In the first episode of our new podcast, host Robert Chaplin and guest Azad Ali, from Skadden’s UK and EU financial services practice, discuss the UK government’s recently announced post-Brexit Solvency II reforms. Known as Solvency UK, the reformed regime is expected to boost innovation, assist the government’s drive for investment and release a considerable amount of regulatory capital from UK carriers’ balance sheets.
As part of its departure from the European Union (Brexit), the United Kingdom is moving away from key EU insurance prudential regulatory standards, including by liberalizing the EU Solvency II regime. These reforms can be seen as political as well as regulatory — and if you’re an insurance professional, it is important to understand what these changes mean and how they may impact you.
The Solvency II regime came into force in the UK in 2016. The government announced a review of the regime in June 2020, followed by a range of proposed amendments this year.
The reformed regime — which will be called Solvency UK — is meant to boost innovation in the sector and assist the government’s drive for investment.
Though the reforms have not yet been implemented, “early speculation indicates a number of market impacts,” says Azad Ali, who leads Skadden’s UK and EU financial services regulation practice. Azad predicts the new reforms will lead to more investment in areas like infrastructure and clean energy, among other developments.
This is the first episode of “The Standard Formula,” a podcast from Skadden covering subjects of interest for UK and European insurance professionals in the Solvency II world. Host Robert A. Chaplin — a partner at Skadden — is joined in this episode by Azad as they discuss the UK’s recently announced post-Brexit Solvency II reforms.
- Risk margin. In the government’s final proposals, the risk margin is reduced, using a modified cost of capital method, by around 65% for life carriers and 30% for non-life carriers.
- Matching adjustment (fundamental spread). There will be no change to the design and calibration of the fundamental spread, save for an increase in risk sensitivity to allow a ‘notched’ approach within credit steps. This will, however, be accompanied by enhanced governance requirements.
- Additional proposals. Other reforms in the final proposals concern MA (including various steps to liberalize the MA eligibility criteria), requirements for UK branches of foreign insurers, the application thresholds for Solvency UK and a new regime for startup insurers.
- The full impact remains unknown. Azad speculates that the reforms will bring a number of market impacts, like a degree of investment in infrastructure and clean energy, a new boost for bulk annuity pension deals, innovative approaches to non-conventional assets and more.
From Skadden, the Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner, Robert Chaplin, leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome to our first ever Standard Formula Podcast. This new podcast series will cover subjects of interest in the Solvency II world. In today's episode we'll be covering the UK Government's recently announced post-Brexit Solvency II reforms. I'm Rob Chaplin, one of the insurance partners at Skadden. With me today is one of our Regulatory of Counsel, Azad Ali.
Following its departure from the European Union at the end of 2020, the UK is now exercising its freedom to move away from key EU insurance prudential regulatory standards. These include liberalization of the EU Solvency II Regime. The reforms are expected to release a considerable amount of regulatory capital from UK carriers balance sheets. In the UK, the reformed Solvency II Regime will become known as Solvency UK.
The reforms are intended to boost innovation in the sector and to assist the government's drive for investment, including in areas such as infrastructure and clean energy as well as its leveling up agenda. These developments can be seen as much as political as regulatory.
It's no coincidence that the at points difficult discussions between the government and the Prudential Regulation Authority were resolved in time for announcement on the same date as the Chancellor of the Exchequer's significant autumn statement speech of November 17.
The changes should also be seen in the context of the Financial Services and Markets Bill, which is currently making its way through Parliament. The FSMB will first revoke most EU-derived financial services statute law, as it applies in the UK, on the basis that this will instead be covered in P and financial conduct or foreign rules.
And second, make important amendments to the detail of the framework of financial services regulation, including the introduction of a new statutory objective for the PRA and FCA for competitiveness and growth as well as an important new regulatory principle in support of net zero. So, Azad, how did this all come about?
Azad Ali (02:50):
Solvency II Regime came into force in the UK at the start of 2016. In June 2020, the government announced a review of the regime in the UK, and with consultations launched in April of this year, the government proposed amendments across a range of areas. Most significant area for reform was thought to be the risk margin.
"Risk margin" is the additional reserve required to be maintained by an insurer above its best estimate of liabilities and below solvency capital requirement. The risk margin is currently calculated using the cost of capital approach, which is set at 6% for both life and non-life firms.
The government proposals in April of this year was to make deep cuts to that risk margin on the basis that it was larger than required to serve its intended purpose, which was to provide a sufficient buffer above the best estimate of liability so that if an insurer fails, there will be enough reserves to fund a transfer of insurance liabilities to another carrier.
The other key area was in relation to matching adjustment, or MA for short. The MA benefits insurers who hold long-term assets which match the cash flows of similarly long-term insurance liabilities by allowing them to recognize an illiquidity premium. The MA is a particularly material benefit and advantage for insurers writing annuity business which are thereby incentivized to invest in a wide range of long-term illiquid fixed interest assets and hold them to maturity.
And when insurers hold assets matched to maturity, they are less exposed to illiquidity risk, but do retain credit and other residual risks. And it is those other retained risks which are reflected by excluding from the MA and allowance for them, which is referred to as a fundamental spread.
Government's proposals in April was to make this spread much more sensitive and tailored so that it better reflects and measures credit risk. So, Rob will now talk us through the final proposals.
Rob Chaplin (04:52):
Thanks, Azad. In mid-November 2022 the UK government announced its final proposals. The risk margin is to be reduced using a modified cost of capital method by around 65% for life carriers and 30% for non-life carriers. In a surprise result, which was enthusiastically welcomed by the industry, there will be no change to the design and calibration of the fundamental spread within the matching adjustment calculation save for an increase in risk sensitivity to allow a notched approach within credit steps.
This will, however, be accompanied by enhanced governance requirements. There will be regular stress testing exercises, attestation, by nominated senior managers with formal regulatory responsibilities. That residual credit risk is not incorporated within the claimed MA. In relation to the latter requirement, the industry will watch with interest how the PRA uses this regulatory tool, and for individual firms, whether it's a way in which the regulator can strengthen reserves, which is seen as being overly weakened by significant risk margin release.
Likewise, the regulatory approach to internal models and solvency capital requirement, or SCR composition, will be carefully watched for signs of greater conservatism. The government will review whether the calibration of the fundamental spread remains appropriate in five years time.
Various steps have been taken to liberalize the matching adjustment eligibility criteria. A requirement of highly predictable rather than necessarily fixed cash flows for investments has been introduced, although it is stated that in practice the government expects the vast majority of cash flows to remain fixed, which suggests a degree of compromise with the PRA.
There would be broader eligibility for MA treatment, including flexibility to include assets with prepayment risk such as callable bonds or a construction phase, a wider range of liabilities eligible for the MA, to include products that ensure against morbidity risk, such as income protection products, and removal of the disproportionately severe treatment of assets with a rating below Triple B.
Other MA reforms include a more proportionate approach to MA breaches by carriers, and fast-tracked MA eligibility applications to include automatic approval for simple assets, no approval requirements for minor changes to existing applications, and a PRA-maintained register of approved assets and features.
Other proposals in the reform package include the removal of the requirements for UK branches of non-UK insurers to calculate branch capital requirements and to hold local assets to cover them. This significant reform should benefit around 160 branches immediately, as well as any other branches that establish in the UK in the future.
In addition, the proposals anticipate an increase in the thresholds before the Solvency UK regime applies. Up to £15 million in annual gross written premiums, triple the previous threshold, add to 50 million in gross technical provisions, double the previous threshold, which is aimed at nurturing insurtech businesses.
And finally, a new regime for startup insurers with adjusted entry requirements such as a lower capital floor, lower expectations for key personnel and governance structures, and exemptions from some reporting requirements, which is also aimed at developing the UK insurtech sector. So, Azad, what might the possible market impacts of the changes be?
Azad Ali (09:05):
Well, Rob, it's too soon to say with certainty what the market impacts the reforms will be as they are still being considered and analyzed by the industry, by advisors and commentators on the industry. I would suggest that early speculation indicates a number of market impacts.
Firstly, a degree of investment in infrastructure and clean energy, although perhaps more returns of value to shareholders than Government may have expected. Fresh boost for bulk annuity pension deals, a move away from a reinsurance offshoring of longevity risk, although perhaps less than what might be expected. Flourishing of branches, possibly, favoring the London market with an expected regulatory arbitrage potential, maybe.
Innovative approaches to non-conventional assets. A new look at life securitizations, and possibly and finally, new opportunities for insurtech where it is hoped that a new way forward will be found to enable successful creation of small innovative carriers in the industry. So, what comes next, Rob?
Rob Chaplin (10:14):
Well, Azad, the next step in the proposals is for Government to work with the PRA to enable implementation of these reforms. Then, we will await with interest to see how the compromises inherent in the reforms manifest themselves in practice. We hope you found the first episode of the Standard Formula Podcast useful. We very much look forward to you joining us next time.
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