In an announcement mostly lost to the scrutiny of the Autumn Budget statement, HM Treasury has published its finalised reforms to parts of the Solvency II regime. With the reforms likely to be mostly welcomed by UK Insurers and those International insurers with a UK branch, we can only conclude this was unfortunate timing and should not be perceived as an attempt to bury the news.

Solvency II could certainly not be said to have been universally popular and the aim of enhancing the competitiveness of the UK as a global financial centre, and to deliver better outcomes for consumers and businesses, will be welcomed by firms conducting insurance business in the UK

In the consultation report, HM Treasury say:

“These steps … will enable insurers to increase their investment in productive assets, fuelling the UK economy.”

That is an objective that should be welcome news to the wider population, and perhaps another example of the good served by the insurance industry that it rarely receives credit for.

Unimaginatively named Solvency UK, the new regime will formally replace Solvency II, an EU directive. The consultation response makes it clear that the UK’s financial services regulatory framework must adapt to the UK’s new position outside of the European Union and the reforms, which offer many positive elements, will be portrayed in a political context as a benefit of Brexit.

The Government expects the reforms to:

• spur a vibrant, innovative, and internationally competitive insurance sector;
• protect policyholders and ensure the safety and soundness of firms; and
• support insurance firms to provide long-term capital to support growth.

Those objectives will be welcomed by the industry and we would expect them to make the UK a more attractive place for firms to invest in insurance businesses. We expect the consequences of the reforms to include:

• making the raising of capital easier;
• enabling insurers to use more of their capital as investments;
• encouraging healthy competition; and
• enabling new entries in the market – both products and providers.

While the publication was somewhat overshadowed by the Chancellor’s budget statement of the same day (17^th November), Solvency UK did get a mention in Jeremy Hunt’s speech, with the proposed reforms noted as seeking to “unlock tens of billions of pounds of investment across a range of sectors”.

Solvency UK: The Changes

The Government published its original Solvency II consultation in April 2022 and the consultation closed in July 2022. It sought views on the following proposals:

• releasing capital by changing the calculation of the risk margin and cutting the risk margin substantially, including by 60-70% for long-term life insurers in recent economic conditions;
• reforming the fundamental spread of the matching adjustment;
• unblocking long-term productive investment by making it easier to include a wider range of assets in matching adjustment portfolios; and
• reforming reporting and administrative requirements to reduce EU-derived burdens.

There has been no consensus on the reform of the fundamental spread. Originally set by EIOPA, and designed to protect firms against credit risk by requiring a minimum capital reserve, only minimal changes are to be made, with the Government clearly concerned about policyholder protection. The PRA had wanted to tighten the regime, but this has not happened.

Regarding the matching adjustment, designed to ensure assets generate enough returns to cover policy liabilities, changes will be made to how the calculations better reflect market conditions, and to extend the range of liabilities eligible for inclusion. The rules around the matching adjustment will be broadened to allow the inclusion of assets with highly predictable cashflows, subject to some safeguards that the PRA will implement; there is no suggestion of a wide-open field being made available. Expanding the asset options for annuity providers should assist them in meeting the expected high demand for pension risk transfer solutions in the near future.

These changes all contribute to greater investment flexibility for insurers, including longer term, higher risk investments.

With the greater flexibility to invest capital, firms will also need to consider their approach to asset valuation and asset matching – that is how they ensure they maintain sufficient liquidity, if less of their assets are liquid and available at short notice. It’s an area the PRA will be keeping a close eye on and firms need to ensure they have appropriate controls in place.

It is also expected that pricing may become more competitive as a result. It is possible that reinsurance programs could be impacted as a result; a stronger financial position could lend support to pension providers’ negotiations with reinsurers.

Regulatory Oversight

A number of additional measures are to be made available to the PRA to assist in maintaining market safety and soundness, and policyholder protection. These include:

• Requiring insurers to participate in regular stress testing exercises, with published results; and
• Nominated senior managers to attest to the level of sufficiency of the fundamental spread of assets.

The Government will ask the PRA to provide regular reports on matching adjustment approval rates and times, with a particular focus on long-term productive investments, so the market will be monitored.

The risk margin, the difference between an insurer’s best estimate of its liabilities and its market value,  is to be reduced for long-term life insurance business by 65%, and for general insurance business by 30%. This is expected to increase insurers’ own funds and improve balance sheet stability. Substantial amounts of capital should be released, for investment in the UK. The Treasury make it clear that insurers will be required to retain a risk margin that ensures they hold sufficient assets to transfer their liabilities to another insurer if required, for example if the business becomes distressed.

There was strong market support for the proposal to reduce the reporting burden, on the grounds of improved efficiency. We can expect further consultation from the PRA in this area, in the near future. However there may be additional requirements around asset liquidity as we mentioned above.

Third Country Branches of International Insurers

In a move to make the UK more attractive to foreign businesses, UK Branch capital requirements will be removed provided the parent company is sufficiently capitalised. This will benefit both existing insurers and new entrants. The Insurance Europe Reinsurance Advisory Board regards this as a “quick win” and we expect to see more interest from third country insurers seeking to invest in UK insurance businesses as a result.

Size Thresholds

The Government has decided to increase the thresholds for the size and complexity of insurers before Solvency UK applies to:

• £15 million in annual gross written premiums (triple the previous threshold); and
• £50 million in gross technical provisions (double the previous threshold).

Firms below this threshold will still be able to opt into Solvency UK should they choose to. This reform is intended to boost competition and innovation, reducing barriers to market entry and allowing smaller firms to grow more quickly. This will be significant for smaller niche insurers and third country insurers seeking to establish a UK branch, who are not otherwise exempted.

The consultation report also states, should there be any concerns on this question, that proposed reforms will be subject to a number of safeguards which the PRA will implement. The PRA themselves have said that the proposals on reduced reporting requirements will still allow it to meet its statutory objectives, and are proportionate. It is apparent that there were differing views on some issues between the PRA and the Treasury, but it is the government view that is published.

Timeline

These changes require both legislative change and changes to the PRA Rulebook to take effect. No timeline is given for these to be implemented. That said, the progress of the work on the Future Regulatory Framework is mentioned in the HM Treasury response and we can expect, given the Government’s ongoing pre-occupation with seeking to prove the benefits of Brexit, that there will be political will to see these changes happen quickly.

One aspect firms should keep in mind too is a commitment to review whether the calibration of the fundamental spread remains appropriate in 5 years’ time. That is of course after the next election cycle.

Conclusion

Reaction in the market, including the ABI, to the changes has been generally positive, and supports the view that investment money can go into the infrastructure of the country, including social and green/eco projects, most of which are long-term investments.

One possible outcome might be increased captive activity in the UK. But for that to happen, we would hope to see the PRA invest in its authorisation process and make it easier for firms with those levels of income to obtain authorisation. Currently, the cost and time of setting up a captive or small insurer is prohibitive, for what is otherwise an attractive option for some firms. A two-tier authorisation process, which makes it easier to set up an insurer with smaller levels of income, and offers a second phase once they are ready to increase business levels beyond a pre-determined threshold, might prove both appropriate and attractive in generating investment in the UK.

Overall, these are changes that we expect will prove to be advantageous on a wider basis for the insurance market, with consumers ultimately benefitting from more choice of product and insurer as investment within or into the UK becomes more attractive.

If you have any questions about the way the shift from Solvency II to Solvency UK might affect your firm, please speak with Kenneth Underhill.