Response by the Association of British Insurers to the Commission Services Staff Working Document of 26 February 2010

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1 CAPITAL REQUIREMENTS DIRECTIVE (CRD IV) Response by the Association of British Insurers to the Commission Services Staff Working Document of 26 February 2010 The Association of British Insurers (ABI) is the voice of the insurance and investment industry. Its members constitute over 90 per cent of the insurance market in the UK and 20 per cent across the EU. They control assets equivalent to a quarter of the UK s capital. They are the risk managers of the UK s economy and society. Through the ABI their voice is heard in Government and in public debate on insurance, savings, and investment matters. And through the ABI they come together to improve customers' experience of the industry, to raise standards of corporate governance in British business and to protect the public against crime. The ABI prides itself on thinking for tomorrow, providing solutions to policy challenges based on the industry s analysis and understanding of the risks we all face. Summary We have focused our response on the issues which are of greatest significance to ABI members as both providers of insurance and savings products and as institutional investors. As active market participants, ABI members want confidence in the financial markets for consumers and investors through an equal measure of financial stability and efficient markets. Of notable concern is that while the focus of this consultation is on reforms to the banking sector there are already indications that a direct read across to other financial sectors is likely to occur (see Q.46/47). While we acknowledge that, as a result of the financial crisis, the banking sector must be given immediate attention, it must be fully recognised that reforms for other sectors, such as insurance and asset management, have to be properly considered and tailored to the structures of those sectors in order to be both effective and feasible. In addition, reforms to the Capital Requirements Directive must take into account the needs and potential unintended consequences for the buy-side. Any changes to the treatment of certain capital instruments will impact on the balance sheets of their owners and their beneficiaries. Dependent upon the exact nature of the changes it could mean a lowering of quality (and therefore value), but they could also force investors to (simultaneously) sell out of certain instruments, which in turn would cause market volatility. 1

2 Section II: Definition of capital Question 23: What is your view of the purpose of contingent capital? What forms and triggers would be most appropriate? Question 24: How should the grandfathering requirements under CRD II interact with those for the new requirements? To what extent should the grandfathering provisions of CRD II be amended to bring them into line with those of the new capital requirements under CRD IV? Our analysis looks at contingent capital from three different viewpoints; that of regulators, of issuers and finally the investor base. We are not persuaded that contingent capital does have the potential to play a significant role in the capital structure (paragraph 70). We understand the regulators desire for instruments which have greater certainty of loss absorption whether through conversion to equity or write-down of principal. However, the formulation of these instruments, so far, appears to have been predominantly undertaken assuming a single point crisis intervention scenario rather than the unpredictable momentum of a dynamic environment and too little consideration of the requirements of the investor base. At the macro level contingent instruments are likely to be of only marginal value unless their issue is of sufficient size that in times of stress their conversion makes a material impact on Core Tier 1. However, their conversion in itself could engender panic and a rush for the exit in respect of an institution under stress. The comments in paragraph 72 suggest the Commission is aware of these dangers. From the viewpoint of issuers the attraction of the instruments for regulatory capital purposes is evident. Institutional investors have been disappointed at the opportunistic approach adopted by some banks, not in distress, in using the crisis period to promote exchange and tender operations for hybrid debt at sub par prices. For the investor base the viewpoint depends very much on the type of investor and their fund. For institutional investors such as insurers and pension funds running matched funds the prospect of coupon payment interruption is unacceptable. Historically it is these funds who have been the buyers of bank hybrid capital. Such funds generally have mandates with criteria which include investment grade rating and inclusion in bond indices. The position of the rating agencies in respect of contingent capital remains to be completely clarified but investment grade status for contingent capital is by no means guaranteed. ABI has pressed index providers not to include contingent capital in bond indices as, in our view, it does not have the predictability of cashflow which is the hallmark of contractual debt. However, there may be other types of investors who would be prepared to invest in such instruments for an appropriate risk adjusted return, possibly high net worth individuals and hedge funds for example. It is not clear that a long term liquid market could develop on such 2

3 a limited investor base. Moreover, potentially it implies an increase in the weighted cost of capital, to the ultimate cost of bank clients. Notwithstanding the above, institutional investors recognise that there is a case for the enhancement of bank capital. Thus they would support grandfathering of existing bank hybrid instruments to allow for their orderly run off over time in line with their original maturity/first call. Section V: Countercyclical measures; This section examines what measures are required to guard against pro-cyclical risk in regulation of banking activities and what contribution changes in accounting standards might make toward this objective. We intend to respond to the IASB s current consultation on its Exposure draft ED/2009/12 on Financial Instruments: Amortised Cost and Impairment which closes on 30 June 2010 and we will refine our views as we develop our response. However, we consider the objective of the expected cash flow approach as proposed by the IASB to be essentially the right one for the accounting standard and that it, or a variant of it, should be applied in place of the current incurred loss approach. Question 39: Views are sought on the suggested IRB based approach with respect to the through-the-cycle provisioning for expected losses as outlined above. We support the IASB s clear rejection, in establishing its expected loss approach for accounting purposes, of the through-the-cycle dynamic provisioning for which banking regulators appear to be looking. If IASB s approach does not deliver what regulators need, they should consider separately what different requirements to apply for regulatory purposes. We wish to emphasise our strong support for what the Commission acknowledges was the majority view from its consultation last year i.e. that introducing regulatory prudence through financial reporting risks undermining the true and fair view of financial position and economic performance, and that caution should therefore be exercised in introducing dynamic provisioning by this route. It is not the role of accounting standards to create an impression of financial stability that is not warranted by the facts, or to withhold, delay or obscure information which properly needs to be provided to investors making decisions to buy and sell shares and to shareholders who need to be furnished with the information to hold to account the management of the companies they own. Question 41: Which elements should be subject to distribution restrictions for both elements of the proposed capital buffers and why? Financial reporting should not be the means by which earnings are smoothed or held back from distribution in order to achieve regulatory objectives. Indeed, the logic of seeking to apply increased capital requirements through restrictions on distributing profits as dividends is not obvious since this would tend to result in unprofitable companies being permitted to 3

4 trade with poorer capital backing than profitable ones. If banking regulators nevertheless choose to apply smoothing of profit available for distribution to shareholders or to qualify the recognition of earnings for inclusion in regulatory capital calculations it would be helpful if the impact of this is shown in an appropriate manner within the accounts of the entity in question. This could be by way of the creation of a special non-distributable reserve but it should not be done in a manner which impairs the reporting of profits or the proper recognition of assets and liabilities. Section VI: Systemically important financial institutions; Question 46: What is your view of the most appropriate means of measuring and addressing systemic importance? Question 47: How could the Commission services ensure a consistent prudential treatment of systemic importance across financial sectors and markets? We agree that more emphasis should be placed on identifying and addressing systemically significant institutions. However, it is vital that in doing so the Commission recognises the significant differences between sectors in terms of their business models and the impact of failures which means that the systemic importance of different sectors vary considerably. In particular the Commission needs to recognise that insurers are not normally a source of systemic and that it would, therefore, be inappropriate to extend systemic regulation designed for banks to the insurance sector. It is difficult to envisage circumstances in which the failure of an insurer would significantly impair the financial system (the definition of systemically important adopted by the Financial Stability Board, International Monetary Fund and Bank for International Settlement in their recent paper 1 ). Insurance risks are real (ie caused by outside events such as accident, illness or natural disasters) rather than financial. They are, therefore, largely idiosyncratic and are not correlated either with each other or with financial markets. Insurers limit the effect of these risks by pooling the risks of a large number of policyholders. Therefore, the occurrence of even a significant event or series of events will not affect all insurers or, even where the occurrence leads to the failure of one insurer, lead to contagion between insurers insurers are not interconnected in the way banks are. Insurers are largely funded by premiums paid in advance. They are not dependent on wholesale, short-term debt and withdrawals of funds by policyholders are either impossible or financially unattractive. In addition they manage their business in such a way as to match 1 Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations (October 2009). 4

5 assets to liabilities. Insurers are not, therefore, subject to the liquidity risks that face banks and it is very difficult for there to be a run on an insurer. Banks give rise to particular systemic issues because of their interconnectedness, both with each other and with the real economy, which gives rise to the greatest risks of systemic failure. These connections (through payment systems and outstanding inter-bank transactions) can give rise to contagion between institutions and so ensure that the failure of one firm can lead to difficulties at others triggering a systemic crisis. Few of these considerations apply to insurers. As noted above insurers are largely funded through premiums received and, unlike many banks, are not dependent on money-market loans. Insurers are not, therefore, connected to the banking sector through short-term funding requirements. Nor have insurers any responsibility for the operation of payment systems. Also, unlike banks, insurers are not generally closely connected with each other. It is also worth noting that, unlike banks, existing insolvency and compensation regimes have proved capable of dealing with the rare circumstances where insurers have become insolvent. This is largely a result of the fact where an insurer becomes insolvent there is no need for large amounts of money to be paid quickly to policyholders (claims on an insolvent insurer will continue to be settled as they fall due probably over many years) which provides time for the failed insurer to be run-off in an orderly manner without disruption to the wider financial system. Although insurers are very important within the financial system they are not, in normal circumstances, a source of systemic risk to the financial system. The failure of a major insurer could cause significant disruption to policyholders (although these would be mitigated by the existence of compensation schemes) and losses to investors and creditors but would not have the widespread effect in either the financial system or the real economy that a banking failure can have. It is not, therefore, appropriate for insurers to be subject to additional regulation as systemically risky institutions. 16 th April