Today the government has released a new consultation paper on its proposal for significant reforms to Solvency II – the prudential regulatory regime introduced by the EU in 2016 and inherited by the UK following the implementation of Brexit.
The consultation follows a speech to the ABI on 21 February 2022 by Economic Secretary to the Treasury & City Minister, John Glen, announcing the long-awaited reforms and touting them as having the potential to unlock billions for productive investment by insurers. We reported on the speech in greater detail in our article.
Whist the consultation paper doesn’t provide the finer detail of the government’s proposals, it builds on the speech with the following notable points:
- Risk Margin: the “risk margin” requires insurers to hold a margin over the “best estimate” of their liabilities and has been criticised as an undue capital burden. The consultation confirms the government’s intention, announced in its ABI speech, to reduce the risk margin (by around 60-70% for life insurers and 30% for general insurers), either by adopting a modified cost of capital methodology (which appears to be the preferred approach), or the “Margin over Current Estimate” model used in the International Association of Insurance Supervisors’ International Capital Standard.
- Matching Adjustment: the “matching adjustment” (MA) allows insurers to take credit for the reduction in their exposure to illiquidity risk where they hold long-term assets to maturity to meet appropriately matched long-dated liabilities. Calculating the MA involves determining the “fundamental spread” i.e. measure of the other risks – such as credit risk – to which insurers remain exposed in these circumstances. The government’s consultation confirms that it proposes to reform the fundamental spread to better reflect these risks by incorporating market measures of credit risk. In some cases, this has the potential to reduce the MA available for certain assets.
- Investment Flexibility: the consultation also confirms the government’s intention to widen the assets and liabilities which insurers can include in MA portfolios. It is proposed that permitted assets will additionally include those with prepayment risk for which the issuer has an option to repay the asset early and assets with construction phases. It is also proposed that the cap on the MA benefit for assets rated below BBB is removed (with the risks better reflected in the recalibrated fundamental spread). The stated intention is to ease investment in long term productive finance such as commercial real estate lending and infrastructure projects. Permitted liabilities are also proposed to be widened to include morbidity risk, with profit annuities and deferred annuities.
- Reporting and Administrative Burden: the consultation confirms a number of proposals to reduce reporting and administrative burdens on insurers including: reducing the number and prescriptiveness of internal model standards; removing the requirement for UK branches of foreign insurers separately to calculate and hold local assets against branch capital requirements; reducing reporting frequency and complexity of reporting templates; and doubling the size and complexity threshold for Solvency II to apply to insurers.
The consultation will run for 12 weeks, closing on 21 July 2022. Insurers are likely to take a keen interest on its impact on their balance sheets as further details of the reform package emerge.