Solvency II reforms

UK regulators have begun stepping up efforts to reform the insurance market. 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.

The headlines of the government's reform package include:

• A 60-70% reduction to risk margin for long-term life insurers and a 30% reduction in risk margin for general insurers. The consultation also flags the modified cost of capital methodology as the preferred approach to calculating risk margin (as opposed to the margin over current estimate approach)
• Updates to the fundamental spread metric, so that it includes a credit risk premium (targeting 35% of spreads on matching adjustment (MA) assets) reflecting 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 as it would reduce the amount of capital that annuity providers recognise, as explained below, and would 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

To date, it appears that the Government and the PRA have focussed their considerations on the impacts on own funds, but firms will also need to consider the Solvency Capital Requirement implications of the proposals. Firms that wish to put forward their views should respond by 21 July.

The government has asked firms to respond to the consultation by 21 July 2022. HMT will then consider the responses before determining how the proposals will be reflected in government legislation and PRA rules.

The PRA will also consult separately on changes to the reporting templates in late summer 2022.

Risk margin

The risk margin is the difference between an insurer's best estimate of its liabilities and its market value. In the UK, this amounts to £32bn for life business and £7bn for non-life business.

As things stand, there is consensus across HMT, the PRA and industry that the current risk margin design is too sensitive to changes in interest rates. Specifically, the risk margin becomes too high when interest rates are low.

The HMT proposals will substantially reduce risk margins — by around 60-70% for life business and 30% for non-life business. The PRA is also proposing that the new approach to risk margin calculation involve a “taper” for life business.

While the proposed reduction sounds substantial, it still falls short of the 75% scenario that industry originally lobbied for. In fact, for business written before 2016, much of the release in the risk margin will be offset by the transitional measure on technical provisions (TMTPs), a provision that enables insurers to spread the impact on technical provisions of moving from Solvency I to Solvency II over 16 years.

It is worth noting that, as a result of these proposals, general insurers might seek to encourage more claims be written in the form of periodic payment orders (PPOs), as the risk margin would be lower than before.

All UK insurers (both general and life) will need to consider the potential impacts of risk margin reforms on their capital projections and pricing strategies.

Fundamental spread

In relation to the fundamental spread, the MA currently enables, principally, 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.

The PRA considered two scenarios in its 2021 quantitative impact study (PDF 668 KB) — scenario A and scenario B.

Using a representative asset portfolio, KPMG estimated (PDF 835 KB) that:

• Scenario A (envisaging 25% of current z-spreads and 25% of 5-year average spreads of an asset on an index of the same sector and credit quality step) would reduce own funds by £16-£24bn, while
• Scenario B (which only considered 25% of current z-spreads) would reduce own funds by £2-5bn

KPMG professionals estimate that the proposal to use 35% could reduce own funds by £6-10bn. This means that the benefits of the overall package for some annuity providers (taking into account risk margin, fundamental spread and TMTPs) could be marginal.

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 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 in 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.

Removal of the 'BBB' cliff edge

The government is proposing to remove the disproportionately severe treatment of assets whose credit rating falls below `BBB'. This will reduce the incentives on insurers to sell BBB assets in a market downturn.

As above, annuity providers might seek to revise their investment strategies and risk appetites for investing in sub-investment grade assets.

Matching adjustment processes

The PRA is also considering introducing a more streamlined approach to MA eligibility decisions for less complex assets. It also proposes to introduce a more proportionate approach for insurers that breach the MA requirements.

Reduced reporting and administration burdens

The proposals plan to reduce the number and prescriptiveness of internal model requirements and provide more flexibility around how firms meet these requirements - including:

• Removing capital requirements for branches of foreign insurers
• Increasing thresholds before Solvency II comes into effect — thus making regulatory compliance less burdensome for smaller firms entering the market. (Please note that any benefit might be offset by the cost of the external audit requirement which currently applies to all non-Solvency II firms irrespective of size, while only `large' Solvency II firms are subject to an external audit)
• Introducing a mobilisation regime for new insurers with reduced requirements accompanied by proportionate restrictions on a new firm's activities during the mobilisation phase
• Potentially simplifying the calculation of the transitional measure on technical provisions to reduce the administrative burden of maintaining legacy systems

The PRA has announced that it will consult on further reductions to regulatory reporting requirements in late summer 2022.

These changes will interest all insurers to varying degrees and firms will want to explore the implications for their strategies and operating models.