Proposed reforms to Solvency II in the UK

The UK government has given an indication of how it wants to reshape Solvency II post Brexit to benefit UK insurers, and to release capital for infrastructure investment.A formal consultation paper is expected in April, but a speech to the Association of British Insurers by City Minister John Glen on 21 February has set out the proposals the UK government is currently working on with the PRA.

The UK government wants to reform Solvency II, to replace what it characterises as an EU-focused, inflexible and burdensome body of regulation, with one that is UK-focused, agile, encouraging to new types of assets and new and innovative firms, and which allows the release of capital for productive investment.

Proposed reforms will involve:

• a substantial reduction in the “risk margin”… (a cut of around 60-70% for long-term life insurers).
• a reassessment of the “fundamental spread” used to calculate the matching adjustment, to better reflect its sensitivity to credit risk.
• a significant increase in flexibility to allow more investment in long-term assets including infrastructure.
• a major cut in current EU-derived reporting and administrative burden.

The UK government hopes that as much as 10% to 15% of the capital currently held by UK life insurers can be released, allowing them to put tens of billions of pounds into long-term productive assets, and says it is confident reforms will also safeguard policyholder protection.

Risk Margin

Under Solvency II, risk margin is part of the technical provisions against which insurers must hold capital. It is intended to represent the additional amount that would have to be paid on top of an insurer’s ”Best estimate of liabilities” to transfer its insurance liabilities to another insurer. It is currently calculated by reference to the notional cost to the acquiring insurer of the additional capital it would need to hold – set at what the industry considers is an unrealistically high rate of 6%, discounted by reference to long term interest rates. The methodology for calculating the risk margin has been criticised as resulting in a much higher than expected overall risk margin, and in significant volatility, because of its sensitivity to interest rate movements.

The UK government agrees with these criticisms. Its view is that other protections in Solvency II already mean insurers will hold sufficient capital to cope with a 1 in 200 year shock, and that contemplated reforms could stabilise insurers’ balance sheets, and reduce the risk margin for long-term life insurers by 60 to 70%, and also reduce incentives for UK insurers to reinsure longevity risks offshore.

Fundamental spread and the matching adjustment

The UK government also intends to look at alternative methodologies for calculating the “fundamental spread”.

Under Solvency II, insurers who have liabilities with predictable cash flows e.g. under annuity contracts, are able (with supervisory approval) to apply a “matching adjustment” to the rate at which they discount those cashflows if they hold a matching portfolio of assets (e.g. government bonds) with similar cashflows. The matching adjustment has to take account of a “fundamental spread” which seeks to reflect the risk of default or downgrade represented by the matching adjustment assets.

The UK government believes that the fundamental spread doesn’t explicitly allow for uncertainty around defaults and downgrades, and is insufficiently sensitive to differences in risk across asset classes and quality ratings. It therefore intends to consult on reforms that to the fundamental spread that will set it at a level and with a sensitivity that more genuinely reflects an asset’s credit risk.

The UK government expects its proposed approach to the fundamental spread to boost incentives to invest in infrastructure and other long-term productive assets. John Glen has said this could be a “gamechanger” allowing investment capital “to shift, for instance, from bonds to wind farms”.

The proposed approach would be phased in, and is intended to:

• avoid introducing short-term market volatility on to balance sheets;
• mitigate incentives to reinsure credit risk offshore;
• take into account other tools within the regime to protect policyholders, such as supervisory powers, the prudent person principle, and the ability to impose capital add-ons.

The UK government also intends to broaden the range of assets eligible for the matching adjustment portfolio, to include assets with the option to change the redemption date, assets with construction phases, and callable bonds. It also wants to broaden the liabilities that are eligible, to include income protection products and those that insure against morbidity risk, and to end the disproportionately severe treatment of assets whose ratings fall below BBB in matching adjustment portfolios.Finally, government proposals will seek to speed up applications for assets to be eligible for the matching adjustment, and provide greater flexibility for how new or innovative assets without historical data are treated.

Comment

The UK insurance sector will have an opportunity to consider these proposals in detail when the consultation paper is published. The UK government will wish to show that it can move quickly post-Brexit towards what it describes as ‘Solvency UK’, a regulatory framework which meets the UK’s needs, and maximises opportunities available to the UK industry. The UK government wants this to include releasing large amounts of capital for infrastructure and green investment.

Meanwhile, the EU is proceeding with its own changes to Solvency II. The Commission adopted a package of proposals for amendments to the Solvency II Directive and for a new Insurance Recovery and Resolution Directive in September 2021. The EU is also ambitious for the benefits its Solvency II reforms will bring – the Commission thinks they could release EUR 90 bn of insurers’ capital for investment in the short term and EUR 30 bn net when proposals to strengthen capital requirements in other areas have been phased in.

As regulations begin to diverge between the UK and the EU, there will be a strong political imperative for the UK government to demonstrate that its approach will deliver a Brexit dividend, in the shape of tangible benefits for the UK insurance sector and the wider UK economy.