Speaking recently at the Westminster and City Annual Conference on bulk annuities, David Rule (PRA Executive Director of Insurance) set out his views on the risks facing UK life insurance firms as they expand into the bulk purchase annuity market and increasingly back these liabilities with investments in illiquid assets. He also made some important observations on the appropriate level of the risk margin1.

Illiquid assets currently make up around 25% of assets backing annuities, but this is expected to increase to around 40% by 2020 according to firms’ business plans. Many UK corporates remain keen to transfer their pension liabilities to third-parties; and potentially a rising interest rate climate will make such deals more economic for them to do so.

This blog highlights three points from David Rule’s speech that are particularly relevant to insurance firms considering investing in or looking to increase their exposure to illiquid investments such as Equity Release Mortgages (ERMs):

(I) The PRA is concerned that the trend towards illiquid investment may be leading insurers to increase their exposure to the UK housing market at possibly the wrong point in the economic cycle.

  • We have previously discussed the PRA’s positon on ERMs in our blog, published last year, in which we highlighted the PRA’s likely concern about insurers’ future house price growth assumptions.  David Rule explicitly confirmed this in his speech saying that “from a prudential perspective, the main risk is long-term stagnation in UK house prices”. 
  • David Rule illustrates this point by showing a chart outlining how the loan value could exceed property value in a market when house prices stagnate (resulting in a loss for the insurer) and another chart showing stagnating house prices in the Japanese and Italian markets. On the latter, he was keen to emphasise that that nominal house price growth has been subdued or has seen declines in some advanced markets and that the UK experience of sharply rising house prices has not generally been replicated in other advanced markets and so cannot necessarily be relied upon to continue.
Fig 1 Fig 2

(II) The PRA will be increasing its scrutiny of investment in illiquid assets, which not only offer insurers large spreads but also large a matching adjustment benefit in contrast to traded debt securities.  

  • David Rule presents a key chart below demonstrating that both the spread and the matching adjustment available on illiquid assets are generally higher than that available on corporate bonds, and is particularly high for ERMs. In our previous blog, we discussed the PRA’s concern that some firms might be claiming undue matching adjustment on illiquid assets through internal rating and valuation processes that do not take full account of all the relevant risks.
  • The speech explores two possibilities for the relatively high matching adjustment on illiquid assets. One possibility is that that the wider spreads are compensating other investors for the risk that they might need to sell into secondary markets that are less liquid than the corporate bond market. However, Rule largely dismissed this possibility by saying that insurers are beginning to dominate a number of these markets, notably ERMs. The other possibility is that the matching adjustment on these assets is capturing returns in excess of an appropriate risk premium. The fact that the matching adjustment is calculated as a residual of the risk free rate and the fundamental spread means that it captures any factor causing the yield on an asset to be higher, not just compensation for risks to which the insurer is not exposed.
  • The implication of these comments is that PRA is concerned that insurers may be taking some spread in the matching adjustment which de facto reflects default or downgrade risk and hence should have been captured by the fundamental spread. Accordingly, we expect that the PRA supervisors will be paying particular attention to the internal ratings of securitised notes backed by ERMs.


(III) The PRA’s view appears to be that a risk margin broadly some 30% below current levels would be “more appropriate”.      

  • David Rule reiterated the PRA’s oft-stated view that the risk margin, whilst conceptually sound, is too sensitive to the level of interest rates, too high currently, and potentially pro-cyclical in its effect. Importantly, he stated “that a more appropriate level of risk margin - similar to envisaged when Solvency II was negotiated, would lead to better balance between longevity risk being retained and reinsured by UK insurers on new business.” Given that Solvency II was negotiated over a decade or more, there are a range of possibilities as to what the PRA has in mind here. In our view, however, this indicates that the PRA would like to bring the risk margin at least down to the level envisaged during the long-term guarantees assessment conducted in 2013 by EIOPA which formed the basis of the eventual long term guarantees measures that accompanied Solvency II implementation2.
  • David Rule has previously stated that the aggregate level of risk margin for UK life firms in 2017 was approximately 50% of SCR, compared to around 35% of SCR when the EIOPA impact study was conducted. All else being equal, and recognising nonetheless that the risk margin trend is not linear, this would imply that the risk margin across the UK life sector would have been, very approximately, some 30% smaller in 2013 (i.e. 70% of the 2017 level). However, we would highlight that the actual sensitivity of the risk margin depends firm by firm on the composition of the underlying business. Moreover, the risk margin’s effect on firms’ solvency position is mitigated significantly by the Transitional Measures on Technical Provisions covering business written pre-Solvency II’s implementation.
  • As a rule of thumb, David Rule has previously said that a 100 basis point reduction in interest rates increases the aggregate risk margin for firms by around 27% and a 100 basis points increase in rates lowers it by around 20%3. Graph A shows the evolution of the 10-year nominal yield from 2012 to 2018. Over this period, the 10-year yield has fluctuated somewhat, reaching its peak in January 2014 at just over 3% and its lowest point in August 2016 at just over 0.6% (a change of approx. 240 basis points in a 2 year period). The 10-year yield is currently 50 basis points lower than it was in March 2013 at the time of the EIOPA assessment.
  • Perhaps more significantly, Graph B, which shows the nominal spot gilt curves at Jan 2013 and April 2018, demonstrates that yields have decreased still more substantially at the long end; for example the 15 year rate fell by approx. 96bps and the 25 year is down 160bps. This flattening of the curve at the longer end, rather than a parallel shift, has had a larger overall impact on the degree of risk margin borne by firms writing long-term annuity business.

Graph A

Graph B

Fig4 Fig 5
  • With EIOPA having decided not to adjust the cost of capital assumption – a decision Rule described as “disappointing” – the PRA is actively looking at further steps available, within the present constraints of Solvency II, to address the risk margin issue. David Rule has previously said that it will be for firms to go to the PRA with proposals4. In our view, the PRA’s eventual response may include, inter alia, limited recognition, firm by firm, of contingent management actions to use risk mitigation and transfer mechanisms. This would plausibly allow for a certain proportion of longevity risk to be treated as a hedgeable-risk and hence to be excluded from the risk margin calculation. This approach would reasonably recognise how the market has developed in the last few years, but would, we expect, involve the PRA’s reaching individual firm judgements as to how far this contingent management action might be recognised, taking account of the scale of their reinsurance arrangements and plans and of their overall risk profile. Later this year, the PRA is expected to consult on any proposals that flow from its current policy review of the risk margin.

Implications for firms

  • We expect the PRA to step up its supervisory scrutiny of firms’ management of risks from illiquid investments and emphasis upon senior management accountability for understanding these risks and ensuring that appropriate expertise and skills are in place to manage these risks (for example work-out expertise when investing in projects or other types of direct lending normally associated with specialist lenders to ensure value can be preserved in distressed situations). Boards will therefore need to keep under close review whether their firm has appropriate skills and capabilities for managing all aspects of its investment in illiquid assets.
  • David Rule has said that the PRA will focus on firms where illiquid assets have a material effect on insurers’ overall solvency position and that the PRA may commission an opinion from an external party, in the form of a skilled person review, if supervisors continue to have concerns about the internal rating of particular assets. Boards and senior managers will therefore need to be satisfied that their internal ratings processes will meet the market’s current rating standards.


1An annuity is a very serious business - speech by David Rule - published on 26 April 2018. The charts in this blog have been replicated from this speech.
2EIOPA’s long-term guarantees assessment ran from 28 January 2013 until 31 March 2013. Results of EIOPA’s long-term guarantees assessment were published in June 2013. Political agreement was reached on the "Omnibus II" Directive (which enshrined the long-term guarantees measures in EU level 1 text) in November 2013.
4See InsuranceERM article from 31 January 2018 – “The PRA's David Rule on Brexit, the risk margin and the regulator's hotspots for supervision in 2018”.


Andrew Bulley

Andrew Bulley - Partner, Centre for Regulatory Strategy, Deloitte

Andrew Bulley joined Deloitte in October 2016 from the Bank of England, where he was, most recently, the Director of Life Insurance Supervision. Between 2014 and 2016 he was a UK voting member of the Board of Supervisors of the European Insurance and Occupational Pensions Authority (“EIOPA”). In a career with the Bank of England and Financial Services Authority stretching over 27 years, Andrew has held senior roles in the supervision of life and general insurers, the London wholesale insurance underwriting and broking markets, retail and investment banks, asset managers, and IFAs.

Email | LinkedIn


Umair Choudhry - Senior Manager, Centre for Regulatory Strategy, Deloitte

Umair focuses on prudential regulation for insurance firms. His background is in Government, where he worked on development of regulatory policy for insurance companies and occupational pension schemes.

Email | LinkedIn


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