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UK Treasury consults on final Solvency II implementation measures

Out-Law News | 14 Aug 2014 | 10:41 am | 2 min. read

The UK Treasury is seeking views from the insurance industry on the final provisions through which it will incorporate new EU-wide solvency and risk management rules into national law.

The short consultation, which will close on 19 September 2014, sets out the UK's proposed approach to the 'volatility adjustment', which is intended to protect insurers with long-term insurance products from artificial fluctuations in volatility; and to removing firms' regulatory permissions if they do not meet minimum capital requirements under the new rules. The consultation was due to take place in 2011, but was held back pending EU authorities' delayed final approval of the new regime. The new EU directive came into force in May of this year and EU countries usually have two years to transpose directives into national law.

"With the Omnibus II Directive [which amends the Solvency II Directive] coming into force on 23 May 2014, the Treasury is now working to complete the arrangements for transposition of Solvency II in order to ensure a smooth transition to the new prudential regime for insurance business," the Treasury said in its consultation.

The Solvency II regime sets out broader risk management requirements for European insurers and dictates how much capital firms must hold in relation to their liabilities. The Omnibus II Directive, which completed and finalised the new framework, was approved by the European legislative authorities earlier this year. It must be transposed into national laws by 31 March 2015, to come into force on 1 January 2016.

One of the main changes introduced to the Solvency II regime by the Omnibus II Directive was a long-term guarantees package (LTGP), which was designed so that insurers offering long-term insurance products would not be disadvantaged by having to hold enough capital to withstand short-term market movements. The UK Treasury's new consultation addresses one of these measures, known as the volatility adjustment (VA), which would effectively reduce the value of the liabilities of a firm offering long-term products, and at the same time the amount of capital that firm would be required to hold.

The UK government's preferred approach is for firms to have to apply for approval from the Prudential Regulation Authority (PRA) before they would be able to use the VA. The final rules allow national governments to implement pre-approval as a safeguard against the prudential risks of the policy.

"The VA is based on the premise that insurers should not have to recognise the full extent of short-term volatility in asset prices," said the consultation. "This is because many long-term insurance products, typically offered by life insurers, give rise to illiquid, predictable liability types which enable an insurer to hold onto its assets and 'ride out' period where asset prices are depressed. The government believes that such an approach is good for policyholder protection and helps to support financial stability."

"However, the VA raises prudential issues because its design permits the measure to be applied to all liability types and not just those which would genuinely allow insurers to safely hold assets over the long term. The government's view has been that the VA may be much less appropriate for liquid or volatile liability types, such as those where there can be sudden large claim payments, or where policyholders can surrender their policies in exchange for a guaranteed amount ... If the VA is used for such products, asset losses will not have been allowed for within a firm's technical provisions or capital requirements, meaning the firm is undercapitalised relative to the true risks it faces," the consultation said.

The consultation is also seeking views on the application of the PRA's new obligation to withdraw authorisation from a firm that does not meet Solvency II minimum capital requirements. The UK's approach would require firms subject to this sanction to be closed to new business but would permit them to continue to manage existing insurance contracts in appropriate circumstances, subject to PRA approval.

The Treasury plans to publish its response to the consultation later this year, alongside a final statutory instrument to be submitted for parliamentary approval. In addition, the PRA will carry out its own consultation on amendments to its regulatory rules to include the long-term guarantee measures.