This blog was published on 11 August 2021.
At a glance
- The UK Treasury’s response to its Call for Evidence on the UK Solvency II review and the PRA Quantitative Impact Study do not provide answers on the future reforms to Solvency II in the UK, but show how wide the range of options is that the UK is considering.
- Divergence from EU Solvency II appears certain. However, the PRA will have some difficult cost-benefit decisions to make as it develops future UK policy.
- The Treasury and PRA expect to present a package of changes which is likely to be broadly neutral in overall sector capital terms. Given the risk margin should reduce in size, this implies tightening in other areas.
- The response reinforces previous statements by policymakers on the continued importance of international standards in the UK. We expect the IAIS ICS and ICPs to increase in importance as reference benchmarks for capital and supervision in the UK.
- The response appears to add weight to the possibility that the PRA may in the future have objectives linked to, or “have regards” to, UK competitiveness or the role of financial services in the UK economy and investment.
Who this blog is for:
Senior leaders of UK insurers responsible for setting strategy on their firm’s approach to regulation across the UK and EU, including CROs and CCOs.
Approximate reading time: 10 minutes
The UK Treasury published its response to its call for evidence on the UK Solvency II review on 1 July 2021, and the PRA has since launched a Quantitative Impact Study (QIS) to support the review. The Treasury’s response gives away little on actual future reforms to the UK insurance prudential framework that was not in the call for evidence itself (see our earlier blog), and, while the PRA’s QIS does test some concrete proposals, it states clearly that they should not be taken as indicative of any preferred courses of action. But, combined, they do make clear the very wide range of potential options for UK reform that are under consideration.
This blog discusses our key observations on the progress of the review and its possible outcomes, that can be inferred from the Treasury’s response and the PRA QIS.
UK/EU regulatory divergence
- Divergence from EU Solvency II already appeared practically certain; the response and QIS confirm that, but the response equally makes clear the balance that the Treasury and PRA will need to strike between reforms that make sense for the UK market, the potential practical costs for insurers of divergence from EU standards, and wider considerations around, for example, regulatory equivalence and potential for regulatory arbitrage between regimes.
- As we discussed in our earlier blog series Ruling the waves or waiving the rules?, regulatory change carries both one-off costs of implementation and ongoing costs for firms operating across both the UK and EU. Cost benefit analysis for new policy must consider these costs. In practice, this may mean that potential reforms that could make sense for the UK market in isolation may not pass cost-benefit analysis.
- The PRA may also have to make difficult cost-benefit decisions on reforms being made to EU Solvency II as part of the European Commission’s Solvency II review (as and when those changes themselves become clearer). For example, there may be a case for the UK to align with reforms such as those being considered for the Standard Formula or certain aspects of reporting, when one-off implementation costs are compared with the annual costs of divergence for insurers operating internationally.
Capitalisation of the UK insurance sector
- The quantitative effect of the various options discussed in the response could vary widely, but the response is clear that the Treasury and PRA will look at the effect of the package of changes in the round. The PRA has stated numerous times that it considers the overall level of capital in the UK insurance sector to be broadly appropriate. Given that risk margin reform is highly likely to reduce the quantum of the risk margin (albeit the risk margin is offset to an extent by the transitional measure on technical provisions (TMTP) and by the use of reinsurance), it appears likely that other areas of the review could tighten calibration of some of the UK requirements.
- The matching adjustment for illiquid assets such as infrastructure could be an obvious area for attention in this regard – albeit not a straightforward one given the overall focus in the Treasury’s call for evidence on increased investment in infrastructure by insurers. For example PRA CEO Sam Woods stated in March 2021 that “the increasing role played by illiquid assets – whilst wholly consistent with the advantage that insurers have as investors in this space – is a growing source of uncertainty and makes it essential that the calibration be set at a level appropriate to the assets that firms actually hold”.
- However, while the review may turn out to be broadly neutral in terms of overall sector capital, there will undoubtedly be winners and losers among individual firms. This may depend, for example, on whether individual insurers use the matching adjustment, the duration of their liabilities, investment strategy, and their historical use of the TMTP and reinsurance to manage the risk margin.
- Given most of these factors focus on the life sector, general insurers are, at face value, likely to be more affected by the supervisory process aspects of the review. This may include, for example, changes to internal model approval and reporting, as well as potentially alignment/divergence with the EU in general, given UK general insurers’ often international footprint.
The role of international standards
- The response also makes a few mentions of the International Association of Insurance Supervisors (IAIS) Insurance Capital Standard (ICS). And indeed (and consistent with our previous suggestions) the QIS tests the ICS Margin Over Current Estimate (MOCE) as a possible risk margin approach – albeit with a different scope of risk coverage.
- This echoes strong statements by UK policymakers and regulators following Brexit in support of international standards (as we discuss in our previous blog, for example). The ICS MOCE approach has international recognition, and our expectation is that it would reduce both the current quantum and the interest rate sensitivity of the risk margin by more than EIOPA’s proposed Lambda reduction factor reform (which is also being tested in the QIS).
- More broadly, we expect the importance of the ICS framework and the IAIS’s Insurance Core Principles (ICPs) to grow in the UK as important reference benchmarks for insurance capital and supervision. In particular, ICS/ICP compliance could provide a reference framework for the UK regulators to assess regulatory alignment and outcomes-based equivalence with other jurisdictions, given the worldwide recognition of the ICS and ICPs.
Role of the UK regulator
- The response refers to ongoing Government work on the PRA’s objectives and principles, and also suggests the Government will look at the PRA’s “have-regards” with respect to Solvency II.
- The UK Solvency II review places significant emphasis on UK competitiveness and the role that insurers can play as investors in infrastructure and green investment. The response could therefore be seen to add weight to the possibility of the PRA having objectives linked to, or “have-regards” to, UK competitiveness or the role of financial services in the UK economy and investment.
Given the clear intention to develop a package of changes as a whole, we don’t expect further clarity on the UK Solvency II review reforms for some time. Engagement in the PRA’s Quantitative Impact Study will be paramount for insurers looking to contribute to or influence the outcomes.