It's an unusually interesting time for the prudential regulatory agenda, both in the UK and further afield. We’re in a period of significant turbulence, with conflict in Europe and a looming recession, not to mention the ongoing consequences of the Covid-19 pandemic and the climate crisis. At the same time, we are living through an unparalleled digital and technological revolution, the longer-term impact of which we still don’t fully understand.
Although the objectives for prudential regulators are typically set in statute, the context in which they are interpreted and actioned is not – and as we’ve seen, the current context is one of enormous uncertainty and fluidity. There are three areas in particular that are expected to play a critical role in influencing prudential regulatory agendas over the next few years:
- Economic conditions
- Political choices
- Net Zero transition
1. Economic conditions
The economic situation has deteriorated since the start of the year, with inflation rising and monetary authorities responding accordingly. This debate about interest rates is key due to their impact on annuity rates and investment returns for insurers
In an environment of rising interest rates, authorities will be expected to adjust fiscal policy to protect vulnerable groups from inflation. But rising interest rates and the need to support vulnerable groups make it more difficult to maintain fiscal sustainability in a context of rising debt. Demographic trends are unlikely to help, with ageing populations leading to rising demand for healthcare and falling working-age participation.
An environment of rising interest rates is likely to lead to an increased risk of insolvency, with SMEs particularly at risk. Even for those businesses that are surviving, confidence is low due to worries over a recession and increased borrowing costs.
Labour markets have been deeply affected by the end of lockdowns, too. Vacancy rates in the UK, US and the Eurozone are at near record highs, for example, with the so-called “Great Resignation” seeing more employees switching jobs.
KPMG’s latest research shows that over a third of workers want to start looking for a new career in 2023 due to the rising cost of living. But central banks are worried that tight labour markets could add more pressure on inflation if workers use their bargaining power to demand higher wages.
The majority of central banks, including the Federal Reserve (Fed), have already moved towards tightening monetary policy. The magnitude of the increases has been notable, with most banks raising rates by at least 50 basis points and the Fed and Bank of England (BoE) going further.
In addition, some have begun phasing out quantitative easing in favour of quantitative tightening. There are clear benefits of doing it now: reducing the stock of assets held by the central bank helps to protect against future crises.
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2. Political instability
The political situation is equally unstable, not only in the UK, with three prime ministers in as many months, but also across the EU, with a new leader in Italy and combative coalitions in Germany and France.
In the UK, much of the Financial Services and Markets (FS&M) Bill, which had its Second Reading in September 2022, is in outline, most obviously on Solvency 2, where HM Treasury’s consultation on the specifics only closed two days after publication of the bill. There is also added uncertainty about a proposal to allow the UK government to ‘call in’ regulatory policy decisions.
In addition, it is still unclear if the Organisation for Economic Co-operation and Development (OECD) minimum tax framework has enough political momentum to make progress globally, but the EU agreement on Pillar 2 announced on December 12th represents a material step forward.
Changes of political leadership, and a new domestic agenda, always means a period of adjustment for businesses and regulators. What is arguably different is the scale of the current political challenges in the UK, Europe and North America:
- How to strike the right balance in fiscal policy to encourage growth and investment, while maintaining market confidence in government finances.
- How to deliver global tax reform to ensure a minimum corporate tax rate and wider tax base that reflects today’s economy.
- How to provide productive investment in healthcare and social care to meet the twin challenges of post-pandemic capacity and ageing populations.
- How to navigate an increasingly tense geopolitical situation while also making hard choices about friends and alliances.
As if these weren’t enough, the new administration in the UK faces a swathe of additional challenges, such as issues around the Northern Ireland protocol and power-sharing, immigration policy, spiralling energy costs and public sector pay.
While not all these issues feed directly through to insurers, they all take up the capacity of decision makers, which is important when considering how much time there will really be for issues insurers care most about.
3. Net Zero transition
The transition to Net Zero is the third key issue affecting discussions around prudential regulation – and one in which regulators in the UK, EU and US are heavily invested.
The newly established International Sustainability Standards Board (ISSB) has been consulting on new standards for sustainability reporting to build on the Task Force on Climate-related Financial Disclosures (TCFD) framework. In the UK, the long-awaited Financial Conduct Authority consultation on sustainability disclosure requirements has been published, and the Government is planning to introduce requirements to comply with the awaited UK Taxonomy and ISSB standards.
The main focus for prudential regulators is the risk to balance sheets from wider economic transition. This was explored in detail at the Bank of England’s recent Climate and Capital conference, and in the PRA’s subsequent ‘Dear CEO’ letter, which highlighted its thematic findings in the PRA’s first year of actively supervising this risk.
The Bank of England’s Climate Biennial Exploratory Scenario (CBES) revealed that climate risks could cause a persistent and material drag on annual profitability of around 10 per cent-15 per cent on average, if insurers do not respond effectively to climate change. This would make individual firms, and the financial system overall, more vulnerable to other future shocks.
Insurers will need to increase their investment in data and modelling capabilities to assess how their counterparties might be affected by transition or physical risk. On the liability side, there is a need to develop their in-house capabilities to incorporate a range of physical risk variables and avoid overreliance on third parties.
In addition to climate transition plans, firms will need to carefully consider the management actions available in different scenarios. They may even want to consider whether their portfolios need adjusting by withdrawing from high-carbon industries such as fossil fuels being. As the CBES exercise has shown, however, there could be macroeconomic consequences if the withdrawal of insurance outpaces new investments in sustainable energy.
Insurers therefore need to be sensitive not just to their own business challenges in adapting to the green agenda, but also to the challenges of the insurance market in general, as well as the wider macroeconomic environment. One option would be for insurers to develop climate recovery plans: a toolbox of management actions to restore progress towards their climate transition goals.
So, what does all this mean?
Public tensions between prudential regulators, regulated firms and elected governments are only likely to increase in the short term, as we’ve already seen with Solvency 2 in both the UK and the EU.
Given the scale of the economic challenges, this isn’t surprising. There are no easy fixes to geopolitical volatility and rebasing supply chains. European economies will have to work hard to avoid the stagflation of the 1970s. It’s clear that inflation will peak higher and persist longer than previously expected. Although central banks are tightening monetary policy, it could take around 12-18 months for interest rate changes to have a meaningful impact on inflation in the real economy. In the meantime, this could mean a prolonged period of rising borrowing costs and squeezed real incomes.
Policymakers will be particularly wary of the risks of prolonged recession. Tighter government spending, rising inflation, and slowing growth have depressed consumer confidence to their lowest levels since records began. Some central banks – including the Fed and the BoE – have already signalled they will tolerate weaker growth and higher unemployment to reduce inflation.
Where there is alignment between the UK and EU prudential regulatory regimes, it’s likely to be more accidental than deliberate. There is no immediate prospect of equivalence or mutual recognition, and disagreements over the Northern Ireland Protocol could put a further strain on relationships.
The exception is on green issues, where the ISSB, Network for Greening the Financial System (NGFS) and Glasgow Financial Net Zero Alliance (GFANZ) continue to collaborate successfully in sharing best practice and developing data and disclosure standards. Prudential regulators also continue to work constructively behind the scenes on firm-specific and supervisory issues.
These debates are likely to continue throughout the decade as prudential regulators evolve their approaches in response to a fast-changing world.
