Solvency II reform: an overview

In a speech to the ABI on 21 February 2022, the Economic Secretary to the Treasury & City Minister, John Glen, announced the government’s proposal for significant reforms to Solvency II – the prudential regulatory regime introduced by the EU in 2016 and inherited by the UK following its withdrawal from the EU.

Solvency II reform has been long-awaited by the UK insurance market. This week’s announcement follows an initial treasury consultation paper and indications in a number of speeches by the regulators – including remarks by Bank of England Governor Andrew Bailey at the recent TheCityUK Annual Dinner:

I do not for a moment consider that the Solvency 2 we transposed from EU law and regulation is best suited to the UK. Why would it be, since it was designed to cover 27 countries? The case for reform is clear.

As a regime intended to harmonise prudential regulation for the insurance sector across the EU, it has often been argued that Solvency II is not well calibrated to the particular features of the UK insurance market – particularly the nature of its established long term (life and longevity) insurance sector. There has therefore been a strong appetite for regulatory divergence in the sector, notwithstanding the possibility that greater divergence could reduce the likelihood of the EU granting an equivalence decision to the UK’s insurance regulatory regime. This is especially true, perhaps, since the equivalence regime under Solvency II is narrow compared to others of the various equivalence regimes for financial services. In particular, an equivalence decision, if granted, would not provide for “passporting rights” for UK insurance firms into the EU in any case.

John Glen’s speech confirms this direction of travel towards greater regulatory divergence and gives further detail of the likely changes in three key areas:

• the Risk Margin;
• the Matching Adjustment; and
• more generally, the reporting and administrative burden of the regime.

The speech gives only a broad overview of the prospective reforms, with a formal consultation to follow in April. However, the following key proposals were outlined.

1. Risk Margin

The Risk Margin has arguably proved to be the most controversial aspect of Solvency II since its introduction, particularly for the UK long term insurance market. It requires insurers to hold assets – additional to those held against their liabilities and to meet their capital requirement – in order to reflect the cost for another insurer in the market, were those liabilities transferred to it, of raising capital to meet the resulting capital requirement.

This is intended as a protective measure, to ensure that, at the point at which a failing insurer has exhausted its regulatory capital “buffer”, it still holds sufficient assets for its liabilities to be transferred to a third party if needed (or for it to close to new business and raise sufficient capital to restore its capital buffer so as to manage those liabilities in run-off).

However, the current “cost of capital” methodology for calculating the risk margin has been criticised as a substantial capital burden (especially for long term insurers), which is over-sensitive to interest rates and encourages insurers to hedge longevity risk with reinsurance, usually with non-UK reinsurers. It became clear after implementation of Solvency II that, for UK life insurers, the risk margin is larger than expected. The Prudential Regulation Authority (PRA) estimated as at 30 September 2016 that the aggregate risk margin held across UK life industry was around £44bn – similar to the aggregate benefit it derives from Matching Adjustment (estimated at £59bn). Its impact is currently muted by the transitional measures on technical provisions (TMTP) under Solvency II – which smooths the introduction of its measures (where they increase requirements on insurers over Solvency I measures) over 16 years – but would increase as TMTP falls away. Insurers have argued that this ties up financial resources unprofitably and raises the cost of capital for insurers by delaying distributions to shareholders.

It is against this background that the speech announces “a sizeable reduction in the risk margin for long-term life insurers… in the order of 60 to 70%”. This is likely to be welcomed by the long-term insurance market, for whom this has the potential to release significant capital. We await detail on what changes to the risk margin calculation methodology are proposed to deliver this reduction – for example, whether the intention is to reduce its pro-cyclicality by reducing its correlation to interest rates; lower the measure of the cost of capital; allow prospective future reinsurance to be taken into account; or some more radical change in methodology.

2. Matching adjustment

The “matching adjustment” allows insurers to discount the valuation of their long-term liabilities under Solvency II at a more favourable discount rate than the usual risk free rate where certain eligibility criteria are met, thereby reducing the assets required to be held against those liabilities. The eligibility criteria broadly requires that insurers maintain a separate portfolio comprising liabilities which have a predictable long term cashflow and assets held against those liabilities which have the same predictable long term cashflow profile – such that, in essence, assets mature to meet those liabilities as they fall due.

This adjusted discount rate is intended to reflect that an insurer who “matches” long term assets and liabilities in this way is not subject to all the risks which are represented in the spread of that asset over the risk free rate. In particular, while insurers remain subject to credit and default risk on the matching assets held to maturity – represented in the calculation of matching adjustment by a measure known under Solvency II as the “fundamental spread” – they are not subject to the “liquidity risk” of having to sell assets before maturity at an undervalue. Accordingly, they should be able to treat that portion of the spread which represents liquidity risk as additionally “risk free” and discount those liabilities accordingly by applying the matching adjustment.

The use of this measure is subject to a detailed application process and a number of eligibility criteria to ensure assets and liabilities are appropriately matched. These criteria have been considered to be overly restrictive and inflexible – and difficult to meet with regards to some common features in assets and liabilities which are argued to be otherwise suitable for matching adjustment. The restrictions they impose on the character of eligible assets and liabilities requires insurers to restructure assets or the terms of their contracts specifically to ensure eligibility. Conversely, it has been argued by some – including the PRA in relation to equity release mortgages – that certain assets that are eligible (or eligible once restructured) may attract an inappropriately high amount of matching adjustment, as the formula does not appropriately account for the risks to which the insurer remains subject.

In his speech, John Glen announced a number of proposed changes in this regard, including:

• a reassessment of the calculation of fundamental spread to better reflect credit risk (the risk to which insurers matching assets and liabilities remain exposed);
• to broaden the assets and liabilities which may be eligible (for example, to include assets with the option to change the redemption date and morbidity risk liabilities), with an apparent intention that insurers are encouraged to invest more in long-term assets such as infrastructure;
• a more proportionate approach to breaches of the matching adjustment (which currently risk causing the whole portfolio to be deemed ineligible); and
• a speedier process for matching adjustment eligibility decisions.

There is therefore the prospect for insurers to widen their strategies for taking advantage of the matching adjustment (with the government’s intention appearing to be to encourage more investment in productive long-term assets, such as infrastructure). However, the proposal to better calibrate the matching adjustment to credit risk has the potential to lower the benefit available from certain asset classes for which the PRA has previously raised concerns that risks are not fully accounted for, such as equity release mortgages.

The details of this proposal therefore have the potential to shape insurer’s investment strategies in ways which would impact the wider market.

3. Reporting and administrative burden

Solvency II imposes a detailed scheme of solvency reporting and administrative requirements upon insurers. The government proposals are described in John Glen’s speech as “a major reduction in the EU-derived regulations which make up current reporting and administrative burden”. They are proposed to include, amongst other things:

• simplifying the approval process for insurers’ use of internal models to calculate their capital requirements;
• reforming reporting requirements, for example, by introducing exemptions for new insurers and reducing the frequency and number of reports;
• simplifying the calculation of TMTP transitional measures (which smooth the introduction of Solvency II requirements as compared to Solvency I), by reducing the burden of maintaining legacy Solvency I calculations; and
• raising the threshold for the size and complexity of insurers before the Solvency II regime applies.

While John Glen’s speech provides only a broad-brush indication of the proposed reform, the reforms are likely to represent a significant change for the UK insurance market. In it, he estimates the reforms will release “possibly as much as 10% or even 15% of the capital currently held by life insurers… allowing them to put tens of billions of pounds into long-term productive assets”. At the same time, any loosening of the prudential requirements to which insurers are subject will need to be balanced against the need to safeguard policyholders against the risks of insurance firm failure.

With the insurance sector representing a significant component of the UK’s total GDP, having approximately £1.9tn of assets under management, the exact nature of these changes could have a significant impact on the shape of the wider UK market in the coming years, by altering the optimal structure of insurer’s asset and liability portfolios.

Like the insurance sector, we will keenly await the further details of the reforms.