Solvency UK — what will change?

Eligible Assets

What we know

HMT has signalled its intention to widen the scope of assets eligible for MA to include assets with highly predictable cashflows, to encourage insurers to invest in long term productive assets such as infrastructure. However, it has also stated that it expects the vast majority of assets to have fixed cash flows, as currently. Earlier this year, the industry came together under the ABI alongside HMT and the PRA to form Subject Expert Groups and provide technical views and ideas around three areas of the reform. One such group has considered Matching Adjustment Investment Flexibility and, in particular, the definition of “highly predictable” and which assets could become eligible that are currently outside the scope of MA eligibility. 

In addition to widening the scope of investable assets, HMT intends to simplify the process for applying for MA especially for less complex assets and to provide greater flexibility for how innovative assets are treated.

What we are waiting on

Annuity writers already invest in a wide range of illiquid fixed income assets. It remains to be seen how much additional flexibility the reforms will allow insurers in practice. The example given by HMT for the sort of asset that might now come into scope is construction phase infrastructure, where cash flow timing can be uncertain until a project becomes operational. Insurers are already able to invest in these assets but often with substantial structuring costs that detract from the economic viability of such investments. Any flexibility provided in this area will be welcome by industry but may not significantly change insurers' asset allocation.

Simplifying the MA application process may allow insurers who could have used MA but elected not to, due to its complexity, to take the plunge and set up a Matching Adjustment Portfolio. It should also make it easier for existing users to adopt new asset classes.

We would also expect some changes to individual insurers' asset allocation depending on the impact of notching (disproportionately impacting those who invested in lower rated assets within individual letter rating bands) and removal of the BBB cliff. This may make BBB investments more palatable to some insurers and may even allow some to consider sub-investment grade assets, including those on a glide-path to investment-grade which is typical of construction phase infrastructure, though always subject to the overriding Prudent Person Principle.

What you can be doing now

• Start to map out the changes needed to Internal Models, Systems and the Actuarial / Finance process to reflect notching and removal of the BBB cliff.
• Estimate the capital impact of these changes on the in-force book and new business pricing.
• Consider whether plans to enter new asset classes can be brought forward based on a more streamlined MA and IM change process.
• Consider, where these are not already used, whether there is scope to use MA in your business. If looked at in the past, refresh past cost / benefit analysis in this area. 

Eligible Liabilities

What we know 

HMT has reiterated its intention to extend the scope of MA to income protection liabilities and some other products not currently in scope — potentially including With Profit annuities, deferred annuities, and Periodic Payment Orders (PPOs).

For some insurers this presents an opportunity for capital savings with potential knock-on implications for product pricing.

What we are waiting on

• Precise confirmation of which liability classes are in scope.

What you can be doing now

• Consider, whether there is scope to apply MA to new liability classes. 
• Carry out cost / benefit analysis of applying MA whether as an existing user or as a new user.

Reduction in Risk Margin

What we know 

HMT have indicated it expects to see a 65% reduction in Risk Margin for long-term life insurance business (including PPOs) and 30% for non-life insurance. The impact of this change is mitigated partly by the use of reinsurance and TMTP, so the exact quantum of capital release may not be as large as some headline figures have suggested. However, it is a welcome change; it will release some capital and help reduce insurers' balance sheet sensitivity to interest rates. 

Insurers will need to decide what to do with this released capital. Perhaps return to shareholders, find opportunities to deploy in writing more business, pass on to customers through keener pricing or invest in more capital-intensive business / assets provided the return on capital is attractive. The Government and HMT will be watching closely how insurers choose to apply the newly released capital and have stated they will work with the insurance sector so that benefits are passed on to consumers through the provision of a greater range of more affordable products. Insurers that return the bulk of freed up capital to shareholders should prepare for some scrutiny, though the Government has stated it has no intention to restrict commercial decisions about capital allocation.

Reducing the size of the RM may impact the relative attractiveness of entering into reinsurance. However, most annuity writers, notwithstanding the reduction in RM, expect to continue to reinsure a significant proportion of new longevity risk while reinsurance supply is plentiful and pricing remains attractive. 

What we are waiting on

We are still waiting on confirmation around the precise Risk Margin formula in the relevant Statutory Instrument. Depending on when this passes through Parliament, the new formula could be applied as early as the end of 2023, though the timescale is tight. 

What you can be doing now

• Quantify the release in RM and make plans for how this capital may be used.
• Review new business pricing and timing for when to reflect the change in RM calculation.
• Review ALM hedging arrangements to reflect smaller size of RM.
• Review use of TMTP  — is it still worth using versus the operational challenges?
• Review internal processes to reflect the change in the calculation of technical provisions. Those insurers who participated in the Solvency II Review QIS in 2021 may have a head start.
• Review the cost / benefit of reinsurance arrangements.

Use of reinsurance

What we know

In addition to the impact of the RM reform above, there are other considerations that might impact the use of reinsurance. The PRA, in its January 2023 Dear CEO letter to insurers, identified reinsurance risk as one of its priorities for 2023 — especially off-shore longevity risk reinsurance and funded reinsurance among annuity writers. 

Insurers use funded reinsurance (where both asset and longevity risk are transferred to the reinsurer) as one means to raise capital to support large deals or to improve their overall returns. A major destination for this reinsurance in Bermuda which has Solvency II equivalence. However, the Bermudian Regulator, the BMA, is currently consulting on proposed enhancements to its regulatory regime, in particular for long term insurers. This will likely increase the amount of capital those reinsurers need to hold for annuity business, which may impact their pricing.

Insurers will still likely look at reinsurance as a means to raise additional capital if needed. They may also look at the examples of side car capacity being set up in Bermuda to target US annuities as a template to bring in third party capital, while retaining more of the reinsurance value chain such as origination, asset management and servicing. If the rules were sufficiently reformed in the UK (either under the ISPV regime or for fully authorised reinsurers) perhaps such vehicles could be set up in the UK rather than overseas.

In future, as credit risk continues to grow as a peak risk for many annuity writers, they may look to use reinsurance as a means to transfer remote credit risk and release capital under the MA framework.

What we are waiting on

• Timing and confirmation of the precise formula for the Risk Margin change as above. 
• Confirmation of the impact of regulatory change in Bermuda whose consultation has only just ended. 

What you can be doing now

• Review the cost / benefit of new reinsurance arrangements.
• Consider future capital needs and how these might be best addressed

Internal models

What we know

Several insurers have done a lot of the preparatory work for an Internal Model (IM) but didn't pursue final regulatory approval. Some insurers use these models to produce their ORSA and set their internal risk appetite. HMT and the PRA have signalled their intention to implement a significant streamlining of the rules for internal model approvals and to do away with around 70% of internal model tests and standards and move to a more principles-based approach. 

Use of an Internal Model often comes with some regulatory capital benefits as insurers are better able to reflect their own risks and diversification, so if the process is made more user friendly, more insurers may be encouraged to go down this path. 

For those that already have approved models, the reform should make it easier to apply for Major Model Change which will shorten the time needed to enter into new asset classes or launch new products.

What we are waiting on:

• Precise details on how the application process is to be reformed. 
• Confirmation of easing of constraints on the number of Major Model changes that can be brought before the regulator every year.

What you can be doing now:

• Consider, where these are not already used, whether there is scope to use an IM in your business. If looked at in the past, refresh cost / benefit analysis carried out in this area. 
• Consider if you can bring forward any planned Major Model Changes or investments into new asset classes which would require such a change.

Overseas Insurers / New Entrants

What we know

HMT has said it will remove capital requirements for UK branches of overseas insurers and will also set up a mobilisation regime for new insurers giving them more time to set up their business and raising the size threshold where the Solvency UK rules will apply. 

It is hoped this will increase competition and will encourage overseas insurers to write more business in the UK. HMT has in particular noted this may be beneficial for the London market. It will also help insurtechs coming to market and may also help potential new entrants to the UK bulk annuity market by reducing some of the barriers to entry.

Overseas insurance groups operating in the UK may see an opportunity to convert a subsidiary to a branch if below a certain size.

What we are waiting on:

• Confirmation and timing of removal of branch capital requirements.
• Details of the new mobilisation regime.

What you can be doing now:

• If part of an overseas insurance group review corporate structure in the UK.

Balance sheet optimisation is a dynamic process as capital needs and the market environment, whether investment, regulatory or competitive, evolve. As we have shown, insurers can start planning today for some of the changes highlighted in this article. 

Please reach out to your usual KPMG in the UK contacts if you would like to further explore what you can be doing now in preparation for the upcoming changes. As more detail is provided in forthcoming PRA consultation papers, the to-do list will only grow. 

In our next article in this `Solvency UK — what will change?' series we will look at regulatory application and reporting changes coming out of the proposed reforms.