verena. The prudent person principle specifically incorporates sustainability and requires that insurers diversify their asset portfolios so as to avoid excessive sustainability risk. The PRA expects that an insurer's response to financial risks from climate change be proportionate to the nature scale and complexity of their business, and that their approach to managing the financial risks from climate change will mature and will develop over time. The PRA also notes that climate risk is more complex and less understood, and as a result, reinsurers and insurers must pay particular attention to climate risk and avoid over-exposure to such risks. What this could mean for insurers is that they divest some of their carbon intensive investments in exchange for low carbon alternatives. They could do, so and many insurers already have by investing in sustainable bonds, for example, which are aimed at funding projects with a positive environmental aspect to it.

In its September 2023 consultation paper, the PRA has indicated that the Solvency II reforms with respect to investment flexibility could improve the availability of the insurance sector to contribute to the UK government's net-zero targets. This is because the reforms may free up significant sums of capital by reducing the safety margins demanded of insurers in combination with rule changes, making it easier for insurers to invest in long-term sustainable assets. EIOPA has noted that insurers are taking steps to mitigate the effects of climate change by implementing dedicated adaptation measures in the insurance products and offering premium related incentives. However, EIOPA has reported that the EU insurance market generally appears to be only at an early stage in its journey to increase resilience to global warming, and I think it's the same in the UK. And with that, back to you Rob.

That's an excellent note to end on, Verena and Ben. Thank you to our listeners for joining us. We hope that you will continue to tune in for future episodes. In case you missed it, our last episode covered the matching adjustment, and our next topic will be technical provisions. If you have any questions or comments on any of the topics we spoke about today or Solvency II in general, do please feel free to contact us. Thank you, and we hope you'll join us next time.

Thank you for joining us on the Standard Formula. If you enjoyed this conversation, be sure to subscribe on your favorite podcast app so you don't miss any future episodes. Additional information about Skadden can be found at skadden.com. The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP and affiliates. Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisors on a wide variety of transactional and regulatory matters. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.