Market Security Bulletin – The EU Referendum

July 5, 2016

On June 23, the United Kingdom held a referendum over the question, “should the United Kingdom remain a member of the European Union or leave the European Union?” A 51.9% majority of those that voted opted to leave. 

The vote is not legally binding on the UK Government and the UK has not formally notified the European Council of its intention to exit. In his resignation speech of June 24, UK Prime Minister David Cameron stated, "I think it's right that this new Prime Minister takes the decision about when to trigger Article 50 and start the process of leaving the EU," adding that there should be a new leader by the time the Conservative Party holds its annual conference in October. 

Many commentators expect that the UK Parliament will first be asked to vote before the notification is issued.  Once the formal notification is issued, Article 50 of the Lisbon Treaty obliges the EU to negotiate a ‘withdrawal agreement’ with the UK. If agreement cannot be reached, EU treaties would automatically cease to apply to the UK in two years, unravelling all the rights and obligations that the UK has acquired both during its accession to the EU and its 40 year membership. The complexity of the withdrawal negotiations is further increased as the UK would also want to negotiate its post-exit arrangements - including on labour movement, trade agreements and single market access - with the EU at the same time. Any extension to the two year period set out in Article 50 would require the unanimous agreement of all 27 remaining EU Member States. 

The outcome of negotiations over the terms of any UK exit and its future trading relationship with the EU is highly uncertain, and further monetary, fiscal and/or political policy responses will differ depending on how those negotiations conclude. In the absence of agreement within the withdrawal period, future trade rules would default to those set out by the World Trade Organisation which, except in a limited number of circumstances, would oblige the EU and UK to apply to each other the same tariffs and trade restrictions that they apply to the rest of the world. 

It is not possible to predict with certainty all of the consequences of the outcome of the referendum, although many economists and analysts expect a prolonged period of volatility. Political risk is currently elevated, both in the UK and elsewhere in the European Union. The extent of volatility and the full response of policy makers is not yet clear.

Each of the major rating agencies has taken a rating action on the UK sovereign in response to the vote:

  • Moody’s: Affirmed its Aa1 rating; but lowered its rating outlook from Stable to Negative; 
  • Fitch: Lowered its rating of “AA+, Stable Outlook” rating to “AA, Negative Outlook”
  • Standard & Poor’s: Lowered its rating of “AAA, Negative Outlook” by two notches to “AA, Negative Outlook” 

The UK continues to hold ratings 1 that are stronger than those of most EU countries.

The appendix to this note covers the rating agency comments, assumptions and expectations on the impact of Brexit on the UK and other sovereign ratings. Standard & Poor’s has noted that it does not expect rating actions to other sovereigns in response to the UK vote. Similarly Moody’s “does not expect Brexit to have major credit implications for most EU-based issuers. The UK market makes up a small share of overall revenues for most EU-based entities, while the European Central Bank would provide liquidity support in the event of major market volatility.” A break-up of the Eurozone is not considered to be a base case scenario of the major rating agencies and is considered sufficiently remote so as not to affect the rating level of most issuers. Should a break-up occur, many ratings would undoubtedly be affected.

Insurer Financial Strength

The above rating actions on the UK sovereign are unlikely to have significant direct impact on the financial strength rating levels of UK domiciled insurance and reinsurance businesses. Moreover, the rating agencies are indicating that actions to insurer financial strength rating levels are not anticipated as a direct consequence of the referendum outcome in the near term. 

Insurers are potentially in a better position to withstand volatility than those in certain other parts of the financial services sector, as was evidenced during the Global Financial Crisis of 2007-09. In particular, Non-Life insurers tend to be less sensitive to investment market volatility and sustained economic weakness; typically they are 

  • not as heavily leveraged to investment risk as banks;
  • not heavily dependent on short term funding through debt or commercial paper markets;
  • invested in less speculative and less volatile investment portfolios;
  • not generally susceptible to immediate liquidity issues associated with the withdrawal of funds, en masse, by clients (often known as ‘a run on the bank’) and
  • well-matched in terms of duration and currency with respect to asset-liability management.

Such characteristics are shared by Life insurers, although Life insurers tend to operate – depending on product mix – with a greater degree of investment leverage than Non Life insurers and demand for their products tends to be more closely linked with wider economic factors. 

No insurance financial strength rating levels have yet been changed as a direct result of the referendum although the rating agencies will continue to monitor this. We note that Moody’s has changed the rating outlook on a number of UK Life insurers and on US Life insurance groups with significant business in the UK but that none of the insurers’ rating levels have been downgraded and none are ‘under review’ for downgrade.

Willis Towers Watson Market Security Group continues to monitor and review the releases and commentaries issued by the rating agencies. Each of the rating agencies has issued broad commentary on the insurance sector, extracts of which follow.  Some of the rating agency activity in the insurance sector may focus on the intent of larger groups to restructure UK-domiciled insurance subsidiaries and establish an EU-domiciled subsidiary in order to operate under the EU’s “single passport” mechanism. We anticipate that insurance groups will respond to the impact of probable passporting changes by articulating their own strategies for group structure realignment. The rating agencies’ respective assessments of “strategic importance” of the UK subsidiary (in accordance with their rating criteria) to the group and the expected financial implications to the group could lead to negative rating activity; there is no guarantee that a subsidiary would continue to be assigned the “parent rating”, for example.2

Ultimately, however, the extent of rating activity will depend critically on political response and market volatility; we note that a break-up of the Eurozone is not considered to be a base case scenario of the major rating agencies and that this is considered sufficiently remote so as not to affect the rating level of most European issuers. Should a break-up become a base case rating scenario, many ratings could be affected. 
The outcome of the referendum could have a major impact on financial services within the European Union and its outcome may affect policyholder security offered by insurers. However, Willis Towers Watson Market Security Group does not at this time expect systematic failure of insurers to honour policyholder obligations as a direct result of the outcome of the referendum. Willis Towers Watson Market Security Group continues to monitor developments closely and expects to issue further updates as necessary. 

Rating agency observations on potential impacts of a Brexit vote on the Insurance sector

The following observations have been released by the rating agencies on the on the potential impacts of a Brexit vote on the insurance / reinsurance sector including its potential impacts on insurer and reinsurer ratings. 

AM Best, June 24, 2016: 

AM Best stated on June 24 that it “does not expect to take rating actions in the near term as a direct consequence of the decision by UK voters to leave the EU. The implications for the financial strength of insurers with regard to subsequent investment market volatility, currency fluctuations and increased economic uncertainty will be closely monitored. Also, as the terms of the exit are negotiated, A.M. Best will discuss with rated companies what prospective changes will mean for their competitive positions and ability to continue to access business in the UK and the EU.

The decision has led to a sharp drop in sterling and global equity markets. AM Best notes that the financial market volatility could have a material impact on insurers’ half-year results and balance sheets, with most companies reporting their positions as at 30 June 2016. Solvency II’s market-consistent approach to valuing the economic balance sheet means that financial market volatility will be closely reflected in European insurers’ reported solvency capital ratios. AM Best will discuss the implications of this with rated entities, but will continue to incorporate a prospective view when assessing insurers’ financial strength.”

In April 2015, AM Best had stated that in the event of an exit, “risks would likely be mitigated to an extent as any withdrawal would be managed over a number of years to avoid disruption, rather than ties suddenly being severed.” 

Standard & Poor’s, June 24, 2016: S&P Global Ratings Comments On Brexit Vote

Standard & Poor’s stated within its ‘cross-sector’ commentary on June 24 that it would be reviewing the ratings potentially affected by the referendum result noting, “any exit will likely be a drawn-out process while treaties or other arrangements are negotiated between the UK and the EU regarding their future dealings. As we have stated over the last several months, certain ratings may be affected sooner including the sovereign rating on the UK as well as the ratings on entities directly linked to the UK sovereign rating.”

On the Insurance sector, S&P added, “The leave vote is not expected to lead to rating actions on UK insurers.”

"We see the insurance sector as less exposed to the leave vote than the rest of the financial sector. While representing about one-third of the UK's very substantial financial services net export surplus, the insurance sector is far more reliant on trade with non-EU countries - especially the US. The sector is also a very limited recipient of inward investment.

 “The nature of any future trading relationship between the UK and the EU is yet to be established. However, even in the absence of any trade agreements or passporting rights, we believe that UK insurers operating in the EU could, through appropriate planning, continue their businesses largely uninterrupted. The same would apply for EU insurers who currently trade in the UK through branches. 

“The period of uncertainty while treaties or other arrangements are negotiated between the UK. and the EU could weigh on insurers' investment returns and possibly on the rate of future economic growth. However, we do not now believe that these potential issues are likely to lead to immediate rating actions on insurers.”

Moody’s, June 24, 2016:  UK Vote for EU Exit Signals A Prolonged Period of Uncertainty

In its ‘cross-sector’ comment, dated June 24, 2016, Moody’s observes, “For UK banks, insurers and asset managers, we believe that Brexit will pose moderate credit challenges… For insurers, we do not expect changes to current insurance passporting rights to have profound implications for the insurance industry overall because most UK groups operate in continental Europe through subsidiaries, and vice versa for continental European insurers. However, significant and prolonged financial market volatility would weigh on insurers’ solvency positions, particularly for UK life insurers, which are typically more sensitive to capital market movements given their high asset leverage.”

Fitch, June 24, 2016: “Brexit” to Drive Widespread Credit Pressure: Ratings Impact Depends on Macro Factors, Markets and Exit Terms

On June 24, 2016, Fitch noted that the result in the UK referendum, “is credit negative for most sectors in the UK, due to weaker medium-term growth and investment prospects and uncertainty about future trade arrangements.” 

Fitch adds, “UK life insurers have significant exposure to the UK sovereign via their portfolios of corporate and sovereign debt securities. We do not expect to downgrade any insurers in the near term as a direct result of the referendum outcome. In the longer term, a weaker economic operating environment could lead us to review highly rated UK life insurers… Life insurers tend to be sensitive to deterioration of the market values of their assets. But falls in equity, credit or real estate markets are likely to be manageable given life insurers’ strong and generally resilient capital positions. However, sustained economic weakness leading to intensified competition and material deterioration in the market values of assets could place life insurers at risk of downgrades.”

“Domestic non-life insurers tend to be less sensitive to asset-value deterioration and would probably be resilient to sustained economic weakness. A weaker exchange rate would have adverse consequences for non-life insurers’ profitability, but the impact should be manageable and temporary as most non-life business is short term and can be repriced regularly. The international nature of much of the business placed through Lloyd’s of London insurers could increase downgrade risk if economic uncertainty leads to a material portion of international policyholders placing their business overseas.”

Lloyd’s of London

On June 30, 2016, Lloyd’s issued a statement, “Lloyd’s plans in Europe”, in which it observes that it has been working on plans to protect its access to the European market:
“We have analysed in-depth each European market and our strong preference following discussion is to operate under a passporting system, similar to what we do today. As we move from contingency to implementation we are:

  1. Engaging with the UK government at all levels to push for similar passporting arrangements;
  2. Entering into discussions with regulators across the continent;
  3. Maintaining a dialogue with the market, industry, coverholders and customers; and
  4. Conducting further analysis of the EEA territories and their impact on Lloyd’s.”

Lloyd’s further notes, “the decision to leave the EU has no impact on Lloyd’s financial strength and S&P affirmed Lloyd’s A+ rating on the same week as the referendum vote.”

“The Market remains well capitalised to pay any major claims and will not be adversely affected by the fluctuations in Sterling due to good currency matching discipline covering assets against claims reserves and capital against exposures.  More than 50% of Funds at Lloyd’s are held in US dollars, and the Central Fund’s investment portfolio contains unhedged US $ exposure that will move in step with regulatory capital requirements. While investment volatility is to be expected, portfolios of the Central Fund and syndicates operating at Lloyd’s are generally conservative, with high quality fixed interest and cash as the majority of assets.” 

Lloyd’s adds, “no existing policies or renewals written whilst a member of the EU will be affected by the referendum. Policies are still legally binding and claims will be met – these are not affected by the referendum. Multi-year policies remain legally binding, regardless of when the UK formally leaves the EU. The referendum has no impact on Lloyd’s trading rights in all non-EU territories. Lloyd’s values its historical trading rights across the EU and EEA. We are keen to ensure policyholders have continued access to Lloyd’s specialist insurance and reinsurance in the long term. The EEA accounts for 11% of Lloyd’s Gross Written Premium – GBP 2.9 billion. Of that GBP 1.1 billion is reinsurance that we expect to be largely unaffected. GBP 557 million is Marine, Aviation and Transport. GBP 1.2 billion is non-MAT of which GBP 800 million is written cross-border and most likely to be affected by the UK’s withdrawal from the single market. This represents 4% of Lloyd’s global GWP which is GBP 26.6 billion, of which 47% comes from our largest market, Canada and the United States.”


Further information: Willis Towers Watson does not guarantee or otherwise warrant the solvency of any insurer. In the event you wish to discuss the financial security of specific insurance or reinsurance counterparties, please refer to your normal Willis Towers Watson contact in the first instance.

Important disclosure for clients of Willis Towers Watson: The information compiled in this note by Willis Towers Watson is compiled from third party sources we consider to be reliable. However we do not guarantee and are not responsible for its accuracy or completeness and no warranty or representation of accuracy or completeness is given.  We do not offer advice in relation to tax, accounting, regulatory, legal or investment matters and you must take separate advice as you consider necessary regarding such matters. This note is not prepared for and should not be construed as providing investment advice or services. It speaks only as to the date on which it was created and we shall have no obligation to update or amend.  Willis Towers Watson does not guarantee or otherwise warrant the solvency of any insurer. Willis Towers Watson assumes no responsibility or duty in tort, contract or otherwise to any third party in respect of this document. Please note that this note is confidential and not for onward dissemination.

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Appendix - Sovereign Rating Actions following the outcome of referendum 

Standard & Poor’s, June 27, 2016:  Ratings On The UK Lowered To 'AA' On Brexit Vote

On June 27, 2016, S&P lowered the long term sovereign credit rating of the UK by two notches, “in our opinion, this outcome is a seminal event, and will lead to a less predictable, stable, and effective policy framework in the UK. We have reassessed our view of the UK's institutional assessment and now no longer consider it strength in our assessment of the rating. The downgrade also reflects the risks of a marked deterioration of external financing conditions in light of the UK’s extremely elevated level of gross external financing requirements. The vote for “remain” in Scotland and Northern Ireland also creates wider constitutional issues for the country as a whole… The negative outlook reflects the risk to economic prospects, fiscal and external performance, and the role of sterling as a reserve currency, as well as risks to the constitutional and economic integrity of the UK if there is another referendum on Scottish independence.” 

Moody’s, June 24, 2016:  Moody's changes outlook on UK sovereign rating to negative, affirms Aa1 rating

On June 24, 2016, Moody’s affirmed its UK sovereign rating at Aa1, noting “the economic and fiscal consequences of the referendum result are highly uncertain as they depend crucially on the outcome of future negotiations with the EU as well as with other trading partners. Moody's believes that a scenario in which the UK manages to preserve many (albeit not all) of its current trade benefits from EU membership is plausible. The long-term economic impact would be limited in such a scenario and the UK's current sovereign rating of Aa1 would remain appropriate. Also, the UK authorities might well adopt policies that mitigate the above mentioned negative consequences of the decision to leave the EU. Those policies - in the areas of trade, regulations, immigration, tax- will become clearer over the coming 1-2 years. ”

Moody’s nevertheless lowered the rating outlook to negative from stable, citing three key drivers: i) the negative impact that Moody's believes the decision to leave the EU will have on the UK's growth prospects and economic strength, ii) the risk that policy predictability and effectiveness might be somewhat diminished as a consequence of the vote and iii) the negative effect on the UK's public finances arising from lower economic growth.

Fitch, June 27, 2016:  Fitch downgrades the United Kingdom to 'AA'; Outlook Negative 

On June 27, 2016, Fitch lowered the long term sovereign rating of the UK by one notch to AA following the UK vote to leave the European Union, which “will have a negative impact on the UK economy, public finances and political continuity.” 

“Fitch believes that uncertainty following the referendum outcome will induce an abrupt slowdown in short-term GDP growth, as businesses defer investment and consider changes to the legal and regulatory environment…” 

“The extent of the medium-term economic shock will mainly depend on the nature of any future trade agreement with the EU, by far the UK's largest export market… Prime Minister David Cameron has indicated that negotiations with the EU will not begin in earnest until 4Q16, and the final position may well not be known for several years…”

“The outcome of the referendum has precipitated political upheaval, including the announced resignation of the Prime Minister, contributing to heightened uncertainty over government economic policies and diminished scope for policy implementation at the current conjuncture.” 

“Furthermore, the fact that a majority of voters in Scotland opted for 'Remain' makes a second referendum on Scottish independence more probable in the short to medium term. The Scottish First Minister Nicola Sturgeon has indicated that a second referendum on Scottish independence is "highly likely". A vote for independence would be negative for the UK's rating, as it would lead to a rise in the ratio of government debt/GDP, increase the size of the UK's external balance sheet and potentially generate uncertainty in the banking system, for example in the event of uncertainty over Scotland's currency arrangement…”

Fitch’s rating assumes “that the present heightened volatility in financial markets will abate in due course.”

1 Definitions: S&P: An obligor rated 'AA' has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree; Fitch:  'AA' ratings denote expectations of very low default risk. They indicate very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable event;   Moody’s: Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.

2 Automatic access of UK-established insurers to the EU market would cease upon the UK’s exit from the EU and be subject to negotiations and agreements. Similarly, automatic access of EU-established insurers to the UK and London insurance markets would be subject to the same considerations. Currently, almost 600 non-life insurers and almost 200 life insurers from outside the UK write business in the UK via the passport mechanism. S&P has observed (June 2015) “If a Brexit were to put an end to passporting rights, it would no longer be possible for EU firms to write business in the UK via branches or a life or non-life passport… These groups would have to set up UK subsidiaries. This would necessitate set-up costs, capitalization, and - probably more stringent - regulation by UK regulators, the PRA and FCA. Equally, UK insurers would need to acquire licenses and regulation for operations in the rest of the EU. While inconvenient and expensive in the short term, these changes are unlikely to lead to any but the smallest and most marginal of businesses to cease writing in the UK. The same goes for UK companies with continental operations. Importantly, a subsidiary would require its own rating, while a branch would not. And it is possible that a small overseas subsidiary might not share the rating of its parent, whereas a branch would.”