Post-Brexit Solvency II reforms: what is changing?
Insurer Update - June 2023
Read time: 42 mins
Following last year’s Government consultation on Solvency II, here’s an overview of the main proposals and decisions made as a result.
Solvency II is the regime for (re)insurance undertakings within the European Union. Aiming to reduce the risk of insolvency, the directive and supporting regulation introduced harmonisation across the EU. Before Brexit, entities in the UK had to comply with this regime.
In April 2022, the UK Government released a consultation to review Solvency II so that it could adapt to the UK’s position outside the EU. This consultation was underpinned by three objectives:
- to spur a vibrant, innovative, and internationally competitive insurance sector
- to protect policyholders and ensure the safety and soundness of firms
- to support insurance firms to provide long-term capital to support growth, including investment in infrastructure, venture capital and growth equity, and other long-term productive assets, as well as investment consistent with the Government’s climate change objectives.
The consultation received 67 responses from insurance market stakeholders including insurers, consultancies, industry groups and individuals.
The full consultation documents can be found here.
Matching adjustment – fundamental spread
The consultation paper proposed a review of the ‘fundamental spread’. This is used by firms as part of their matching adjustment calculation (which is mainly utilised by larger life insurers). It represents the expected cost of default and downgrade of assets which back providers’ annuity business, and to which firms are therefore exposed.
This review responded to several indicators suggesting that the fundamental spread may not be capturing retained risks properly. Miscalibration of the fundamental spread would mean that credit risk may not be appropriately captured in insurers’ balance sheets. This, in turn, could weaken protection for policyholders.
Respondents recognised the risks to the current calibration but considered the current methodology to be prudently calibrated. The consensus was that incorporating a credit risk premium would increase the best estimate liability, reduce own funds and hence increase capital buffers.
What’s more, there would be an increase in balance sheet volatility which would then require further capital buffers. The impact on the market would be a disincentive to the provision of annuities and investment in illiquid assets such as infrastructure. The cost of these disincentives would be passed on to consumers.
Following this feedback and its own independent analysis, the Government decided not to make any updates to the current design and calibration of the fundamental spread. However, it has introduced further controls to ensure that risk management by insurers is aligned with the Prudential Regulation Authority (PRA)’s risk tolerance. These include:
- Regular stress testing exercises as prescribed by the PRA (which will be allowed to publish individual firm results).
- Senior managers holding formal regulatory responsibilities being required to formally attest whether there is sufficient fundamental spread on their firm’s assets to reflect all retained risks.
- Permission for insurers to apply a higher fundamental spread through an add-on if they believe that the standard allowance is insufficient.
- An update to the matching adjustment rules (see below).
The Government will revisit the calibration of the fundamental spread in five years’ time to ensure that the approach remains appropriate.
Matching adjustment – increasing investment flexibility
The consultation also made the following proposals for the matching adjustment:
- The current Solvency II regime only allows cash flows generated by assets which are fixed in timing and amount to be used for matching adjustment portfolios. The proposal was to allow a broader range of assets to be eligible.
- Extending the range of eligible liabilities for the matching adjustment to include morbidity risk products, such as income protection products.
- Assets which have a credit rating below BBB will no longer be as disproportionately treated in matching adjustment portfolios. The objective was a more credit risk sensitive fundamental spread.
- Faster decisions by the PRA on matching adjustment eligibility applications for less complex assets. This will be achieved through the separation from the review of asset valuation, credit rating and capital modelling. This will enable insurers to deploy capital into new asset classes.
- Currently, a breach to the matching adjustment rules lasting more than two months would lead to the entity losing the full matching adjustment benefit. A more proportionate approach to such breaches is proposed, which will help insurers to plan better on the basis of a more stable matching adjustment benefit. It would also lower costs associated with asset portfolio restructuring.
The above proposals will be implemented. Following market feedback, the Government also decided to replace the requirement for ‘fixed cash flows’ to be reworded as ‘highly predictable cash flows’, further supporting flexibility.
Risk margin
The consultation paper proposed that the risk margin calculation be reviewed to achieve a 60-70% cut for long-term life insurers. The Solvency II regime uses a cost of capital approach and is sensitive to the duration of the liabilities, the risk-free yield curve at the time of the calculation, the lines of business and the resulting risk profile of the entity.
The Government proposed a modified cost of capital approach that would retain the sensitivity to the differences in risk profile and duration. What’s more, the disruption would be minimal as the approach is similar to that being proposed in the EU. The 60% reduction would mean that insurers reduce the sub-optimal allocation of capital resources. A lower risk margin would also lead to a reduction in the volatility in insurers’ balance sheets introduced by the change in interest rates from one reporting period to the next.
Another incentive to reduce the risk margin was the current loss of life reinsurance business to jurisdictions outside the UK, where a lower risk margin is required.
Market respondents agreed with the concept of having a risk margin to transfer a book of insurance business. However, most believed that under the Solvency II regime, the margin is higher than necessary and that the proposed cuts are useful. They agreed with a modified cost of capital method, as it is theoretically sound and in alignment with the current approach.
The final reform is that the risk margin will be reduced by 65% for long-term life insurance business, including PPOs. Since general insurers typically have a lower risk margin which is less volatile, mainly as a result of the shorter tail on average, they would be less impacted by a reduction in the risk margin. A 30% cut for general insurers was deemed appropriate.
Reducing reporting and administrative burden
The consultation made these additional proposals to reduce the burden on entities:
- Reforms to the internal model framework. This will include reduced requirements for documentation, statistical quality standards, the ‘use test’ and profit and loss attribution. The aim is to enable simpler approaches when they are sufficient. Any remaining limitations would be mitigated through safeguards, which could be capital add-ons, exposure limits and approval conditions.
- Branches of foreign insurers will not be required to calculate local capital or to hold assets to cover them. This was estimated to impact around 160 branches at the time of writing.
- Increase thresholds of premium and technical provisions before Solvency II becomes applicable.
- Make reporting more proportional by simplifying complex templates and deleting others. Also reduce reporting frequency of some templates and amend others so they are applicable to the UK market.
- Introduction of a mobilisation regime for new insurers, with an optional phase for new insurers to enter the market. This will include modified entry requirements, such as a lower capital floor and lower expectations for key personnel and governance structures. There may also be reporting requirement exemptions. To protect policyholders, proportionate restrictions will accompany these reduced regulatory standards.
- Allow groups to temporarily use multiple group internal models following an acquisition or merger. Further, acquired firms will not be required to hold temporary additional capital post-acquisition.
- Reduce the administrative burden of legacy system maintenance. A simplification of the calculation of Solvency II transitional measures was also proposed.
Many market respondents welcomed the reduced burden proposed. Some were concerned that reduced reporting may lead to an increase in ad-hoc reporting requests. Others worried that any significance divergence from European templates would increase costs for entities required to report under both regimes. However, the market did support the proposals to remove branch capital requirements and introduce a mobilisation scheme.
The Government decided to proceed with the proposals and to increase the threshold to £15m in annual gross written premiums, which is triple the previous threshold. It will also increase the threshold to £50m in gross technical provisions, which is double the previous threshold. Entities which have a lower threshold may still opt into Solvency II (as adopted in the UK) if they wish.
Implementation of the Reforms
In February 2023, Sam Woods (CEO of the PRA) gave a speech at the ABI dinner about the next steps for Solvency II reforms. He said, “Discussions with colleagues in the Treasury about precise timings are ongoing, but at this point our broad expectation is that we will publish a first consultation on some of the topics above in June, followed by a second consultation, on those areas that will benefit from more time for industry engagement to make sure we can get the details right, in September.”
In June 2023, the UK Government has released draft regulations to give effect to the consultation’s reforms. These confirm a drop in the cost of capital used to calculate the risk margin from 6% to 4%, cutting risk margins for general insurers by circa 30%.
The drafts regulations are subject to change, but have been released to aim for early engagement and implementation. The Government expects the reforms to the risk margin to be implemented by year end 2023 and the reforms to the matching adjustment by June 2024. The other outstanding reforms are expected to be in place by year end 2024.
The draft Regulation can be found here.
Given the desire to implement some of the package of changes for upcoming December 2023 year ends, government and industry will need to move at pace to make this a reality.
For more information on any issues raised in this article, please contact Michaela Buttigieg.