Her Majesty’s Treasury (HMT) has published consultation on Solvency II review, detailing the UK government’s package of proposed reforms to the prudential regulatory regime for insurance firms. The Prudential Regulation Authority (PRA) has also published a discussion paper DP2/22, setting out its view on the proposals. The consultation will run for 12 weeks, with responses due by 21 July 2022.

Below is a summary of what the proposed reforms cover.

Risk Margin

Issues with current methodology:

• Results in a risk margin that is too volatile due to significant sensitivity to movements in interest rates.
• Risk margin is too high, particularly in a low interest environment

Reform proposals

• Two possible approaches considered i.e., (i) Modified Cost of Capital (which could amend the cost of capital rate used and includes a tapering parameter, lambda), and (ii) a percentile approach similar to Margin Over Current Estimate used by the International Association of Insurance Supervisors (IAIS) under the Insurance Capital Standard (ICS) regime.
• The UK government sees merit in the Modified Cost of Capital approach for a number of reasons. The PRA’s view is that the tapering parameter should only be applied to life insurance business.
• The proposals would reduce the risk margin significantly, e.g. by around 60-70% for long-term life insurers and by around 30% for general insurers, under current economic conditions
• The PRA considers that a reduction in the risk margin could be justifiable given observed transaction prices , but only if considered alongside a significant strengthening of the Fundamental Spread used in the Matching Adjustment calculation.

Matching Adjustment

Issues with current methodology:

• Concerns that the current methodology does not reflect appropriately the risks retained by insurers as it does not fully and explicitly allow for uncertainty over future credit losses
• The current Fundamental Spread is the same for all assets with the same credit rating, sector and term. This low level of granularity may mask signals of credit deterioration.
• There’s a risk that the Matching Adjustment benefit currently being taken by insurers is too high, particularly as insurers’ investments have changed over time, with the proportions of illiquid assets and investment assets rated and valued by insurers themselves having increased over time.

Proposed reforms

• The Government is considering the merits of a fundamental spread methodology that incorporates market measures of credit risk.
• The modified fundamental spread would be the sum of allowances for:
  • The expected loss, determined by the historic profile of defaults and recovery rates associated with assets of a certain rating ; and
  • A credit risk premium (CRP) based on the market measures of the asset spread, where:
    • CRP = X*(average spread for comparator index over n-years) + Z*(difference between the spread of an asset and that of the comparator index)
    • The parameters X, Z and n will be appropriately parameterised to reflect the credit risk of an asset, will reflect changes in investment conditions, should avoid introducing material volatility to insurers’ balance sheets and should therefore continue to incentivise insurers to provide long-term products such as annuities and to invest in long-term assets such as infrastructure.
  • The PRA considers a CRP calibrated to be equivalent to at least 35% of credit spreads on average and over time to be consistent with its statutory objectives. The PRA points to academic research which it judges supports a range of 35% to 55% as being appropriate.
  • The Government has not reached a final decision on calibration at this stage but proposes that any changes should be phased in to allow firms to reflect the impact on capital, pricing and investment decisions in an orderly manner.
• The PRA currently assesses that a package of around a 60% risk margin reduction (for life business) and a modified fundamental stress calibrated to include a CRP equivalent to 35% of credit spreads over the cycle would release between 10% and 15% of capital from the life sector in current economic conditions.
• Reform of the fundamental spread will likely lead to a re-evaluation of the internal models used to determine the solvency capital requirement (SCR). The PRA intends to collect further information from firms on implications of any changes to the Fundamental Spread design and calibration for the SCR later this year. However, it is not the PRA’s current expectation that such changes would necessarily lead to a material change in the level of SCR capital held by firms.

Investment flexibility

• Broaden the range of assets eligible for the Matching Adjustment  portfolio e.g., to include assets with prepayment risk and greater flexibility for how innovative assets are treated.
• Extend the range of liabilities eligible for the Matching Adjustment  portfolio e.g., to include income protection products, With-profits annuities and deferred annuities in with profit funds.
• Acceleration of Matching Adjustment eligibility decisions and more proportionate approach to Matching Adjustment breaches.

Reporting and Administrative burden

• Reforms to the internal model framework e.g., reducing the number and prescriptiveness of standards.
• Removing requirements for branches of foreign insurers to calculate local capital requirements and hold local assets to cover them.
• Doubling the size thresholds for firms before Solvency II requirements apply.
• Reforming reporting requirements e.g., simplifying particularly complex templates, reducing the reporting frequency of some templates and deleting others and making other templates more appropriate for the needs of the UK market. This builds on Phase 1 of the reforms as set out in PS29/21. The PRA plans to consult again on further reductions to reporting requirements in late summer 2022.
• Introduction of a mobilisation regime for new insurers.
• Allow more than one approach to calculating consolidated group capital requirements e.g., it will allow groups to temporarily use multiple group internal models following an acquisition or merger and acquired firms will no longer be required to temporarily hold additional capital post-acquisition, while legacy models are combined with those of the acquiring insurer.
• Simplification of the calculation of Solvency II transitional measures to reduce the administrative burden of maintaining legacy systems.

Zenith comment

Zenith Actuarial welcomes the proposed changes. The capital savings from the reform package remain uncertain, particularly for those insurers that have a significant Matching Adjustment benefit currently (mainly annuity writers), but other insurers should see a more stable and significantly improved capital position. If you would like to understand the implications of these proposals on your business, please get in touch and we would be happy to assist.

Link to HMT consultation: 20220328_Review_of_Solvency_II_Consultation.pdf (publishing.service.gov.uk)

Link to DP2/22: DP2/22 – Potential Reforms to Risk Margin and Matching Adjustment within Solvency II | Bank of England