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Solvency UK update

HM Treasury confirms risk margin reforms, and paves the way for the PRA to update matching adjustment rules

27/06/2023
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Authors

Ruolin Wang
Solutions Manager

A little over six months since releasing its final “Solvency UK” consultation response, HM Treasury published on 22 June a draft version of some of the reform wording for early engagement. Many of the previously proposed reforms are taking shape, including the highly-anticipated reduction of the risk margin[1], and additional powers of the Prudential Regulation Authority (PRA).

Unfortunately, however, for those of us holding onto the edge of our seats about the meaning of “highly predictable cash flows” and other proposed matching adjustment[2] reforms, we cannot let go and leap up just yet. According to HM Treasury’s accompanying statement, the Treasury expects the risk margin changes to be implemented by year end 2023, with matching adjustment and remaining reforms coming into effect by June 2024 and year end 2024 respectively. For now, we will have to wait a little longer.

Risk margin

The risk margin has been one of the more controversial aspects of Solvency II since the regulations came into effect in 2016, with industry long criticising its size and procyclicality. One of the headline changes, now detailed in the draft regulations, is a 60-70% reduction to the risk margin for life insurers. For general insurers, the reduction will be one-third. In both cases, these will increase firms’ own funds in relative terms, and reduce the cost of writing new business (particularly for life insurers). However, with material rate rises since consultation started and the resultant (sometimes sizeable) reductions in risk margin for long-term business, the absolute savings from the reform will have reduced.

The risk margin reduction will be implemented through the following mechanism changes in Solvency II’s Cost of Capital approach[3]:

  1. A reduction of the assumed Cost of Capital from 6% to 4%, and
  2. The introduction of a tapering parameter, lambda, for long-term insurance obligations. This tapers future SCR projections to 0.9t at each time step t, and is floored at 0.25 (effectively limiting tapering to approx. 13 years).

As seen in the example below, these changes can materially reduce the projected future cost of capital for long-term insurers, achieving the expected 60-70% saving (60% in the example below). 

Graph - Solvency UK update

For non-life insurance obligations, the tapering mechanism will not apply. However, firms can still expect a one-third reduction to risk margin from the Cost of Capital being reduced from 6% to 4%.

For firms with the risk appetite, the capital savings can allow them to seek greater returns by increasing allocation to riskier, including illiquid, assets. In addition, long-term insurers who have been hedging their risk margin against interest rate risk should now revisit their hedging strategies, as the duration of their risk margin is also likely to have reduced due to the introduction of the lambda parameter.

Matching adjustment and additional PRA powers

Compared to the universally popular risk margin reforms, matching adjustment reforms have attracted a little more debate and revision. Although the final outlined proposals, as released in November 2022, were generally well-received by industry, some expressed concern[4] at the additional powers that the package would bring to the PRA.

Some of these additional powers are now visible in the draft regulations. In addition to powers to make rules, the regulations include provisions for the PRA to “disclose confidential information if it is necessary to do so in order to publish the outcome of a stress test conducted in respect of an insurance undertaking or a reinsurance undertaking”. In particular, this can include the publication of individual firms’ stress testing results.

Final details regarding the matching adjustment rules themselves, have not yet been released. Previously signalled headline changes are not described at this level of legislation, such as:

  • Broadening asset and liability eligibility,
  • The removal of the BBB cliff,
  • The use of notched ratings, and
  • The treatment of applications and breaches

One of the drafts nods[5] at the proposal to allow assets with “highly predictable” (as opposed to “fixed”) cash flows to be matching adjustment-eligible, but stops short of providing any details.

As the Treasury signals further revocations of current regulations, as well as new and updated PRA rules, we will have to wait a little longer for full details to emerge.

Footnotes

[1] The risk margin is a provision which insurance companies are required to hold under Solvency II, and is the amount the insurer would be required to pay to transfer the business to another firm.

[2] The matching adjustment is an increase to an insurer’s liability discount rate under certain conditions, which can reduce the present value of the insurer’s liabilities, benefiting an insurer’s solvency position.

[3] Under this approach, an insurer’s risk margin is the discounted cost (currently set at 6% p.a.) of holding solvency capital for non-hedgeable (i.e. non-market) risks.

[4] Insurance ERM: UK Solvency II reform sparks worries of extra regulatory requirements, November 2022

[5] Draft Insurance and Reinsurance Undertakings Prudential Requirements Regulations 2. Paragraph 5.(8)(b) on the application of the matching adjustment: The cash flows of the assigned portfolio of assets must be fixed and not capable of being changed by the issuers of the assets or any third parties, except— […] (a) where the risks to the quality of matching are not material, and (b) where only such limited proportion of the portfolio as the PRA may determine is affected.

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Authors

Ruolin Wang
Solutions Manager

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