The UK Government's consultation on Solvency II: Part 1 – Risk Margin and Matching Adjustment eligibility impacts

Who is this blog for?

Senior executives and actuaries in the UK and elsewhere, who work on balance sheet management, pricing, reporting, capital optimisation and risk.

At a glance:

• The reforms set out in the UK Government’s consultation on Solvency II are broadly in line with those indicated by John Glen, Economic Secretary to the Treasury, in his speech to the ABI earlier this year. The Government’s aim of the Solvency II review is to ensure that the UK’s prudential regulatory regime is better tailored to the UK following its departure from the EU.
• The consultation focuses on reforms to Risk Margin (RM), Fundamental Spreads (FS), Matching Adjustment (MA) eligibility and reporting requirements.
• The PRA issued a Discussion Paper (DP) which outlines its assessment of the proposed reforms for RM and MA.
• The Government and PRA are requesting feedback on these reforms to help shape the final outcome. The PRA will then follow up with a more detailed consultation later in the year.
• This blog is the first of a two-part series exploring the proposals for RM and MA. In this blog, we will consider the changes to the RM, MA asset and liability eligibility criteria and other aspects of the MA (not related to the calculation of the FS). Part 2 of the blog will consider the revised framework for the FS.
• Also, for consideration of how the reforms may meet the Government’s objectives of enabling long-term investment while enhancing the overall competitiveness of the UK insurance industry, see The UK Government's consultation on Solvency II: A green and competitive future, Linda Hedqvist (deloitte.com).

Reading time: 7 minutes

Executive Summary

On 28 April 2022, the UK Government released its long awaited consultation on reform of Solvency II. The proposed reforms include:

• A substantial reduction in the RM of around 60-70% for long-term life insurers based on a cost of capital approach;
• A reassessment of the FS used in the calculation of the MA;
• More flexibility to MA eligibility rules for both the asset universe and the liabilities to which an MA can be applied;
• A reduction in the EU-derived regulations which make up the current reporting and administrative burden; and
• The combined impact of the RM and FS reforms has been estimated by the PRA to result in a release of up to 10-15% capital currently held by life insurers.

At the same time, the PRA issued a DP outlining its assessment of the proposed reforms for RM and MA, and discusses which potential combinations of reforms to the FS and RM would (or would not) be consistent with its statutory objectives. Both the PRA and the UK Government are seeking responses by 21 July 2022.

Our interpretation of the consultation, in summary, is detailed below:

• From these papers, it appears that the Government and PRA prefer a modified cost of capital approach to reform the RM, and responses to the consultation will inform the calibration. It is worth noting that neither the previous calibration set out in the Quantitative Impact Study (QIS) nor EIOPA’s RM proposal is likely to be sufficient to deliver the 60-70% reduction the Government is targeting.
• Although the consultation proposes broadening MA asset eligibility to assets with prepayment options and infrastructure in the construction phase, defining eligibility in relation to specific asset classes would be a departure from previous PRA guidance which tended to rely on key principles. Therefore, we expect the future PRA consultation to set out defining principles by which to judge asset eligibility, with the expectation being that the updated guidelines will be loosened to permit the range of assets detailed in the Government consultation to be included within an MA portfolio. These principles can then be extended to newer asset classes.
• MA liability eligibility will be extended to products that insure against morbidity products as previously indicated. With the significant reduction in RM for long term products, this may be a double win for social care products, a sector of the market the Government is keen to invigorate.
• The signals around the MA approval process (both in terms of speed and flexibility for innovative assets) continue to be promising. However, without further detail on any additional safeguards the PRA may feel are necessary, particularly on risk mitigation requirements, it is difficult to determine what this will mean for the appeal of previously MA-restricted asset classes.
• The consultation proposes accommodating a more proportionate approach to MA breaches. This could help insurers plan for a more stable MA, and could result in more beneficial treatments in the calculation of the spread risk Solvency Capital Requirement (SCR) where insurers may be allowed more time to restore compliance following a breach. This is one of the few indications of how the changes to the MA may impact the SCR and could be of material benefit to annuity writers.

Risk Margin reforms

Preference for a modified cost of capital approach 

The Government consultation proposes a material reduction in firms’ RM of 60-70% for long-term life insurers. The size of the reduction is larger than that indicated from the QIS results, although closer to what industry had lobbied for in the past. Both the consultation and the DP make clear, for the first time, that the PRA considers a reduction of 60% would be consistent with historic transfer values but only if this occurs in conjunction with an appropriate strengthening of the FS.

The RM approaches considered in the QIS were the Margin Over Current Estimate (MOCE) and a modified cost of capital approach. The approach now favoured by both the Government and PRA is the modified cost of capital approach largely because:

• It recognises significant differences in firms’ risk profiles and liability durations;
• There would be less disruption to firms adopting this methodology since only small changes would be required to current systems;
• It is comparable with the EU proposed RM methodology, benefiting insurers with a presence in both the UK and EU; and
• There remains a clear theoretical link to the concept of the RM as the amount needed to facilitate a transfer to a third party.

A disadvantage of the modified cost of capital approach, however, continues to be its sensitivity to interest rates. Nevertheless, a substantial reduction in RM reduces the significance of any retained volatility in the RM in the context of the overall balance sheet.

Backsolving the required parameters?

The calibration of the modified cost of capital approach as set out in the QIS (of a cost of capital of 6%, lambda of 97.5% and a floor of 50%) would not provide the 60-70% reduction in RM that is being suggested. Even moving to EIOPA’s proposal (of a cost of capital of 5% and removing the floor) would be unlikely to meet the desired outcome.

Our analysis suggests that a lambda reduction factor of between 80-90% with no floor and a cost of capital of 5% is more likely to generate the 60-70% reduction in RM anticipated by Government. The table below summarises the reductions estimated for a number of firms focused on long-term business. The percentages signal the percentage decrease in the value of the RM compared to the current RM.

Our analysis also indicates that the results above are relatively insensitive to different prevailing interest rates.

Other than re-calibrating the lambda factor, other design variations to achieve the targeted level of RM reduction include:

• Reducing the cost of capital parameter - the PRA has indicated it would consider a reduction in the cost of capital from 6%. The analysis above was performed on the basis of a 5% cost of capital rate, consistent with the design being explored by EIOPA. However, it is unclear if a reduction below 5% would be supportable;
• Removing longevity risk from the list of non-hedgeable risks given the active and relatively liquid market for hedging longevity risk; and
• Including the MA/Volatility Adjustment (VA) in the calculation – this design aspect was explored by the PRA as part of the MOCE approach in the QIS. However, this design would lead to Risk Margin sensitivity towards the MA/VA.

While a simple mathematical exercise could be undertaken to determine the RM calibration that gives the desired answer, the PRA will want to able to robustly justify the calibration selected.

As noted in the consultation, a reduction in RM will be partially offset by a reduction in the Transitional Measure on Technical Provisions (TMTP), albeit the impact of any loss in the TMTP is due to run-off over the next 10 years. Also, for firms who have substantially reinsured out their longevity risk (a key driver of RM), the day 1 impact on the RM will be much smaller.

Implications for firms

With such large RM reductions on the horizon, life insurers should consider re-evaluating their approach to:

• Product strategy and pricing – certain products may now be more economically viable to write (particularly in conjunction with proposed changes to MA liability eligibility); and pricing could be made more favourable for policyholders;
• Deploying the capital released from the RM reductions - the Government is keen that this is used to support further investment in long-term assets and growth in the insurance market, rather than increasing dividends to shareholders.
• Hedging – driven by the change in the sensitivity of the RM and consequentially the balance sheet to movements in interest rates; and
• Reinsurance strategies and risk appetite – demand for longevity risk transfer could reduce, driven by the reduction in the cost of capital of holding longevity risk. The UK could end up retaining a greater proportion of longevity risk and, depending on the resulting calibration, could even become a more favourable place to hold longevity risk more generally.

Extending the MA asset eligibility landscape

The Government consultation largely builds on the easing of restrictions on MA asset eligibility as commented on in John Glen’s speech to the ABI.

As it currently stands, the fixity of cashflows is a key criteria when assessing MA eligibility for different assets. The Government proposes easing of this criteria such that the following assets with prepayment risk can be included in matching adjustment portfolios:

• Callable bonds;
• Commercial real estate lending;
• Housing association bonds and loans;
• Infrastructure assets; and
• Local authority loan portfolios.

Additionally, for assets with construction phases, insurers will be allowed to recognise penalties and other consequential amounts payable upon delay of completion. The consultation also confirms that the sub-investment grade cap will be removed.

However, whilst the consultation provides a helpful list of types of assets that could become eligible, the universe of potential assets remains far larger than that suggested. To ensure that all assets can be assessed for eligibility, we would expect a robust set of principles to be published in due course so that both firms and the PRA can extend such an analysis to all asset types, including those that emerge over time.

Risk mitigation to maintain policyholder protection

The consultation discusses the need for firms to employ appropriate risk mitigation techniques. This is in line with current practice where firms are required to conform to the Prudent Person Principle (PPP). What is unclear at present is the extent to which risks that are symptomatic of a relaxation of the eligibility rules, such as pre-payment risk without adequate make whole clauses, will need to be mitigated. Were the PRA to set a particularly high bar of risk mitigation, firms may find that they may need to couple these assets with financial instruments to mitigate these risks. Such a requirement may end up diminishing the MA-earning capability of such assets.

Whether the easing of eligibility restrictions has any bearing on increasing the in-flows towards these types of investments will largely depend on, amongst other things, the calibration of the FS and the resulting relative attractiveness of different asset classes and credit ratings.

Details of our analysis on the Government’s consultation on reforms to the FS calculation will be detailed in our follow up blog.

Extending MA liability eligibility 

Morbidity-exposed products

As previously indicated, the Government proposes to extend MA liability eligibility to products that insure against morbidity, such as income protection. This is an obvious extension to MA liability eligibility and paves the way for further product development and innovation in long term care and social care insurance, a priority for the Government. This treatment, in conjunction with the material reduction in RM (discussed below) may make such products a more attractive proposition for insurers and potentially more affordable for consumers. It will be interesting to see the extent to which protection providers make use of these new tools and whether any reduction in reserves from using the MA translates to more favourable pricing.

With-profits annuities and deferred annuities in with-profits funds

The broadening of the MA liability rules to include with-profits annuities and deferred annuities in with-profits funds is a new development which may prove to be beneficial to firms with these exposures. However, any benefit may be small as a significant portion of these annuity liabilities is from asset shares, which are not eligible for the use of MA. Also, insurers with pre-2016 annuities in with-profits funds may hold some TMTP benefit on their deferred annuities, which would be reduced if they gained approval for the use of MA on these liabilities. Nevertheless, they may value the permanency of the MA benefit above the temporary TMTP benefit.

The use of MA may bring a small benefit to with-profit policyholders, although this will also depend on whether the fund is currently managed on a Solvency II basis. Any benefit to shareholders will be limited due to ring-fencing if the with-profits fund is a sub-fund, and the profit-sharing mechanism between shareholders and the with-profits policyholders.  Firms will want to carefully consider the costs of applying for and complying with MA regulations, along with any reduction in their TMTP benefit. Proposals to streamline the MA application processes (discussed below) may well help persuade insurers that the cost is worth it.

Change to MA approval process and breaches

MA approvals

The consultation states that the PRA will consider streamlining MA applications, both in relation to less complex assets and for more innovative assets where the risks may be harder to assess. The PRA may differentiate between the eligibility decision and the review of the asset valuation, credit rating and capital modelling, therefore simplifying the approval process.

When it comes to approving innovative assets, the PRA may consider approval precedents set by other participants in the market. If this change is implemented, any first mover advantage from investing in new innovative assets may be dampened by virtue of the first mover having to do the hard work in arguing the case for eligibility. However, asset eligibility only forms a part of the PRA’s considerations of whether the asset in question is approved for use in the MA, and appropriate risk controls and compliance with the PPP will be key for individual firms to evidence.

Signal of treatment of Matching Adjustment under stress?

A further proposal, to follow a more proportionate approach to MA breaches, should allow insurers to be less overly cautious in managing their MA portfolio due to the current material consequences of breaching the MA conditions. A more proportionate approach to MA breaches could also have a positive impact for a firm’s SCR. If firms can benefit from a longer period over which they can restore compliance following a stress, they could allow for rebalancing management actions that more closely link to their MA risk strategy, rather than focus on fast restoration at the cost of MA. This could increase the benefit of the management actions, reducing the overall SCR.

Look out for the second part of our blog, where we will consider the proposed changes to the FS and potential impacts on the SCR.