Changes to UK Solvency II regime full steam ahead

Chancellor announced plans for capital risk rations in autumn statement, which were welcomed by industry.

Brexit 2704055 1920 @Pixabay
The proposed changes to the Solvency II regime in the Uk have garnered approval.

The long-discussed changes to the Solvency II capital ratio by the UK financial services industry have taken another step closer to fruition.

The Bank Of England (BofE) moved forward with plans to make changes to the stipulations around capital at Risk portions of Solvency II rules.

Last week, Chancellor of the Exchequer, Jeremy Hunt, announced changes were likely in his autumn statement after a consultation concluded that it was fiscally possible and wanted by the industry.

On November 17, the BofE to Solvency II following a feedback period on changes it could make, which provided a summary of the responses received to the Prudential Regulation Authority’s (PRA) Discussion Paper (DP) 2/22 ‘Potential Reforms to Risk Margin and Matching Adjustment within Solvency II.'

“The PRA supports the objectives of the Review and worked on potential reforms to the matching adjustment (MA) and risk margin (RM)," it said.

The consultation sought feedback specifically on:

  • a potential formulation for a Credit Risk Premium (CRP), an allowance for uncertainty around credit risk in the MA framework to correct a weakness in the current design;
  • a potential new suggested design and calibration of the RM; and
  • the extent to which combined potential reforms to the MA and RM might result in a package that is compatible with the PRA’s statutory objectives.

Some of the key proposals for reform are:

  • 60-70% reduction to risk margin for long-term life insurers
  • 30% reduction in risk margin for general insurers.
  • A modification to the cost of capital methodology as the preferred approach to calculating risk margin (as opposed to the margin over current estimate approach)
  • Fundamental spread metric update to include a credit risk premium (targeting 35% of spreads on matching adjustment (MA) assets)
  • More assets eligible for the MA
  • More insurance products eligible for the MA
  • Removal of the BBB 'cliff edge' for MA assets that are downgraded
  • Simplifying the internal model approval process, and building more flexibility into the MA approval process, removing branch solvency capital requirements, increasing thresholds for non-directive firms and reforming reporting requirements

Solvency II introduced a harmonised prudential framework for insurance industries across the European Union. The framework, which was a mammoth undertaking for the insurance industry when introduced several years ago, became an area of interest for the UK government to make changes to when the country left the EU.

"Meaningful reform of the rules creates the potential for the industry
to invest over £100bn in the next ten years in productive finance."

The ‘post-Brexit’ British financial services industry was a key facet of Boris Johnson and his successors’ desire to differentiate the country from the EU.

“Meaningful reform of the rules creates the potential for the industry to invest over £100bn in the next ten years in productive finance,” said Hannah Gurga, Association of British Insurers (ABI) Director General. Gurga said that this included areas such as UK social infrastructure and green energy supply, whilst ensuring high levels of protection for policyholders remained in place. The ABI added that it welcomed the proposed reduction to the Risk Margin by 65% for life insurers and 30% for non-life insurers. “We agreed with the PRA’s view that the Risk Margin was too large and sensitive to interest rates and consider that the changes proposed address both these issues,” it said in a statement.

Any reform could potentially loosen up access to billions of pounds, which the industry has said could be invested in infrastructure projects to boost growth and the ‘levelling up’ campaign or to help the country meet its net zero climate targets.

Solvency II problems

One of the main gripes with Solvency II has been the capital ratios held on hand, which are sometimes described as tying up large amounts of capital that could be invested. The insurance industry has long hankered to have these rations reduced to enable them more leeway.

"The fact that the fundamental spread methodology and calibration
is to remain largely unchanged will be a relief for annuity firms."

“Capital requirements under Solvency II will be forward-looking and economic, i.e., they will be tailored to the specific risks borne by each insurer, allowing an optimal allocation of capital across the EU,” said the EU’s official statement on their design. “They will be defined along a two-step ladder, including the solvency capital requirements (SCR) and the minimum capital requirements (MCR), in order to trigger proportionate and timely supervisory intervention.”

Some parts of the industry welcomed the changes with caveats. "The fact that the fundamental spread methodology and calibration is to remain largely unchanged will be a relief for annuity firms particularly, which would otherwise have faced significant increases and volatility in the level of capital required,” said Loic Bellettre, Partner and EMEIA Capital Leader at EY. “Changes announced to the risk margin will release some capital, and changes to matching adjustment eligibility criteria could, depending on the final detail, increase insurers’ ability to invest in supporting the UK economy.”

Any decisions, however, could be hampered by the volatility in UK government bond markets after Hunt’s predecessors mini-budget, which badly hit pension funds.

Sunak promised stability when he took the keys to 10 Downing Street, which could however hamper any demand for major change in policy.