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Government outlines final reforms to Solvency II regime

Author: ICAEW Insights

Published: 22 Nov 2022

The government has set out its final reforms to the Solvency II regulatory regime, striking a balance between relaxing requirements and giving the PRA additional powers.

As part of the Autumn Statement, the government has published a Consultation Response setting out the final reforms to the Solvency II regulatory regime, which it predicts will unlock tens of billions of pounds for investment across a range of sectors.

The Financial Services and Markets Bill, introduced in July 2022, will repeal retained UK law, including the Solvency II Directive. This will permit a new Solvency II framework within which insurance and reinsurance can be regulated in the UK. This new solvency regime is part of the government’s wider reform programme to tailor financial services regulation to UK markets in order to bolster the competitiveness of the UK as a global financial centre and deliver better outcomes for consumers and businesses.

Solvency II background

Solvency II EU legislation was implemented in all member states from 1 January 2016, introducing a harmonised EU-wide insurance regulatory regime. This primarily concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency.

It was argued by the UK insurance sector that the existing regime forced firms, particularly within life insurance, to ring-fence more capital than necessary by valuing insurance liabilities at greater levels than warranted relative to the risk.

Two areas came in for criticism:

- Risk margin: the provision for an insurance liability is theoretically the amount a third party would be given to assume the insurance obligation. The provision comprises the best estimate of the insurance obligation and a risk margin. It was argued the risk margin element was too conservative and trapped capital.

- Matching adjustment: the matching adjustment allows firms to adjust the relevant risk-free interest rate (ie, the discount rate) for the calculation of the best estimate of insurance obligation. It was argued the fundamental spread component (an adjustment to the risk-free rate to exclude retained risks) does not properly capture the retained risks, and that the eligibility criteria were consequently too restrictive.

Initial reform proposals

The Treasury’s consultation on Solvency II, which closed on 21 July 2022, proposed reforms that could result in a release of 10%-15% of the capital held by life insurers. It was thought that by reducing the risk premium on liabilities and reforming the fundamental spread through the matching adjustment, tens of billions of pounds of capital could be freed up to invest in the economy. For example, capital could be invested in infrastructure assets and the transition to a greener economy.

The Prudential Regulation Authority (PRA) was broadly in agreement with the proposed reforms but advocated measures to strengthen buffers against credit risk in the matching adjustment through the introduction of a 35% credit risk premium. A number of firms opposed such a measure, believing that it would significantly offset the potential capital release provided through the other reforms.

Proposed changes as of 17 November

Following the consultation, the government has expressed confidence that the package of reforms will fulfil its objectives and will take proposals forward by amending legislation.

According to the Consultation Response, the government proposes reducing the risk margin for long-term life insurance business by 65%, and for general insurance business by 30%, and to enable a modified cost of capital approach to its calculation.

It does not propose legislating to restrict commercial decisions about how freed-up capital is used. Several respondents to the consultation indicated that released capital may be used to reduce pricing, or increase the market rather than be returned to shareholders.

Although the government has decided to retain the design and calibration of the fundamental spread, the consultation proposes various changes to the matching adjustment. These include:

  • “To allow the inclusion of assets with highly predictable cash flows, subject to a number of safeguards which the PRA will implement.” The current regime requires cash flows to be fixed.
  • To “increase the risk sensitivity of the current fundamental spread approach to allow different notched allowances to be made within major credit ratings” (for example, different allowances for assets rated AA+ or AA- compared with AA).
  • [To remove] “the disproportionately severe treatment of assets in matching adjustment portfolios whose ratings are below investment grade (BBB)”.

These proposals should enable insurers to invest in a broader set of asset categories, notably those that are more illiquid and have a lower rating but that are longer term in nature and geared towards infrastructure projects.

The PRA has been asked to keep the use of the matching adjustment under close scrutiny, with the government planning to review the appropriateness of the calibration of the fundamental spread in five years’ time.

Among other proposals, the government will legislate to remove branch capital requirements. Its view is that reform should increase the attractiveness of the UK as a location to do business. It will also introduce a new ‘mobilisation regime’ and will increase the thresholds before which the new Solvency II regime applies. The aim is to reduce barriers to entry and boost competition by enabling smaller firms to grow more quickly.

Striking a balance

Commenting on the Consultation Response, Simon Gibbs, ICAEW Head of Banking and Insurance, says that the proposals are welcome in addressing what seems an accepted truth by firms and the regulator – namely that Solvency II and the risk margin was overly conservative and tied up capital unnecessarily.

However, the government has struck a balance between relaxing the requirements and giving the PRA additional powers to ensure the regime as a whole remains prudentially sound and protects policyholders.

The changes to the risk margin should enable greater capital to be available for investment or to benefit shareholders through lower pricing. Through other actions, such as broadening the eligibility criteria for the matching adjustment, the government is also enabling or facilitating investments into infrastructure and/or green assets that should benefit the UK economy longer term. 

Reuben Wales, ICAEW Head of Financial Services, adds: “We think it right that the government does not legislate the type of assets that insurers invest in but leaves it as a commercial decision. That does mean there is a risk the freed-up capital is returned to shareholders. We note, however, the respondents to the government’s consultation have indicated that this is not the expected outcome. We would encourage the government to continue to work with the industry to ensure that there are appropriate investment opportunities for insurers that also promote sustainable UK growth.”

Autumn Statement

On 17 November 2022, the Chancellor delivered the Autumn Statement. Read ICAEW's analysis and reaction.

Westminster

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