At a glance:
- The UK Treasury’s Call for Evidence suggests a move towards much greater flexibility and scope for supervisory judgment - including in the area of model approval - in the UK’s insurance regulatory framework, more in the spirit of the former ICAS regime. However, there remains a strong commitment to the key components of Solvency II (i.e. market consistency, a 1 in 200 capital standard, and use of internal models) and to maintaining approaches where solvency II has delivered improvements over the ICAs regime, for example consolidated Group capital adequacy measurement
- In our view, specific reforms are likely to include the risk margin, with a potential move towards the less interest rate sensitive International Capital Standard (ICS) approach; MA asset eligibility and matching criteria so as to avoid the need for complex securitisations; more room for judgement around capital, including judgment-led capital add-ons; a less binary model approval regime more congruent with the banking side; removal of local capital requirements for foreign insurers operating in the UK; and a wide-ranging review of reporting perhaps aimed at greater proportionality via differentiation by firm size.
- The UK Government’s broader policy agenda runs through all areas of the review, in particular competitiveness of the UK and UK insurers, attracting more insurer investment into long term capital, supporting the Government’s “levelling up” priorities, and its objectives on sustainability and climate change.
Who this blog is for:
Senior leaders of UK and EU27 insurers responsible for setting strategy on their firm’s approach to regulation across the UK and EU, including CROs and CCOs.
Approximate reading time: 15 minutes
In our recent report, Solvency II - Continuity, change and divergence in a post-Brexit world, and blogs (here and here), we identified areas in which we expect the most pressure for future divergence between the UK and EU regulatory frameworks following Brexit . Our report identified two main planning scenarios, featuring limited and more substantial reform of the insurance regulatory regime in the UK and hence departure from the current Solvency II regime.
In recent months, the UK Treasury has indicated that material divergence from Solvency II as implemented in the EU is a material likelihood, with a list of policy topics under review that aligns closely to our suggested shortlist. The Treasury’s recently-released Call for Evidence on the Review of Solvency II provides some specificity on what these reforms could mean for UK insurers and non-UK firms operating in the UK market.
Below, we take stock of the overarching messages from the Treasury’s Call for Evidence, and some potential implications in each area covered by the Call for Evidence. The changes that are made will, of course, reflect the UK’s broader approach to policymaking following the end of the Brexit transition period, including any potential future trade agreement. However, the Call for Evidence provides clear indications of the UK Government’s direction of thinking on some of the most important issues for Solvency II implementation in the UK. The Call for Evidence is open for comments until 18 January 2020.
Overarching themes from the UK Treasury Call for Evidence
- The UK continues to support the basic design architecture of the Solvency II framework, including capitalisation on a market consistent basis to a 1 in 200 year standard, and the use of approved internal models. This is not surprising, given the very significant influence of the PRA in the design and detail of Solvency II. It reflects numerous previous PRA statements, and a widely held view between regulators and government that many aspects of Solvency II are working well.
- Importantly, there is no suggestion that the overall level of industry capitalisation needs to change.
- However, throughout the Call for Evidence the Treasury explores how the UK could adopt a more principles-based and judgmental regime – closer to the operation of the UK’s former ICAS regime in key respects. The future UK insurance prudential regime looks likely to provide more scope for supervisory judgment and flexibility as to how insurers can meet the requirements. It could also include more “phasing” of the requirements for smaller and simpler firms, for example some progressive steps between the current regime for non-Solvency II firms and the full Solvency II requirements. Reforms in this direction may be especially relevant for insurers in run-off.
- Increased flexibility is likely to be welcomed in many respects by the UK industry, though it could well also increase the PRA’s scope to apply judgment-led capital add-ons, and could free the PRA to tighten the regime in some respects (for example, the PRA may consider reverting to its previous policy position on the dynamic volatility adjustment).
- The UK Government’s broader policy agenda is front and centre in the Call for Evidence, in particular attracting more insurer investment into long term capital, including infrastructure, venture capital, growth equity and other long term productive assets. There is a close link to the Government’s “levelling up” priorities, as well as its objectives on sustainability and climate change. We think that a recurring theme will be how the UK regulatory framework and prudential capital framework can contribute to achieving the Government’s broader policy agenda.
- The role of the regulatory framework in supporting competitiveness for UK insurers, and providing an attractive jurisdiction for international insurers to operate, are also clear priorities. The call for evidence indicates a clear willingness to tailor the UK regime to the specificities of the UK market, departing from international “standards” where these are considered poorly suited to the UK market, and to tailor the regime for incoming insurers, while not compromising on standards of policyholder protection.
- The call for evidence refers to the International Association of Insurance Supervisors (IAIS) International Capital Standard (ICS), and states that “the review of Solvency II will be informed by recent international prudential regulatory developments”. The ICS has a similar conceptual framework to Solvency II but departs in some important points of detail, in particular around the risk margin and long term discounting, as we have discussed in previous blogs. We think that the UK review will look to the ICS approaches, particularly for the risk margin, as potential alternative models that meet the UK’s reform objectives whilst enabling the UK to remain aligned with international standards.
Specific potential areas of reform
The Call for Evidence poses questions on the below specific areas for review.
- Risk margin – the Government has clearly signalled that it will reform the risk margin. A complete redesign of the methodology appears to be on the table. The ICS approaches to calculating the Margin Over Current Estimate (MOCE) – for more detail see our blog – could well influence the future UK risk margin design.
- Matching Adjustment (MA) – the application process and criteria could be simplified. The PRA is likely to support reforms that would allow equity release mortgages (ERMs) to be included in MA portfolios without the need for complex restructuring, though without relaxing the requirements so far as to allow a wider range of assets with weaker matching to liabilities. (Here, the Call for Evidence also recognises the risks to policyholders that this scenario could create.) The Call for Evidence also suggests the potential for the regulator to have more options than the current binary “yes” or “no” on use of the MA, consistent with the overall direction of the Call for Evidence towards greater regulatory flexibility. Reforms could also make it easier for insurers to include infrastructure, long-term and sustainable finance investments in MA portfolios, with greater recognition of the potential transition risks of climate change (for example, “stranded” investments).
- Calculation of the SCR – the Call for Evidence sets out to explore how the SCR calculation could be made less prescriptive, less complex, and with more scope for supervisory judgment: “a more appropriate mix of judgment and rules”. This includes both making the standard formula more flexible, and therefore more likely to be appropriate for more firms, and also, as we predicted in our previous report, making the internal model approval process more flexible and more judgment-led, so bringing the system more into line with that in operation on the banking side and making internal models a more viable option for more insurers. The Call for Evidence also suggests more flexibility in how the group SCR is calculated by insurance groups immediately following mergers and acquisitions, where the “new” group has not yet receive approval for an updated group internal model.
In our view, the PRA’s views on capital and internal models are likely to be influenced heavily by its more judgment-led and model-output focused approach in the banking sector; the PRA is most likely to want to see the insurance regime convergence towards the banking approach, particularly in areas such as precautionary capital add-ons and approval conditionality. The Call for Evidence also discusses the potential for the PRA to take other sources of information into account as it makes judgments on insurer solvency, which may include stress testing or assessments over different time horizons. While pointing to more future flexibility, reforms in this direction would also likely increase significantly the PRA’s flexibility to apply capital add-ons for insurers.
- Branch capital requirements for foreign insurance firms – the Government is looking broadly at how to reform branch regulation to “increase the attractiveness of the UK” as a destination for branches of foreign insurers. This includes removing capital requirements at the UK branch level, recognising that “the branch cannot fail independently of the insurance firm”. Reforms in this direction are likely to increase the attractiveness of branch rather than legal entity establishment for foreign insurers operating in the UK, but may well not be welcomed by the PRA, given they could remove capacity for formal or informal ring-fencing of branch resources in the UK.
- Reporting requirements – the Call for Evidence suggests the potential for a wide-ranging review of the reporting requirements and available exemptions. While, in our view, the UK is highly unlikely to move towards “light-touch” regulatory reporting, some significant simplification and potentially stratification of the Solvency II reporting package, and a wider scope for exemptions, is possible.
- LIBOR transition – the Government and PRA intend to “give certainty to insurance firms as soon as possible” on the switch from LIBOR to OIS rates for calculation of the risk free discount rate term structures. The Call for Evidence notes that the PRA is already working on its future methodology to calculate discount curves in the UK from 31 December 2020, and indicates that the PRA will consult on various aspects of the LIBOR transition later in 2020.
- Other areas of reform – the Call for Evidence also discusses reforms in several other areas, including:
- Removing the need for insurers applying the Transitional Measure on Technical Provisions (TMTP) to maintain legacy models. The Call for Evidence also suggests that other transitional measures may arise as a result of the review.
- Increasing the thresholds for regulation under Solvency II.
- Approaches to improve “mobilisation” of new insurers, for example no longer requiring certain new insurers to apply Solvency II in full immediately upon authorisation, linked to the PRA’s work on the New Insurer Start-up Unit.
How things stand in Europe meanwhile
The EU’s Solvency II Review continues to progress in the EU, although the timing has been delayed by the COVID-19 pandemic. EIOPA’s advice on the review is expected by the end of 2020, and significant progress on the Commission’s proposals are therefore to be expected in 2021.
The EU Solvency II Review is evaluating many of the same reform priorities as the UK review. In particular, the risk margin appears likely to be reformed to be less interest rate sensitive, and some significant changes are being discussed to long term discounting. Infrastructure investment, sustainability and long-term financing have also emerged as major themes in the EU review. To the extent that comparable changes are made between the EU and UK the eventual level of actual divergence between the two regimes could be lessened.
In our view, the reform of most long-term significance is likely be a shift in UK regulatory policy-making towards greater judgment and flexibility. In the EU – quite naturally for a regulatory regime that seeks harmonisation across multiple jurisdictions and markets – the direction of travel continues to be towards greater codification and alignment in areas where the UK would prioritise judgment and outcomes-led interpretation. In this key respect, the future UK and EU regimes could diverge quite substantially, even though both are seeking similar outcomes
 Where we refer to “Brexit”, we are referring to the moment at which the UK becomes a “third country” for the purposes of EU regulation.