The Prudential Regulation Authority (PRA) is reviewing the EU Solvency II Directive, the bloc's insurance regulatory regime, so that the UK can develop an appropriate post-Brexit replacement. Simon Perry explains what's happening.
In 2016 the Solvency II Directive replaced Solvency I as the EU's new insurance regulatory regime. The UK was still a member at the time, and despite its formal departure on 31 January 2020, it continues to use Solvency II by default.
Solvency II is a 'one size fits all' regime that did cause some problems for UK insurers. Brexit presents an opportunity for the country to adapt its insurance regulation to one more appropriate for domestic insurers. On 20 July 2021, the PRA launched a quantitative impact study (QIS) for its review of Solvency II. Prior to this, there were a few notable developments:
23 Jun 2020 - The government announced it would review certain features of the Solvency II regulatory regime for insurance firms
19 Oct 2020 - The treasury (HMT) published a call for evidence
19 Feb 2021 - Call for evidence period closed
1 Jul 2021 - HMT published its response to the call for evidence
The PRA is now targeting solo insurers and the Lloyds market, with group entities out of scope unless specifically contacted. Participation in the QIS exercise is voluntary, but it's strongly encouraged given the importance of the Solvency II review for the UK insurance industry. The PRA has asked that participating firms respond by 20 October 2021.
Solvency II Directive quantitative impact study
The PRA is focusing the QIS on three main areas:
1 Calculation of the matching adjustment (MA)
2 Risk margin (RM)
3 Transitional measures on technical provisions (TMTP)
In addition to the above, the QIS will require several balance sheet sensitivities to be performed. These include parallel shifts to the risk-free term structure, credit spreads, and downgrades and changes to the volatility adjustment.
Firms that have approval to use TMTP will be required to recalculate it when performing the QIS exercise to allow the PRA to assess its impact. In addition, the QIS scenarios the PRA have outlined are based on SONIA (Sterling Overnight Index Average) rates. Firms that have not used SONIA rates in their Year-End 2020 position will need to rebase their results.
The QIS contains a mixture of quantitative studies and qualitative questions. The PRA indicated that the scenarios tested in the QIS are designed to gather relevant data to allow the modelling of a range of potential policy options and do not represent reform proposals or decisions.
In a letter to regulated Solvency II firms, Charlotte Gerken, Executive Director of the PRA, stated that there is a broad consensus between the government, the PRA and the respondents to the call for evidence. All parties agreed that the risk margin is too high and too sensitive to movements in interest rates. The QIS outlines two alternative approaches for the risk margin to inform the changes:
Margin over current estimate (MOCE) approach
‘Risk tapering’ (lambda) approach
The first approach (scenario A) uses an approach similar to the MOCE method adopted by the international capital standards (ICS). It approximates a percentile of the distribution of technical provisions (TPs), assuming the TPs are normally distributed with a mean equal to best estimate liabilities (BEL) and a 99.5th percentile equal to the solvency capital requirement (SCR) for non-hedgeable risks. The non-hedgeable risks are the same risks currently included in the risk margin. For this QIS exercise, the ICS MOCE calibrations have been chosen: the 85th percentile of the SCR for non-hedgeable risks for life insurance liabilities and the 65th percentile for non-life insurance liabilities.
The second approach (scenario B) or the lambda approach follows a modified form of the current Risk Margin formula:
The lambda approach allows for a time-varying cost of capital starting at the current prescribed amount of six per cent, gradually reducing until year 28, where it will be three percent. The remainder of the calculation remains unchanged from the current prescribed methodology.
The MA forms an important part of the Solvency II Directive. As indicated by Charlotte, in 2020 the MA improved insurer Solvency positions by £81 billion out of a total capital requirement of £116 billion. Since the development of the MA framework, the asset allocations of insurers have changed and in recent years seen steady growth in illiquid alternative assets. By 2020, the PRA estimated the proportion of illiquid assets in MA portfolios to be almost 40%.
The PRA is concerned that firms are capitalising too much benefit on the illiquidity premium and that some of the return is instead compensation for a variation on future credit losses.
Additionally, due to the heavy dependency of the MA calculation on asset credit ratings, the PRA is concerned about inconsistencies and inappropriate mappings due to increasing reliance on firms’ internal ratings.
Similar to the risk margin exercise, the QIS requires insurers to quantify the impact of scenarios ‘A’ and ‘B’. The calculation of the MA under the QIS shares similarities to the current prescribed approach but with changes to the calculation of the fundamental spread (FS). The FS calculation under the QIS consists of:
Adjustment for sovereign, supranational, and quasi-government exposures
Credit risk premium (CRP) which consists of: (i) a percentage of the spread on assets, (ii) a percentage of the five-year average spread on an index of the same sector and credit quality step as the asset
Valuation uncertainty (VU) – a fixed amount applied to all assets except sovereign, supranational and quasi-government exposures
Getting involved in the QIS
While participation is voluntary, the PRA is 'strongly' encouraging firms to participate in the QIS. The regulator expects high-quality data and so requires firms to perform an appropriate level of validation.
I anticipate that firms will be keen to participate and help shape the future of the UK regulatory framework. However, given the short timeframe, firms may find it challenging to provision adequate resources for this exercise.
For more information on the QIS exercise and support participating in it, get in touch with Simon Perry.