All material subject to strictly enforced copyright laws. © 2021 Insider Engage is part of Euromoney Institutional Investor PLC.
Terms & Conditions | Privacy Policy | Modern Slavery Act | Cookies
Legal and regulatory

The case for change: The prudential regulatory regime for UK insurers

Kenny McIvor presents Willis Towers Watson’s top five recommendations as made to the HM Treasury Call for Evidence on the review of Solvency II

3D Map of European Union post-Brexit and UK, with EU flag (blue and gold stars) and Union Jack textures
Credit:
Loic Seigland/Getty Images/iStockphoto

The UK insurance sector is at a crossroads. Post-withdrawal from the EU, it has inherited the Solvency II regime it helped to build and must now decide what to keep and what to change for the better. Given the investments already made and the benefits for policyholder protection afforded by the regime, the arguments for change will be focussed on aspects which are poorly designed or calibrated for the UK.

We make the following key recommendations for change:

  • Public disclosures should continue to be improved in the areas of sensitivities and analysis of movement and unnecessary information requirements eliminated;

  • Transition to Sterling Overnight Index Average (“SONIA”) swaps is a missed opportunity to return to gilts as an option for the discount rate basis and this should be reconsidered;

  • Eligibility criteria for assets backing insurers’ long-term liabilities should be more flexible and balanced and the allowance for credit risk should be revisited;

  • Issues in the principle behind the risk margin should be addressed, reflecting that liabilities and backing assets are managed and transacted as blocks of business;

  • The standard formula should be better tailored to reduce pressure to adopt an internal model and a capital add-on should not trigger a disproportionate requirement for an internal model.

Three major stakeholders

An effective insurance regulatory framework should meet the needs of three major stakeholders - consumers, capital providers and Government - working on behalf of society as a whole.

These stakeholders are at the heart of our thinking about the UK insurance market’s future regulatory framework and are a central theme in our responses to the call for evidence, which can be read in full here.

Furthermore, we believe that regulatory change should avoid unnecessarily undermining “equivalence” with Solvency II. HM Treasury should consider developing a roadmap of change in the regulatory framework and bring that change in gradually.

Our five key recommendations for change:

Reporting requirements

We have been calling for a refocus from quantity to quality in insurer reporting for many years. Being able to explain results is crucially important, but we are not yet there as a sector.

An analysis of movement is critical to understanding the developments impacting a firm over a given period, yet there are still gaps in the consistency of reporting across even the biggest firms.

On the other hand, there are reporting requirements which are excessive or unnecessary. Even the regulator can benefit from trimming this back given that it currently runs a risk of receiving information that, due to finite resources, cannot be analysed.

Basic risk-free rate

It is proposed by the regulator that the basic risk-free rate changes from the London Inter Bank Offered Rate (LIBOR) swaps to SONIA swaps by 31 July 2021. However, there are concerns over the future depth and liquidity of the SONIA swap market at medium to long durations.

Previously in the UK, when the Solvency II basic risk-free rate adopted swaps, UK with-profit funds sold gilts and bought swaps resulting in a value transfer from policyholders to investment banks. Incentivisation towards one reference rate over another creates the potential for market distortions. The currently prescribed approach could trigger a similar outcome.

Overall, we believe that Brexit provides an opportunity to allow firms to choose gilts or SONIA swaps (or something in between) as the basic risk-free rate.

Matching Adjustment

The Matching Adjustment approach is currently too prescriptive and binary.

As far as asset eligibility is concerned, the approach to prepayment risk criteria creates a cliff edge (ruling out some classes of long-term assets), cashflow variability limits prohibit assets with uncertainty in timing and amount and there is too much incentive to restructure certain assets which is costly and a drain on resources.

Furthermore, a flexible approach to Loss Given Default in the calculation of fundamental spreads is needed to avoid handicapping infrastructure asset investments which provide societal benefits.

In terms of the allowance for credit risk, we see two broad choices for discussion:

  • Solvency I with more rigour: strong regulation to ensure a robust allowance for credit risk in the discount rate, with the discount rate primarily driven by assets held (which works well at times of stress when holding the illiquid assets becomes important).

  • Solvency II with more flexibility: broad matching adjustment structure remains with more flexibility for how credit risk is allowed for in both the setting of the discount rate and the Internal Model (currently, setting credit risk in the discount rate in isolation is not credible, but is offset by the strictness of the Matching Adjustment criteria).

Risk margin

Our recent survey of the chief actuaries of UK life insurers found that a large majority (16 out of 19) held the risk margin as the highest priority for change. After all, the risk margin is worth £19.9bn (as at YE19, net of Transitional Measures on Technical Provisions)1.

The main criticism levelled at the risk margin is that under low interest rates it is highly onerous to firms and promotes undesirable behaviours. Significant volumes of longevity risk are being reinsured offshore not because of low local appetite for this risk, but because these overseas regimes are not burdened by the same risk margin concept.

Moreover, such a large risk margin leads to firms weighing up their base parameters in light of this loading, which is detrimental to establishing a genuine ‘best estimate’ Best Estimate Liability.

One could argue that the problem is the parameterisation of the “cost of capital” approach; the 6% rate – originally derived from a Weighted Average Cost of Capital in the Swiss Solvency Test – double-counts market and credit risk risks.

Others might say that the design should change, and there are other examples such as the Insurance Capital Standard Margin over Current Estimate to draw on for inspiration. But we urge policymakers to go one step higher and look again at the risk margin principle.

We advocate a revisit of the risk margin principle itself, reflecting that liabilities and backing assets are managed and transacted as blocks of business.

Standard Formula and Internal Models

In the use test, where risk-based capital management needs to be put at the heart of decision-making, Internal Models are falling short. Few firms can claim that their Internal Model has driven their most important strategic decisions.

Regulatory compulsion of Partial or Full Internal Models is a significant cost to firms and hinders the Use Test objective. A better tailored, UK-focused calibration of the Standard Formula approach is necessary to reduce pressure to adopt an Internal Model.

Also, the PRA should be able to give a capital add-on without triggering a disproportionate requirement for firms to develop Internal Models or take decisions which materially change their risk profile.

What next?

What this all means for UK (re)insurers is perhaps very little for now. A watching brief is recommended as HM Treasury considers responses.

The Government has until 14 May 2021 to respond to the call for evidence, and it’s possible that PRA consultations would follow should the regulatory rules have to change. Meanwhile, the European Commission is weighing up the changes to Solvency II which are expected to emerge in Q3 2021.

A better-tailored UK insurance sector regime is in the interests of customers, capital providers and society. Getting there will require vision and perseverance, not least because Solvency II is so embedded. Changes that are focused in key areas of the framework are needed to achieve the laudable objectives of the Government’s review.

[1] Report on economic impacts of potential changes to insurance regulatory framework in response to HM Treasury Review of Solvency II: Call for evidence, Association of British Insurers, February 2021

Share
More...
We use cookies to provide a personalized site experience.
By continuing to use & browse the site you agree to our Privacy Policy.
I agree