Unlocking the potential of Solvency II?

United KingdomScotland

Few Autumn Statements have been of as much interest to insurers (and annuity insurers, in particular) as the one delivered by Jeremy Hunt on 17 November 2022. With a promise of “unlock[ing] tens of billions of pounds of investment across a range of sectors”[1], the statement announced the long-awaited final Solvency II reforms, which were concurrently published in HMT’s Consultation-Response[2] (HMT Response).

According to the HMT Response, the majority of its proposals were supported by the evidence collected as part of the consultation process[3], namely the proposals to:

  • change the calculation of the risk margin to reduce it by 60-70% for long-term life insurers (measured in the context of recent economic conditions);
  • adjust the approach to determining the fundamental spread component of the matching adjustment;
  • widen the range of assets permissible in matching adjustment portfolios; and
  • reform reporting and administrative requirements to reduce EU-derived burdens.

Fundamental Spread

Unsurprisingly, the scope of potential reforms to the fundamental spread component proved to be most pisive. In fact, the majority of respondents to the PRA consultation published[4] earlier this year disagreed with the PRA’s case for reform.[5] In a move that will be welcomed by the life insurance industry, the HMT Response sided with the industry, concluding that the calibration of the fundamental spread will remain unchanged, but for increase to the spread’s risk sensitivity to allow for “different notched allowances to be made within major credit ratings”. It is worth noting, however, that a senior management certification regime for the fundamental spread will be introduced as an additional safeguard (as further described below). The Government intends to review whether the fundamental spread is still appropriate in 5 years’ time.

MA Asset Eligibility

Another noteworthy reform approved for implementation is the widening of the matching adjustment eligible assets proposal to:

  • allow for “inclusion of assets with highly predictable cashflows” (relaxing the strict requirement that all eligible assets have fixed cashflows);
  • include assets with prepayment risk or construction phases;
  • remove the disproportionately severe treatment of assets rated below BBB in matching adjustment portfolios; and
  • introduce greater flexibility in treatment of matching adjustment applications (including introduction of a streamlined process for recognising less complex assets) and breaches.

The remaining HMT proposals will also be taken forward for implementation. All the reforms are to be implemented through a combination of legislation and amendments to the PRA Rulebook and shall include legislation to reduce the risk margin for long-term life insurers by (in the context of recent market conditions) 65% with implementation of modified cost of capital method (for the purposes of calculating the risk margin), and removal of branch capital requirements.

Safeguards

HMT also recommended a number of safeguards to be introduced alongside the reforms. In particular, recognising PRA’s core objectives of (i) promoting the safety and soundness of regulated firms and (ii) (with respect to insurers only) protecting policyholders, HMT provides that the PRA will be granted powers necessary to:

  • require insurers to participate in regular stress testing exercises prescribed by PRA and to allow PRA to publish inpidual firm results;
  • require nominated senior managers under the SMR to attest formally to PRA whether or not the level of the fundamental spread on their firm’s assets is sufficient to reflect all retained risks, and that the resulting matching adjustment reflects only the liquidity premium;
  • allow insurers to apply a higher fundamental spread through an add-on where they conclude that the standard allowance is insufficient taking into account the work undertaken to support the attestations set out above; and
  • update its matching adjustment rules to reflect the Government’s decision to widen the eligibility requirements to include assets with highly predictable cashflows.

Finally, the PRA will also be responsible for evaluating the impact of the implementing the SII Reforms (and the additional measures noted above) on its core objectives and will take over the publishing of technical information for calculation of the matching adjustment to ensure that it reflects the assets held by UK insurers.

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[1] *AUTUMN STATEMENT 2022 (publishing.service.gov.uk)

[2] Consultation_Response_-_Review_of_Solvency_II_.pdf (publishing.service.gov.uk)

[3] Published on 28 April 2022 and closed on 21 July 2022.

[4] Responses to which were summarised in PRA’s Discussion Paper (DP) 2/22 ‘Potential Reforms to Risk Margin and Matching Adjustment within Solvency II’ (FS1/22 – Potential Reforms to Risk Margin and Matching Adjustment within Solvency II | Bank of England).

[5] FS1/22 – Potential Reforms to Risk Margin and Matching Adjustment within Solvency II | Bank of England