UK Solvency II reform - operational impact

• All insurers who will be subject to the new UK Solvency II process should be starting to consider the changes that will needed to be implemented to be compliant by a likely target date of 31st December 2024. 
• In particular, the required operational changes will impact the entire annuity management process, including model calibration, calculation, monitoring, governance, and reporting. 
• There is a significant amount of work for firms to be operational with these changes. If planning is deferred until the conclusion of the industry working party and subsequent consultation, there will be delays in the realisation of the benefits, potentially to beyond FY 24. 
• Work could be initiated on a no-regrets basis to build flexibility and to enable the process to be future-ready, such as updating methodology for the Risk Margin, introducing notches to the credit transition framework and capacity for more granularity in Fundamental Spread (FS) calibrations. 
• Regulatory clarity on the approval process for resulting major model changes and matching adjustment (“MA”) applications would aid firms' planning.

At the end of 2022, the Government set out proposals for reforming Solvency II into Solvency UK. HM Treasury (HMT) and the PRA are now working on the details of these reforms, with two consultations expected in June and September this year. The PRA CEO, Sam Woods, provided an update on the PRA's thinking in his speech to the ABI Dinner in February. There are large changes to the matching adjustment and risk margin, alongside streamlining of the approval processes and reporting. For insurers these reforms will have impacts on data, models, management information and pricing. The impact will be most immediate for annuity writers, but all types of insurers will be affected in some way. 

Continuing KPMG's 'Solvency UK — What will change?' series, which began with a look at five key take-aways from Sam Woods' speech, we now focus on the potential operational impacts from the reforms and where firms can start work now to ensure they are ready for FY24. For each part of the reform, we have set out some of the operational implications. The third part of our series will focus on Balance Sheet thinking and the potential optimisation exercise and be published in April

This table is by no means comprehensive, but it does provide a glimpse into the type and amount of work required if firms want their operational processes and models to comply with Solvency UK reforms by FY24.

The need for regulatory clarity

The landscape of Solvency regulation in the UK is still fluid, with the Sector Expert Groups (and subsequent consultations of June and September 2023) still ongoing. Clarity on the changes is eagerly anticipated by firms who are already planning for life under the new Solvency UK reforms. Key to their planning will be the additional detail which is still to be provided on the approval process for major model changes and matching adjustment applications, but insurers can get a head start now.

Firms who have so far resisted the urge to apply for full Internal model could be swayed by the benefits of the proposed reforms and would welcome clarity on the internal model approval requirements before they plan the necessary operational changes. Firms who find the current matching adjustment approval process to be inflexible and too onerous would welcome a streamlined eligibility application process for less complex assets. They await articulation on how more unusual and innovative assets will be treated in the approval process. (Those wishing to learn more should look out for our future article on regulatory applications and reporting, which forms part of KPMG's series of articles `Solvency UK — What will change?')

What firms can do now

Firms wishing to get a head start on the regulatory compliance journey may want to take a closer look at areas where HMT has already provided enough clarity to start planning and implementing developments:

Of particular interest will be the Government's decision to increase the risk sensitivity of the fundamental spreads approach by permitting notched allowances to be made within major credit ratings:

• A key question is whether a firm's current asset data is fit for purpose — does the data contain enough information?
• If not, can this information be easily appended from existing sources or other readily available information? Considering both:
  • Current asset data, which feed asset hypothecation and MA optimisation processes; and
  • Historic asset data, which inform credit calibration and downstream capital models
• Historic data could prove particularly challenging and may require practical solutions such as interpolating between small data sets to plug gaps.
• For models which digest this data, developments will need to be made to ingest updated data feeds and to allow asset upgrades/downgrades to be driven by notches.

For all firms, including non-annuity providers, Risk Margin could be an area where early developments could be made to change to a modified cost of capital approach:

• Firms will need to amend the cost of capital rate and allow for the lambda tapering parameter in their Risk Margin calculations. Those who participated in the last year's Quantitative Impact Study may find they are more familiar with the necessary changes than other firms.
• Firms will also need to carefully examine how potential Risk Margin reforms impact pricing strategies, hedging, and their firm's approach to reinsurance.

Future proofing for further changes

Seemingly simple changes can have far-reaching operational impacts and the scale of developments required should not be underestimated. Early consideration of how to allow for any of the proposed Solvency UK reforms will prove beneficial to most, but those that use this period of change as an opportunity will reap the most rewards. Those on the front foot should seek to develop a robust modelling framework, which will allow further evolution in the future. For example, the Bank of England has highlighted its intention to consider whether firms adequately allow for climate risks in their Matching Adjustment. A targeted duration-dependent overlay for certain sub-classes of asset exposed to higher migration risk from climate risks may be needed. Firms with the foresight to develop flexible modelling frameworks now will find the path to compliance less burdensome when the time comes to update operational processes.

The assessment of operational processes will need to be performed alongside an analysis of how this interacts with capital management, and the opportunity this presents to optimise the efficiency of a firm's balance sheet to achieve maximum benefit. In the next article in KPMG's 'Solvency UK — series', we consider Balance Sheet thinking and the potential optimisation exercise.