The UK Government’s aims to spur innovation and competitiveness in the insurance sector are at the core of its Solvency II proposals currently out for consultation, writes Matthew Francis, Insurance Director at KPMG UK.
The consolation proposes three major changes for UK insurers, firstly to the risk margin for life insurers, secondly a revision to the fundamental spread component used by annuity providers, and lastly a reduction in reporting requirements. These changes are intended to not only help protect policyholders, but also to support insurers to invest in assets capable of driving growth in the UK economy.
The headline reform of the Solvency II proposals relates to a 60-70% reduction in the risk margin for life insurers. The risk margin is a component added to an insurer’s best estimate of its insurance liabilities to produce a market or ’transfer’ value. The current design of the risk margin is too sensitive to interest rates and therefore requires insurers to hold more assets when interest rates are too low.
The risk margin currently amounts to £32bn across the life insurance sector. Whilst it is not clear how evenly the 60-70% reduction will be shared amongst market participants; this headline figure clearly boasts a potentially significant capital release opportunity.
In some cases, the reduction in the risk margin might be minimal. For some firms, the capital release might be offset in practice by the operation of the transitional measures on technical provisions. This is a mechanism for spreading the impacts of transitioning to the Solvency II regime on business that was written prior to 2016. Reinsurance also plays a factor in already reducing the risk margin in relation to annuity business incepted after the introduction of Solvency II.
The second significant revision of the Solvency II proposals relates to the fundamental spread and matching adjustment mechanism. The fundamental spread is a component of the ‘matching adjustment’ used principally by annuity providers to derive a discount rate to calculate certain liabilities by reference to the portfolio of assets that back those liabilities.
At the request of the Prudential Regulation Authority (PRA), HM Treasury proposes to introduce a ’credit risk premium’ when calculating the fundamental spread to take account of a premium an investor would expect in return for uncertainty over the expected loss on default of an asset. Depending on its final calibration, the credit risk premium could materially off-set the capital released from the risk margin for annuity writers.
Insurers typically invest in illiquid asset classes, such as equity release mortgages, where their regular fixed cash flows are a good match for annuity liabilities. Illiquid asset classes receive a higher spread than corporate or government bonds which means that insurers can derive a higher discount rate to calculate their annuity liabilities.
Whilst illiquid assets would still offer a larger spread than bonds following the introduction of a credit risk premium in the fundamental spread adjustment, the proposal disproportionately reduces the attractiveness of holding illiquid assets, such as real estate and infrastructure debt, relative to the current regime. Therefore, rather than creating incentives for insurers to invest in illiquid asset classes capable of driving growth in the economy and helping the UK transition to a net zero economy, these proposals could in fact diminish the incentives to invest in them.
Whilst the Government is looking into expanding the list of assets that are eligible for the matching adjustment, these would not alter the overall economics of investment decisions taken by insurers and therefore these might fall short of the Government’s own ‘levelling up’ ambitions.
In its consultation, the Government seeks assurance from insurers that they would not seek to distribute the capital released from any savings made by the consultation to shareholders. This is an indication of the political sensitivities around dividends and remuneration, given companies generally return capital to shareholders when they cannot usefully deploy the capital. What is more important is that there are UK projects available to enable insurers and shareholders reinvest this capital back into the UK economy.
Finally, the consultation offers some positive comments around the reduction of reporting requirements, the streamlining and speeding up of certain supervisory approvals, and a mobilisation regime for new insurers. While the proposals are light on detail on these initiatives at this stage, these could make some incremental improvements towards reducing the compliance burden.
To be successful here, the Government will need to challenge the volume and type of data that supervisors request and the frequency of their requests to perform their supervisory duties. The current focus appears to be on reporting templates, and reducing and simplifying these will bring some benefits. However, the proposal to make some templates ‘more appropriate for the needs of the UK market’, might in fact add to the reporting burden by introducing additional data points to be collected, reconciled and submitted. A bolder set of proposals might be required here that also consider narrative reporting and deadlines for submission to alleviate the burden on reporting teams.
Firms have until 21 July 2022 to assess the impacts and respond to the consultation. Many firms stand to benefit from the overall reduction in capital that needs to be retained in their businesses. However, some insurers with arguably the greatest potential to invest in long term infrastructure, will find the current set of proposals disappointing. The Government might also find that its proposals fail to deliver on its own overall objectives given the potential impact of the PRA’s intended revisions to the fundamental spread.
Reforming the risk margin represents a capital release opportunity
The headline reform of the Solvency II proposals relates to a 60-70% reduction in the risk margin for life insurers. The risk margin is a component added to an insurer’s best estimate of its insurance liabilities to produce a market or ’transfer’ value. The current design of the risk margin is too sensitive to interest rates and therefore requires insurers to hold more assets when interest rates are too low.
The risk margin currently amounts to £32bn across the life insurance sector. Whilst it is not clear how evenly the 60-70% reduction will be shared amongst market participants; this headline figure clearly boasts a potentially significant capital release opportunity.
In some cases, the reduction in the risk margin might be minimal. For some firms, the capital release might be offset in practice by the operation of the transitional measures on technical provisions. This is a mechanism for spreading the impacts of transitioning to the Solvency II regime on business that was written prior to 2016. Reinsurance also plays a factor in already reducing the risk margin in relation to annuity business incepted after the introduction of Solvency II.
Many annuity providers are concerned that proposals to change the matching adjustment calculation methodology could offset the release of capital from the risk margin
The second significant revision of the Solvency II proposals relates to the fundamental spread and matching adjustment mechanism. The fundamental spread is a component of the ‘matching adjustment’ used principally by annuity providers to derive a discount rate to calculate certain liabilities by reference to the portfolio of assets that back those liabilities.
At the request of the Prudential Regulation Authority (PRA), HM Treasury proposes to introduce a ’credit risk premium’ when calculating the fundamental spread to take account of a premium an investor would expect in return for uncertainty over the expected loss on default of an asset. Depending on its final calibration, the credit risk premium could materially off-set the capital released from the risk margin for annuity writers.
Insurers typically invest in illiquid asset classes, such as equity release mortgages, where their regular fixed cash flows are a good match for annuity liabilities. Illiquid asset classes receive a higher spread than corporate or government bonds which means that insurers can derive a higher discount rate to calculate their annuity liabilities.
Whilst illiquid assets would still offer a larger spread than bonds following the introduction of a credit risk premium in the fundamental spread adjustment, the proposal disproportionately reduces the attractiveness of holding illiquid assets, such as real estate and infrastructure debt, relative to the current regime. Therefore, rather than creating incentives for insurers to invest in illiquid asset classes capable of driving growth in the economy and helping the UK transition to a net zero economy, these proposals could in fact diminish the incentives to invest in them.
Whilst the Government is looking into expanding the list of assets that are eligible for the matching adjustment, these would not alter the overall economics of investment decisions taken by insurers and therefore these might fall short of the Government’s own ‘levelling up’ ambitions.
In its consultation, the Government seeks assurance from insurers that they would not seek to distribute the capital released from any savings made by the consultation to shareholders. This is an indication of the political sensitivities around dividends and remuneration, given companies generally return capital to shareholders when they cannot usefully deploy the capital. What is more important is that there are UK projects available to enable insurers and shareholders reinvest this capital back into the UK economy.
Reducing reporting requirements will help ease the compliance burden faced by insurers
Finally, the consultation offers some positive comments around the reduction of reporting requirements, the streamlining and speeding up of certain supervisory approvals, and a mobilisation regime for new insurers. While the proposals are light on detail on these initiatives at this stage, these could make some incremental improvements towards reducing the compliance burden.
To be successful here, the Government will need to challenge the volume and type of data that supervisors request and the frequency of their requests to perform their supervisory duties. The current focus appears to be on reporting templates, and reducing and simplifying these will bring some benefits. However, the proposal to make some templates ‘more appropriate for the needs of the UK market’, might in fact add to the reporting burden by introducing additional data points to be collected, reconciled and submitted. A bolder set of proposals might be required here that also consider narrative reporting and deadlines for submission to alleviate the burden on reporting teams.
Firms have until 21 July 2022 to assess the impacts and respond to the consultation. Many firms stand to benefit from the overall reduction in capital that needs to be retained in their businesses. However, some insurers with arguably the greatest potential to invest in long term infrastructure, will find the current set of proposals disappointing. The Government might also find that its proposals fail to deliver on its own overall objectives given the potential impact of the PRA’s intended revisions to the fundamental spread.
