Solvency II reforms must 'strike right balance' for UK insurance industry

Solvency II is an EU directive, retained in UK law, that regulates the insurance industry and outlines the amount of capital that insurance firms must hold to reduce the risk of their financial collapse. Both the UK and the EU are currently working on a raft of changes to update the directive.

As part of the reforms outlined in the consultation document (32 pages/243KB PDF), UK ministers plan to cut the difference between an insurer’s best estimate of its liabilities and the market value of its liabilities, known as the risk margin, for long-term life insurers by between 60% and 70%. The government said such a large reduction is possible because the current methodology used can overstate the market value of a firm’s liabilities, particularly in low interest rate environments.

Ministers hope that, by reducing the capital requirement thresholds and allowing greater flexibility in where insurers can invest their assets, the reforms will result in a “material release of possibly as much as 10% or even 15% of the capital currently held by life insurers” and “unlock tens of billions of pounds for long term productive investments, including infrastructure.”

The Treasury also hopes the proposed reforms will reduce the administrative burden of Solvency II by removing the requirement for UK branches of overseas insurers to calculate local capital requirements and instead rely on group capital. It also plans to increase the thresholds before Solvency II applies and simplify the directive’s reporting requirements.

Charlotte McIntyre, insurance and regulation expert at Pinsent Masons, welcomed the proposals, but added that ministers must balance competing interests carefully. She said: “Solvency II has long been viewed by many within the UK insurance industry as cumbersome and costly to administer, with widespread support for some level of reform. There is concern, however, that the extent of the proposed changes may have a detrimental effect on policyholder protection. The Prudential Regulation Authority (PRA) has acknowledged that there is an increased risk of insurer failure from the position now, although it considers it an acceptable degree of risk.”

McIntyre said: “Achieving the right balance by removing acknowledged adverse consequences of Solvency II while maintaining a proper degree of policyholder protection is going to be the key issue. Done right, the UK insurance market should benefit from increased competitiveness and reduced costs, whilst the UK economy benefits from a significant injection of investment into key infrastructure projects. Done wrong, and policyholders will suffer as a result.”

The consultation comes after John Glen, economic secretary to the Treasury, said in February that the reforms to Solvency II were intended to “replace what is an EU-focused, rules-driven, inflexible and burdensome body of regulation… with one that is UK-focused, agile and easily adaptable.”

But McIntyre said: “The market is going to be carefully monitoring whether the proposed reforms are broadly in-line with the EU’s proposed reforms, and the extent to which regulation of the UK insurance market starts to diverge from the bloc’s. For those insurance groups operating in both markets, any significant divergence is likely to be unwelcome. Any divergence that leads to the UK financial services regulatory regime losing its equivalence would be even more unwelcome - not just with the insurance sector - but across the broader financial services industry too.”

Another key Solvency II reform proposed by the Treasury will encourage further reliance on the matching adjustment, where long term insurers hold long-term assets which match the cash flows of similarly long-term insurance liabilities. Ministers said the close matching that underlies the matching adjustment reduces the risk that insurers may need to sell assets to meet claims by policyholders as they fall due.

The consultation document said: “The matching adjustment allows insurers to recognise upfront capital as part of as yet unearned future cashflows. Use of the matching adjustment provides a substantial benefit to life insurers and has a significant impact on commercial decisions, supporting the provision of annuities and benefiting the wider UK economy. By the end of 2020, insurer balance sheets benefited by £81 billion from the matching adjustment.”

“When insurers invest in long-term assets they are exposed to credit, illiquidity and other residual risks. When insurers closely match asset and liability cashflows they can hold those assets to maturity and should be less exposed to illiquidity risk. However, they retain credit and other residual risks. These retained risks are reflected by excluding from the matching adjustment an allowance for them, known as the fundamental spread. That there is not yet consensus on how the fundamental spread should be reformed demonstrates how important it is and how difficult it is to get right. The higher the fundamental spread, the lower the matching adjustment benefit,” it added.

Alongside reforms to the fundamental spread, the Treasury hopes to expand the scope of assets available for the matching adjustment to include economic infrastructure like clean energy, transport, digital, water and waste. Ministers have made clear they want to see investment from the UK insurance industry to support the transition to net zero, either by allocation of capital to support the development of new green technologies or to support adoption of green solutions.

McIntyre said: “Not least of the government’s drivers in pushing these reforms is the hope of a large capital injection into the UK economy. Whether ministers can achieve the right conditions to encourage insurers to invest in UK infrastructure, rather than release large dividends to their shareholders, remains to be seen.”

Madhu Jain of Pinsent Masons said: “It will be interesting to see if these changes affect UK insurers’ appetite for outwards longevity reinsurance or UK pricing for assuming longevity risk. Markets will also be keen to see whether a bulk annuity contract remains the gold standard in the pension risk transfer market or whether the gap between the level of security provided by bulk annuities and defined benefit consolidators, also known as ‘superfunds’, starts to narrow.”

The consultation on the proposed reforms come as the future regulatory framework review (FRFR) considers how the overall structure of financial services regulation will adapt to the UK’s position outside the EU. Ministers plan to remove large amounts of retained EU law from UK statutes and adopt a model of financial services regulation based on the 2000 Financial Services and Markets Act.

Doing so would give financial services regulators discretion to determine the detailed regulatory requirements that apply to firms within a framework established by the government and parliament. Any reforms to Solvency II are expected to be wrapped into the FRFR’s process with potential for some of the reforms to be included in amendments to the Financial Services and Markets Act.

The consultation will close on 21 July 2022. It is not yet known when the government plans to report on its results.