UK Solvency II reforms to free up capital despite fears over policyholder protection

The UK has announced changes to its Solvency II regime that will help insurers free up capital but raise concerns over policyholder protection. Announcing the changes as part of his much-anticipated Autumn Statement, Chancellor of the Exchequer Jeremy Hunt said the reforms will distance the UK’s capital adequacy regime from the EU’s Solvency II. Although Solvency II is under review at EU level, with similar changes put forward in draft proposals. Hunt predicted that changes in the UK will “unlock tens of billions of pounds of investment for our growth-enhancing industries”. In particular, the new UK regime will reduce the risk margin by 65% for life insurers and 30% for non-life insurers. The risk margin ensures insurers hold sufficient assets to transfer their liabilities to another insurer. Its reduction tackles concerns that the risk margin inherited from the EU’s Solvency II regime was too large and sensitive to interest rates. The UK will also increase the range of asset and liability eligibility criteria for the matching adjustment under Solvency II, which will allow insurers to invest in a broader range of assets. And in response to concerns raised by insurers that reform of the fundamental spread would increase regulatory capital requirements, the UK government has confirmed that its design and calibration will remain unchanged. The fundamental spread is the expected cost of default and downgrade of assets that back annuities. Other changes designed to cut red tape and reporting requirements include the removal of branch capital requirements for foreign firms and a doubling of the premium and reserve threshold for companies before Solvency II applies. The UK’s consultation on Solvency II reforms, which began in April 2022, is reported to have caused a tussle between HM Treasury and the Bank of England’s Prudential Regulation Authority (PRA), which is responsible for policyholder protection. The UK government reminded the PRA that under its proposed Financial Services and Markets Bill, which will repeal retained EU laws, both the PRA and the Financial Conduct Authority will also have competitiveness and growth objectives. The government made clear the split between the lawmakers and regulators in its response to the Solvency II consultation. “The most challenging element of the debate has been about the matching adjustment, including both its eligibility requirements and the fundamental spread component,” the Treasury said. “There has been no consensus on the best approach on reform of the fundamental spread,” it added. But the UK government ultimately rejected the case for reform, including proposals from the PRA. “Although the government has decided not to take forward the PRA’s proposals for reform of the fundamental spread, the government recognises the importance of policyholder protection. With this in mind, the government recognises that the rules set out in legislation must work in close combination with supervisory tools held by the regulator,” it said. It assured the PRA that the regulator will have powers to hold insurers to account and maintain policyholder protection. It announced several new measures to help deliver this. These include regular stress tests for insurers to measure their resilience to PRA scenarios. There is also a new requirement for insurers to nominate a senior manager to attest that the level of fundamental spread on their firm’s assets is sufficient and reflects all retained risks. “The government also supports the PRA in expecting that at all times insurers will apply high standards of risk management and will cooperate fully with the PRA in the use of these supervisory tools,” it said. The government has asked the PRA to “keep use of the matching adjustment under close scrutiny”, while review of the calibration of the fundamental spread will take place in five years. Earlier in the Solvency II consultation process, insurers made clear that the draft proposals could in fact increase capital requirements and fail to realise the objective of freeing up more capital for investment. But welcoming the confirmed changes, Association of British Insurers (ABI) director general Hannah Gurga said the reforms are “meaningful” and could potentially release at least £100bn in the next ten years for investment in social infrastructure and green energy. Gurga added that the new regime will “encourage a thriving and competitive industry”. Barry O’Dwyer, ABI president, argued that the changes to the Solvency II regime will maintain the highest standards of policyholder protection. Amanda Blanc, chief executive of Aviva, said: “This is a very welcome boost for UK investment. We estimate reforms to Solvency II will allow Aviva to invest at least £25bn over the next ten years across the UK, including in critical areas such as social housing, schools, hospitals and green energy projects.” Trevor Jones, head of insurance at KPMG UK, said insurers could unlock up to £35bn of surplus capital from changes to the risk margin. “The government’s reforms on Solvency II are a strong step in the right direction for the insurance sector. The changes strike a sensible balance to enable additional investment and improve internal competitiveness, while ensuring the regulator has sufficient powers to scrutinise decision-making and the protection of policyholders,” he said. Moody’s analyst Will Keen-Tomlinson said the UK’s changes to the Solvency II regime will be “moderately positive” for insurers’ earnings but could lead to lower levels of capitalisation. “The existing calibration of the fundamental spread together with the reduction in the risk margin will trigger a modest release of capital, which insurers can return to shareholders or use to take additional risks,” he said.

UK Solvency II reforms to free up capital despite fears over policyholder protection

Treasury and regulators split over changes

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