The fundamental economic changes and associated uncertainty arising from a ‘Yes’ result in the Scottish referendum poses medium-term fiscal and sovereign risk for the UK according to Towers Watson.
Keith Goodby, UK Co-Head of the Insurance Investment Advisory Group at Towers Watson, said: “Based on our assessment of the UK’s fundamentals and looking at similar historical episodes, we think the main impacts will be felt around exchange rates, gilt yields and UK asset volatility. Other market effects, for example on UK equity prices, are more ambiguous.”
Investment considerations for insurers
The result of the Scottish referendum will be significant for UK insurers, headquartered in both Scotland and rUK[1]; and also for other multi-national insurers if present in the UK. It is particularly pertinent to life insurers given the long dated nature of their liabilities as any prolonged or systemic impact to exchanges rates and yields will be amplified, notes Towers Watson.
The main short term investment concerns for insurers are likely to be:
• Exchange rate movements
• Gilts and swap rate yield movements
• Counterparty exposure to Scottish banks
Longer term there will be additional considerations, particularly for Scottish-based insurers. Of concern would be any change of currency given that a significant proportion of the Scottish-based insurers’ liabilities are likely to be with policyholders in rUK.
In terms of regulation, it would not be unreasonable to expect an independent Scotland to have a regime that is aligned with Solvency II regardless of whether it was part of the European Union (EU) or not, driven by expectations from the rest of the EU and rUK.
Exchange rates
Towers Watson believes that Sterling could weaken materially (for example 5-10% over a few days seems plausible as a central expectation), primarily against the US dollar, but suggests the potential move could be greater than this.
Keith Goodby said: “There are two important drivers: First, without Scottish oil revenues the current account deficit of rUK would increase because rUK would be spending proportionately more on imports and earning less from exports. This would increase the rUK current account deficit from 4% of GDP to around 6-7% of GDP (ex Scotland) - the worst in the G10 set of major developed economies – and lower the short-term value of Sterling. Second, the greater the uncertainties around currency union, integration of future rUK and Scottish government spending and banking union the greater the risk of capital flight, not only from Scotland to rUK but from rUK to the rest of the world. The latter is a relatively low probability event but, if it occurred, could see Sterling fall by more than our expected range.”
The key consideration for insurers is the impact on currency hedging strategies. Any weakening of Sterling would be material in terms of collateral calls. Towers Watson recommends that insurers review their collateral arrangements to ensure they have sufficient liquidity and capital to be able to maintain their foreign exchange hedging positions. The company also suggests they examine their available liquidity in the event of a possible 5%, 10% or 15% fall in Sterling over a few days.
It also noted that where there are unhedged exposures to overseas assets, a weakening of Sterling will be beneficial to the insurer and its policyholders and consideration could be given as to whether to lock in the gains from any such weakening.
Gilt yields
In the event of Scottish independence, the UK government has already stated that it will honour all of the debt previously issued. While some risks remain, this should limit the extent of any movement in gilt yields according to Towers Watson.
Keith Goodby said: “With an equitable distribution of assets and liabilities, Scotland would be liable for around 8-9% of the UK’s current debt burden. It is likely that the rUK government would continue to service all debt, with Scottish repayments being made directly from Scotland to rUK. Thus, post-independence the rUK government would be partially reliant on on-going debt repayment from the Scottish government, exposing it to the credit risk of Scotland, or would have to make the debt repayments itself supported by a smaller residual economy. These factors might be expected to increase the credit risk of gilts from current levels and push up yields.”
However, the company suggests that an alternative argument could also be considered. If independence were anticipated to lead to more difficult economic conditions - for example a protracted period of elevated uncertainty might itself reduce investment and growth - in the rUK, a low interest rate environment might be expected to persist for longer. Lower future interest rate expectations could act to lower gilt yields, perhaps offsetting the impact of the increased credit risk.
Keith Goodby said: “It is not clear which effect would dominate in the short-term, but again insurers with large liability-hedging programmes could usefully think through the implications of a ‘Yes’ vote for large gilt and swap yield moves either way, collateral quality, and counterparty risk to Scottish banks directly or through liquidity management vehicles.
“Movements in the Gilt yield curve are likely to be a lesser issue for life insurers as we would typically expect them to be well versed in managing rates exposure to a broadly neutral position i.e. being duration matched and therefore only have limited exposure to yield changes.”
Separate from the referendum, life insurers have been cognisant that yields may stay low for a long time or rise suddenly and should therefore be well prepared for any volatility, according to Towers Watson. However, they should be careful to ensure that they are not caught out by any unexpected twists in the shape of the yield curve.
Exposure to Scottish based banks could also come under scrutiny. Insurers will typically have exposure through cash held on deposit; cash drawdown facilities, derivative and collateral arrangements, equity and bonds holdings. A review of these exposures may be appropriate given long-term uncertainties over currency and any future Scottish government or central bank’s ability to act as a backstop to its banks.
UK asset volatility
According to Towers Watson the implications of Scottish independence are already likely to be priced in to markets to some extent, especially in Sterling. However, it suggests that once the outcome is known there would be an increase in daily volatility in Sterling and gilt markets.
Keith Goodby said: “The implications for UK equities and credit are similarly uncertain. On the one hand a fall in the value of Sterling might be a boon to the earnings of large UK companies - and hence their equity and debt - as the predominantly overseas sales of large companies are worth more, boosting profits*. However, the impact of greater uncertainty, a possibly weaker growth outlook and capital flight could more than offset this.”
The company asserts that UK corporate bond portfolios may have significant exposure to Scottish bank paper, which would probably come under particular focus following a ‘Yes’. Like gilts, it suggests the obvious thing to expect from UK equity and credit pricing following a ‘Yes’ vote is higher volatility, implying that investors should avoid asset transitions in the three-day period around the election.
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