Reforms to Solvency II

On 23 June 2020, the UK Government announced that it would review certain elements of Solvency II Regulation to ensure that it better reflects specific features of the UK insurance market. In October 2020, HMT launched a Call for Evidence to seek views on reforms to the prudential regulatory regime of the insurance sector to support the unique features of the UK market.

On 20th July 2021, as part of the Solvency II review, the PRA launched a quantitative impact study (QIS) to assess potential reform options for some specific areas. The QIS covered three areas: (i) the Matching Adjustment; (ii) Risk Margin; and (iii) Transitional Measure on Technical Provisions (TMTPs).

John Glen, Economic Secretary to the Treasury, in his speech at the ABI on 21 February 2022 sketched out plans to reform the prudential regulation, focusing mainly on the Risk Margin and Matching Adjustment.

We outline key takeaways from his speech and provide a view on the possible implications for insurers.

1. Risk Margin

The current Risk Margin calculation methodology is too sensitive to interest rates. Insurers have argued that a low interest rate environment has led to an excessively high risk margin and needless balance sheet volatility. The reform options considered for risk margin are envisaged to:

• result in a substantial reduction in the risk margin (in the order of 60% to 70% for long-term life insurers)

• reduce pro-cyclicality

• reduce incentives to reinsure longevity risk offshore.

2. Matching Adjustment

When it came to the Matching Adjustment, Mr Glen broadly covered three important areas:

• shortcomings of the approach taken to the fundamental spread

• extending the scope of eligible assets and liabilities

• streamlining of the regulatory processes.

a. Fundamental spread
The current approach to the fundamental spread does not explicitly allow for uncertainty around defaults and downgrades. Consequently, the risk characteristics of the assets held by the insurers are not appropriately reflected in the Matching Adjustment.

The reforms to the Matching Adjustment are intended to ensure a more risk sensitive treatment of credit risk in the fundamental spread. The intention is to avoid introducing material volatility on to balance sheets – in particular, the fundamental spread should not be materially impacted by short-term fluctuations in market spreads.

Under the current approach, assets below investment grade (i.e., assets with ratings lower than BBB) attract a penal treatment in calculation of the Matching Adjustment. It is proposed that this severe treatment will be removed.

b. Eligible assets and liabilities
Currently, the Matching Adjustment can be applied only to certain long-term liabilities, mainly annuities. This will be extended to income protection products and products with morbidity risk.

The range of assets eligible for the Matching Adjustment will be extended to include assets with options to change the redemption date – for example, infrastructure assets that contain a ‘construction phase’ and callable bonds may become eligible.

c. Streamlining of regulatory processes
Without elaborating on details, Mr Glen outlined several important regulatory changes, including:

• An accelerated time frame for regulatory decisions on approval of Matching Adjustment applications relating to assets eligibility. This will be done by separating the approval decision-making process from the review of valuation, rating, and capital issues for less complex assets.

• A more proportionate approach to breaches of Matching Adjustment regulatory requirements.

• More flexibility for how assets without historical data are treated.

3. View from 4most

a. The changes to the fundamental spread calculation could result in significant volatility on insurers balance sheets and a reduction in the level of the Matching Adjustment, if options tested in QIS are to be implemented. This is because the fundamental spread was calibrated to be based on the spread of MA assets and as a result, was too penal. We expect that any changes to the calculation of the fundamental spread may be a tapered version of one of the options tested in the QIS.

b. The broadening of the scope of eligible assets means there will be more flexibility to invest in some asset classes without needing to restructure them. The Matching Adjustment application requires asset cash flows to be fixed in terms of timing and amount and cannot be changed by the issuers. The PRA has provided flexibility on how this requirement can be met for some assets, for example by allowing firms to recognise cash flows from callable bonds up to the first call date in demonstration of cash flow matching. For assets that are not outright eligible for the Matching Adjustment, insurers restructure them, such as sales and leaseback arrangement for property investments and securitisation of equity release mortgages. We do not expect that the envisaged changes to the eligibility of assets will extend to these arrangements, yet there could be more flexibility in terms of what could the regulator constitutes an ‘acceptable’ restructure of assets.

c. The increase in incentives to invest in infrastructure and other long-term productive assets by the government seems to be aimed at encouraging direct investment to unlock economic growth. It is unclear at this stage as to what incentives the government will provide or changes to the regulation will implement to encourage investment in infrastructure assets. There are non-regulatory barriers limiting access of insurers to these assets class, such as not having the expertise to manage these investments. The construction phase of infrastructure investments is particularly risky as default rates are relatively high and unexpected events are likely due to the complexity of infrastructure projects.

d. The reforms to the Matching Adjustment will have a knock-on impact on the SCR. Firms using internal models to calculate the SCR assume that the Matching Adjustment increases under stress. Anecdotal evidence suggests that fundamental spreads are often not stressed. The regulators may apply a more rigorous interpretation of the requirements, by asking firms to explicitly allow for uncertainty around defaults and downgrades in fundamental spreads in their internal models (given that this is at the heart of the review of the Matching Adjustment calculation). This may offset part of the benefit received due to less stringent Matching Adjustment requirements.

e. If changes result in a significant reduction to the Risk Margin, insurers may be encouraged to reconsider their reinsurance arrangements and appetites for reinsuring longevity risk offshore, may reduce. Several insurers reinsure longevity risk to reduce the Risk Margin via a combination of intra-group and external reinsurance arrangements. For intra-group arrangements, this may mean rearrangement of risks within entities of the same group. The real impact may be reduced transaction costs going forward, as reinsurance purely to reduce the Risk Margin, may disappear.

Overall, we will remain cautiously optimistic about these changes until more detailed proposals are published by the Government in April, and a technical consultation is held by the PRA later in the year.

Do you have any questions? Contact us at info@4-most.co.uk