Technical

Solvency II – a step away from rules based regulation?

Simon Perry Simon Perry

The government is reviewing Solvency II and has called for evidence to assess how it continues to align with the UK insurance sector.

Simon Perry looks at the areas under review and the potential direction of travel.

In October 2020, HM Treasury (HMT) published details of its ‘Review of Solvency II: Call for evidence’, and firms have until 19 February to submit their feedback.

Solvency II was originally designed for the EU insurance sector. The review, driven by Brexit, considers how the regime continues to reflect the UK insurance sector's structural features.

Its ultimate goal is to provide capital adequacy standards for insurance firms, deliver effective policyholder protection, and ensure suitable risk management and governance arrangements. The review also aims to support growth and competition, and help firms provide long-term capital to meet government objectives on key topics, such as climate change.

What’s under review?

Solvency II is inherently complex, and some of the regulatory burdens come from the UK’s transposition of the directive into UK law and regulation, not the directive itself.

In 2017, a select committee investigation found the UK approach had increased the cost of capital for insurers and was expensive to implement. There are shortfalls in the regulation, and the framework is not universally appropriate for all UK insurance businesses.

In its call for evidence, HMT announced a review of the risk margin, the matching adjustment, operation of internal models, and insurers' reporting requirements. It reads almost like a reversal of the Omnibus II Directive, which aimed to resolve the remaining Solvency II policy issues for UK transposition back in 2014.

Looking across 11 areas of interest (see below), HMT asks 29 questions, broadly covering:

  • What changes, if any, should there be to the current process for the area under review?
  • What are the costs and benefits of such changes?

More-specific questions consider the interaction with broader government objectives such as climate change or improving specific technical concerns within Solvency II.

Solvency II

Key areas for review

 

Risk margin

Matching adjustment

Calculation of the solvency capital requirements (SCR)

Calculation of the consolidated group solvency capital requirement using multiple internal models

Calculation of the transitional measure on technical provisions

Reporting requirements

Branch capital requirements for foreign insurance firms

Thresholds for regulation by the Prudential Regulation Authority (PRA) under Solvency II

Mobilisation of new insurance firms

Risk-free rates: transition from the London Interbank Offered Rate (LIBOR) to Overnight Indexed Swap (OIS) rates

Other areas for review – a request for any other areas for consideration

Despite the long list, over half the questions focus on three key areas as detailed below:

1 Risk margin

UK life insurers generally consider Solvency II’s risk margin as too large and too sensitive to changes in interest rates. While firms can mitigate the risks on existing business via transitional measure on technical provisions (TMTP), there are still concerns over the pricing of retirement provision products.

The review does not propose a new methodology but observes that the current approach to calculating the risk margin was designed for the EU insurance sector's structural features. With significant quantities of long-term life business with guarantees, such as annuities, a low-interest-rate environment is likely to have a disproportionate and adverse effect on UK insurance firms.

The call for evidence asks how to reform the risk margin for the UK insurance sector. It also asks respondents what the preferred means of modifying the current ‘cost of capital’ approach would be to reduce the risk margin's size and volatility.

2 Matching adjustment

The 'matching adjustment' aims to quantify the extent to which insurers are protected against credit risk volatility, and around a quarter of the review questions are on this topic. It has been a controversial aspect of Solvency II as it deviates from market consistency principles. That said, it has effectively reduced procyclicality risk on UK insurers’ balance sheets.

The review recognises that the measure is widely used by UK insurers, and reconsiders the eligibility criteria for assets in the matching adjustment. Current eligibility requirements are relatively inflexible and have some unintended consequences.

Ominously, the review notes that the existing methodology may, in some cases, under-estimate the risks that insurance firms retain because of the wide range of assets held.

HMT also asks if there are barriers to insurance firms' current arrangements to provide long-term capital to support growth and investment in appropriate infrastructure assets, restricting contribution to wider government initiatives.

3 SCR calculation

The calculation of the solvency capital requirement (SCR) is a critical part of Solvency II, but HMT will assess if the current approach can be less complex and prescriptive, with greater scope for regulators to apply supervisory judgement.

The methodologies used to calculate the SCR could move from a rules-based approach to a more-appropriate mix of judgement and rules. Among other things, this may allow for better alignment of the standard formula calibration to UK insurance firms' risk profile.

Tellingly, the paper notes the importance of flexibility for the Prudential Regulation Authority (PRA) to assess the capital adequacy of a firm, considering other relevant factors in addition to model calculations. It notes that the current regulations for calculating the SCR limit flexibility for both the PRA and insurance firms.

The outlook

The Association of British Insurers has welcomed the Solvency II review, and it is generally seen as a positive step for the UK insurance sector. Despite no proposed changes, as yet, the review seems to indicate a move toward simpler, less-prescriptive regulation with greater scope for supervisory judgment. 

It also reflects the need to help insurers meet government objectives on climate change and infrastructure investment. That does not necessarily mean an across-the-board reduction in capital, given the objectives for financial soundness, and indeed the review notes in some areas of the matching adjustment “the existing methodology may, in some cases, underestimate the risks”.

It will also be interesting to see how aggressive the UK review will be and to contrast this with the outcomes of The European Insurance and Occupational Pensions Authority's (EIOPA) 2020 assessment of Solvency II. For example, there will be an overlap in the risk margin calculation review, which EIOPA did not change.

To some extent, this may depend on the ongoing discussions on post-Brexit arrangements for financial services. With the UK’s statement to consider diverging from EU rules on Solvency II, equivalency could prove particularly challenging.

What seems clear for UK firms is that there will be incremental change ahead for Solvency II, potentially with less regulatory burden, and a return to a more principle and judgment-based regime. The memo's content between the UK and the EU that is planned for March 2021 is likely to be an important factor.

As mentioned above, 19 February is the deadline to submit evidence to HMT. The government has not set a date for the next steps, but ongoing regulatory reforms, such as the LIBOR transition, may dictate its response speed. Other potential changes will need further consultation by the PRA and potentially further legislation.

Get in touch with Simon Perry for more information on the Solvency II review.

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