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HMT lays out potential reforms to Solvency II

Simon Perry Simon Perry

HM Treasury (HMT) has published details on the government’s proposed reforms to the Solvency II regime, outlining four key measures. Simon Perry highlights the key areas for insurance firms.

On 28 April 2022 HMT unveiled its Review of Solvency II consultation on reforms to the regime, which could lead to significant changes for insurers. The consultation will run for 12 weeks, closing on 21 July 2022.

The proposed reforms focus on four core elements:

  • Material reduction in the risk margin
  • Reform of the fundamental spread used within the Matching Adjustment (MA)
  • Increased investment flexibility within the MA portfolio
  • Reduction in reporting and administrative burden

Risk margin reduction

HMT is seeking to achieve greater alignment with the observed market values of insurers’ liabilities.

It's proposing a 60-70% cut in risk margin for long-term life insurers and a smaller reduction for general insurers and other types of insurers.

It has indicated that the size and volatility of the risk margin could be reduced through using a modified cost of capital methodology (seen as preferred approach), or the margin over current estimate model used in the insurance capital standard.

The PRA’s view is that a cut in risk margin of 60% or just over for long-term life business could be consistent with observed values for transfer of insurance risk only if accompanied by significant strengthening of fundamental MA spread. This equates to a cut in the region of 30% for general insurers. The PRA is expected to set out the detailed rationale behind their view.

Matching Adjustment: reform of the fundamental spread

The fundamental spread used in the MA calculation allows for expected probability of default and the expected cost of selling and replacing a downgraded asset.

It's subject to a floor reflecting the minimum level of retained risks and varying by credit rating.

The fundamental spread is currently heavily driven by the floor – indicating retained risks may be underestimated.

HMT wants to better allow for retained risk through reforms to the fundamental spread methodology.

HMT is proposing to set fundamental spread as the sum of allowances for the expected loss, determined by the historic profile of defaults and recovery rates, and a credit risk premium based on market measures of the asset spread.

These reforms to the risk margin and fundamental spread will be considered together in light of complex interdependencies.

Matching adjustment: increased investment flexibility

Another key aim is to give insurers more flexibility and support investments in economic infrastructure. One measure HMT has suggested is broadening the range of eligible assets and liabilities.

This would potentially cover assets, such as, callable bonds, commercial real estate lending, housing association bonds and loans, infrastructure assets, and local authority loan portfolios, and liabilities, such as, income protection products, with-profits annuities and deferred annuities in with-profits fund.

Other suggestions include:

  • removing the severe treatment of assets in MA portfolios whose ratings are below BBB
  • accelerating MA eligibility decisions
  • introducing a more proportionate approach to MA breaches
  • providing greater flexibility in the treatment of innovative assets.

Simplified reporting and administrative requirements

HMT is also seeking to remove unnecessary compliance burdens, to make reporting and administrative obligations easier to realise:

  • Fewer and less prescriptive internal model standards requirements
  • Easing requirements relating to local capital requirements for branches of foreign insurers
  • Increasing the thresholds before Solvency II applies
  • Rationalising reporting template requirements
  • Easing authorisation process for new insurers
  • Allowing groups to temporarily use multiple group internal models following an acquisition or merger.

If you have any questions on the points discussed or would like to learn more about Solvency II, contact Simon Perry or Simon Sheaf.

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