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Solvency II Regulatory Reforms: Our Guide

  • Publish Date: Posted 8 days ago
  • Author:by Adam Jones
Adam Jones, Senior Consultant and insurance industry expert, shares his guide to the ongoing Solvency II regulatory reforms

UK regulators are currently stepping up efforts to reform the insurance market to provide long-term capital to support growth, including investment in infrastructure. In a nutshell, the reform of Solvency II is a significant opportunity to tailor regulation to the specific needs of the UK.

In April, HM Treasury (HMT) released its consultation on the review of Solvency II, building on proposals put forward earlier this year by John Glen MP, Economic Secretary to the Treasury. Separately, the PRA published a statement and Discussion Paper focused primarily on one aspect of the review, the fundamental spread.

Summary of the key HMT proposals

  • A 60 to 70% reduction to risk margin for long-term life insurers and a 30% reduction in risk margin for general insurers

  • Updates to the fundamental spread metric, so that it includes a credit risk premium (targeting 35% of spreads on matching adjustment (MA) assets). This reflects the premium a buyer would demand to take account of uncertainty around the expected loss due to default

  • An expanded universe of assets eligible for the MA

  • An expanded list of insurance products eligible for the MA

  • Removal of the BBB 'cliff edge' for MA assets that are downgraded

  • Additional measures aimed at reducing the burden of compliance on firms, such as simplifying the internal model approval process, streamlining and building more flexibility into the MA approval process, removing branch solvency capital requirements, increasing thresholds for non-directive firms and reforming reporting requirements.

Of these, the proposed change to the fundamental spread is the most controversial element as it would reduce the amount of capital that annuity providers recognise and largely offset the benefit of the reduction in the risk margin.

  • The government is using this consultation to analyse and assess various impacts including:

  • The level of policyholder protection

  • Insurers' reinsurance, investment and product pricing decisions

  • How insurers will employ capital following the reduction in the risk margin

  • How to calibrate the calculation of the credit risk premium by considering impacts on key balance sheet metrics, annuity prices and incentives to provide annuities

  • How the proposals might translate into insurers' investment in infrastructure (clean energy, transport, digital, water and waste) and in supporting the transition to net zero.

More detailed information

Fundamental spread

In relation to the fundamental spread, the MA currently enables annuity providers to derive a discount rate to calculate their liabilities by reference to the portfolio of assets which back those liabilities. UK insurers recognised around £81bn of benefit from the MA at year end 2020.

The existing fundamental spread calculation takes account of the expected loss due to default. HMT is proposing to introduce a credit risk premium (CRP), a further adjustment, to take account of uncertainty around the expected loss of default that a willing buyer would demand as a premium. The CRP would replace the cost of downgrade and long-term average spread (LTAS) floor in the fundamental spread calculation.

The CRP will be calculated as the sum of:

X (average spread for comparator index over n-years) + Z (difference between the spread of an asset and that of the comparator index)

HMT has proposed a CRP calibration equivalent to 35% of credit spreads, but is seeking input from industry on the impact of using 25%, 35% and 45% calibration. The PRA considers that academic research supports a range of 35% to 55%, but it has not provided any indication of how n, X & Z will be calibrated to achieve this overall target CRP. The final calibrations chosen will materially impact the sensitivity of the CRP to changes in spreads.

Some practical challenges currently exist. As things stand, insurers may be unable to completely access the data needed to determine the indices for calculating spread. Moreover, appropriate indices might not exist for illiquid assets such as infrastructure, equity release and commercial mortgages.

In light of these proposals, all annuity writers, and other firms that already use the MA, will need to review and revise their methodologies and assumptions, sourcing relevant data and consider the impacts of the reforms on their capital projections and pricing strategies. Internal model firms will also need to consider what the implications are on their internal models and will likely need to seek approval of any changes.

Matching adjustment assets

At present, only assets with fixed cash flows can be eligible for the MA. However, HMT is proposing to expand the universe of eligible assets to include assets with prepayment risk (such as callable bonds, commercial real estate lending, housing association bonds and loans, infrastructure assets and local authority loan portfolios). Insurers will be able to recognise penalties and other amounts payable to the firm if completion is delayed for assets with construction phases.

The proposals do not yet clarify how the government intends to adopt these requirements, for example, the requirement that cash flows be `fixed' could be substituted with 'predictable' providing firms with greater flexibility to demonstrate this. As a result, all annuity writers will want to consider the implications on their investment strategies and consider how to optimise the efficiency of their balance sheet by investing in different asset classes. Insurers investing in different classes will need to consider how to reflect changes in their investment risk appetite and tolerance statements as well as considering the resources and expertise their investment teams (plus risk, actuarial and modelling teams) have to manage the risks associated with these asset classes.

Matching adjustment liabilities

Under existing rules, the MA is principally used by annuity providers, however it might also be of interest to other insurers as the government also proposes to widen the scope of eligible liabilities.

The government also proposes to expand this scope to include income protection products, with-profits annuities and deferred annuities in with profits funds. In the UK market, there is approximately £2bn of reserves for in-payment income protection products and £20bn of reserves held against with-profits annuities and deferred annuities with profit funds.

Insurers with income protection products, with-profits annuities and deferred annuities will want to consider the capital benefits of applying for regulatory approval to use the MA for these products.

Read the full consultation here: Solvency II Review: Consultation - GOV.UK.

Adam Jones, Senior Consultant, is one of MERJE's resident Insurance recruitment experts and part of the Actuarial team. He specialises in pairing skilled actuarial candidates with financial services businesses of all sizes. If you would like to discuss the insurance market, regulatory changes, your career, or your hiring needs, contact him on 0161 883 2756 / ajones@merje.com