Vrishti Goel discusses the UK government’s proposed reforms to Solvency II
Solvency II has played a key role in regulating the EU’s insurance industry since 2016. It sets out requirements for governance and accountability, risk management and supervision, reporting and public disclosures.
However, with the UK having left the bloc in 2019, the government can tailor this regulation to meet the specific needs of its insurance industry. The objective of this reformation is to promote the UK’s global competitiveness, protect policyholders and support growth through investment.
The government has proposed reducing the risk margin, reassessing the matching adjustment (MA) calculation, increasing investment flexibility and reducing administrative burden. This could free £90bn of investment that is tied up in reserves and thus help develop the UK economy.
The Prudential Regulation Authority says it is important to ensure that the proposed reforms do not put policyholders at risk – especially pensioners who rely on the insurance sector for retirement income.
This can be achieved by strengthening weak regulation and simplifying over-calibration.
Risk margin is the difference between the market value of liability and the best-estimate liability. The current method under Solvency II overstates the market value, particularly where interest rates are low. The government has thus proposed that the risk margin could be reduced by 60%–70% for long-term life insurers, and by 30% for general insurers. This would free up capital, which could be used to write new and innovative products and reduce premiums, making products more affordable for policyholders. However, we also need to consider the impact it would have on a firm’s ability to fulfil future obligations – would insurers have sufficient capital in worst-case scenarios, such as the recent COVID-19 pandemic?
The government is also considering reforming the fundamental spread used in MA calculation. The MA allows firms to recognise unearned future cashflows as capital upfront, by closely matching assets and liabilities. Holding assets until maturity reduces exposure to illiquidity risk, but the fundamental risks – namely, credit and residual risks – remain. These are allowed for in the fundamental spread. If this spread is high, the benefit from the MA is reduced. At present, the spread doesn’t properly capture the retained risk, which exposes policyholders to the risk that they will not receive their benefit. This risk has been further exacerbated by the fact that investment in illiquid assets rose from 31% in 2018 to 41% in 2021, and MA makes up the bulk of capital for many insurers. As per the current Solvency II regime, there is insufficient allowance for riskiness between assets, or for changing market conditions.
It is proposed that MA regulations should be reformed to consider the risks.
In addition, the government proposes to ease restrictions on assets that can be included in the MA and extend the range of liabilities – for example assets with prepayment risk for which the issuer has the option to pay at an earlier date, such as commercial real estate lending and infrastructure assets, and products that ensure morbidity, such as income protection products. To maintain policyholder protection, risk mitigation actions will also be taken.
The final proposed reform focuses on the reporting framework and aims to simplify complex templates, reducing the frequency of some while deleting others and making the templates more appropriate for market needs.
Loosening risk margin and tightening the MA would free up a significant amount of capital. However, some insurers are concerned that these proposals would not actually result in any release of capital, as different firms have different risk exposures and the MA forms the bulk of their capital.
Any new reform will also entail a cost to the industry, as firms will have to overcome operational challenges and dedicate time to developing new models, collecting data, hiring staff and training resources, carrying out administration and so on. With most firms operating globally and thus having to comply with multiple regimes, will the added cost of reformed regulation be beneficial, or will it end up being just one of many requirements that companies have to follow?
Vrishti Goel is student editor