Solvency II: UK Government consultation

This article was co-authored by Maria Montero Bedon, Trainee Solicitor, London.

On 28 April 2022, HM Treasury published its Solvency II consultation paper following proposals set out by Economic Secretary to the Treasury, John Glen MP, at the Association of British Insurers annual dinner on 21 February 2022.

Solvency II is an EU legislative programme implemented by EU states, including the UK, in January 2016, which introduced a harmonised EU-wide insurance regulatory regime, comprising three pillars:

Financial requirements.
Governance and supervision.
Reporting and disclosure.

Solvency II established requirements concerning the amount of capital that insurance firms must hold to reduce the risk of insolvency.

With the UK having left the EU, the aim of reforms contained in the consultation, summarised below, are to promote growth of the insurance industry in the UK whilst maintaining high levels of protection for policyholders. So far, the proposals have received a positive response, with the Prudential Regulation Authority (PRA) expressing their support and pledging to continue to work closely with the Treasury on the reforms. However, the devil will be in the detail of exactly which assets become eligible for matching adjustment or which reporting requirements will no longer apply.

Proposed reforms

Reduction of the ‘risk margin’

The government proposes to reduce the difference between an insurer’s best estimate of its liabilities and the market value of its liabilities, termed the risk margin, for long-term life insurers by around 60-70%.

This proposal has been put forward, at least in part, due to a concern that current methodologies can lead to the market value of a firm’s liabilities being overstated.

The government hopes that a reduction in the ‘risk margin’ would potentially release 10-15% of the capital held by life insurers and allow greater flexibility for insurers to decide where and how they invest their assets.

Reassessment of the fundamental spread used in the calculation of the ‘matching adjustment’

The matching adjustment is a mechanism that allows insurers to adjust the relevant risk-free interest rate term structure for the calculation of a best estimate of a portfolio of eligible insurance obligations.

As part of the calculation of a firm’s matching adjustment, the expected cost of default and downgrade of assets which back annuity plans, termed the fundamental spread, are taken into account.

The consultation submits that there are several indicators to suggest the existing fundamental spread calculation does not properly capture retained risk and invites responses to a number of questions about the fundamental spread methodology.

Increasing investment flexibility

Following on from the previous point, the consultation paper submits that reforming the fundamental spread so that it better measures credit risk would increase confidence in a wider variety of assets being suitable for inclusion in matching adjustment portfolios.

The government propose to broaden the range of assets and liabilities eligible for the matching adjustment portfolio, as well as to introduce what it terms a more proportionate approach to matching adjustment breaches.

The rationale increasing flexibility to allow more investment by insurers in long-term assets such as infrastructure.

Broadly, the aim appears to be to encourage investment by insurers in economic infrastructure.

Reducing reporting and administrative requirements

The consultation proposes a reduction in EU-derived regulations which make up the current reporting and administrative requirements, which are characterised in the consultation as being burdensome.

Essentially, it is proposed to simplify reporting requirements and to provide additional flexibility in the way that the remaining requirements can be met.

Other proposals include doubling the thresholds for the size of insurers before the Solvency II regime is applicable and introducing a new mobilisation regime with a view to encouraging new insurers into the market thereby boosting competition.

Comment

Identifying appropriate regulatory requirements for the insurance sector involves consideration of ensuring policyholder protection as well as encouraging a successful insurance industry able to support the broader economy.

The government hopes the proposed reforms will encourage the insurance sector to invest tens of billions of pounds of released capital in long-term infrastructure and green projects (such as clean energy, transport, digital, water and waste) and the transition to net-zero.

It remains to be seen how far reaching any actual reforms are and what their real-world impact would be. In particular, it is uncertain what released capital the reforms would achieve and whether the result would be investment in infrastructure and green projects or an increase in dividend payments to shareholders/increased remuneration of employees.

Perhaps pointedly, the consultation poses the question: “how could the government be assured that resource that becomes available following a reduction in the risk margin would not be distributed to shareholders or used to increase remuneration to parties within the insurance firm?”

For insurers operating in both the UK and the EU, there will be an interest on the extent to which any actual reforms implemented diverge from EU requirements and any impact on the equivalence regime. The European Commission published its own proposals for revising the Solvency II programme in September 2021.

The consultation period closes on 21 July 2022. No timeframe has yet been provided for the government’s subsequent response, and a more detailed technical consultation by the PRA is expected later in the year. It seems fair to say that any reforms are unlikely to be implemented quickly, taking account of the complexities involved.

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