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Legal and regulatory

Solvency II: divergence or equivalence?

Many UK insurers want to break away from the more prescriptive requirements of the Solvency II regime, but the room for manoeuvre may be limited

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Since Britain voted to leave the European Union in June 2016 much of the headline news has been about the difficulties this would create for the financial sector. Yet some insurance industry players see an opportunity rather than a threat.

The theme of “taking back control”, that became a rallying cry for Brexit supporters, is perhaps most keenly felt around Solvency II, the EU directive that harmonised insurance regulation across the bloc and came into force just a few months before the Brexit vote.

As Steven Findlay, head of prudential regulation at the Association of British Insurers (ABI), puts it: “The EU Solvency II regime is necessarily highly prescriptive, given it is attempting to harmonise regulation across a multitude of member states.”

He adds: “By contrast, regulation in the UK is less prescriptive and more principles-based, so returning to a more principles-based regime is key.”

The UK insurance industry was a major player in drafting Solvency II and even by 2015 the ABI was estimating UK insurers had invested £3bn in getting ready for it. The ABI said it was the biggest change to insurance regulation in the EU for more than 30 years

However, some concerns of UK insurers were not taken into consideration. For example, there were issues raised related to the effects of persistently low interest rates. Most of the other EU countries saw the concerns as only relevant to the UK. Hopes remained there would be some flexibility for the UK to find a solution.

Now outside the EU, the UK is free to choose its own insurance regulation. The Bank of England’s Prudential Regulation Authority announced on 16 June the next stage of its ongoing review in Solvency II. But UK insurers also want the European Commission to grant equivalence to the UK, which would help them operate in the EU. The more the divergence from Europe’s standard, the harder this will become.

Several factors will inform the Commissions’ decision on whether it deems the UK regime equivalent. “They’re not supposed to be political decisions,” says Bob Haken, partner at law firm Norton Rose Fulbright. “They’re supposed to be technical decisions – but inevitably, there’s some politics at play.”

Risk margin

The UK insurance industry’s misgivings about Solvency II are varied, but the risk margin issue is perhaps the most notable. Insurers say the margin is excessively high for a low-rate environment, especially for insurers writing longer-term business. They say it may be appropriate for some EU countries but not the UK, where insurers write large quantities of long-term business with guarantees.

Many commentators, including professional services firm EY, have also highlighted issues around the “matching adjustment” (MA) which allows the capital held against some long-term books to be reduced if insurance obligations are matched to a portfolio of assets with similar cash flow characteristics. At present, computations and approval for matching adjustment are complex.

The UK government has proposed revisions that will reduce the capital burden on traditional annuities insurers, but also open the door to investments in infrastructure and sustainable assets.

Outside, looking in

Clearly, the UK feels its insurers should have more freedom to address solvency issues in a way that would best suit the UK rather than the EU. But for the time being, UK insurers have to comply with Solvency II and the scope for change may not be as great as some would like.

In March, sister publication Insurance Insider reported that PRA chief executive Sam Woods had lowered hopes that the Solvency II review would result in a significant lowering of capital requirements.

In a speech at an ABI conference in March, Woods cast doubt on claims about the capital-releasing possibilities of the Solvency II overhaul, including the ABI’s assertion that reforms to the risk margin could free up £35bn ($48.7bn). He said such numbers “are a little speculative”.

Analysts at Mediobanca are similarly sceptical. “We expect a reduction in the risk margin, but this will not lead to a capital windfall,” said Mediobanca analysts in an e-mailed statement.

“The main benefit is expected to be more flexibility on MA eligibility. If the criteria changes where it is acceptable to have predictable cashflows (rather than being completely fixed currently), it will enable insurers to invest in a larger pool of assets.”

When in Rome

UK insurers who want to continue operating in the EU after Brexit have faced important changes. It is not enough to have an office there, as each operation would have to be regulated separately by the local country. This would be prohibitively expensive. Insurers have needed full subsidiaries in the EU (though many already had such operations).

Regulatory equivalence is vital here, too, to help reduce the supervisory burden.

In theory, if a UK company sets up in Italy, the local regulator has to look at the solvency of the entire group. If the UK is also looking at the worldwide group, there is duplication and inefficiency.

“Most European regulators don’t have the resources to supervise a large international group,” says Norton Rose Fulbright’s Haken.

“If you have a provision that says if someone else is exercising supervision over the group and they are doing so in a way that is equivalent, so you don’t have to, that is quite useful.”

Haken also points to the separate consideration for reinsurance in Solvency II. If there is equivalence, reinsurers do not need to have a subsidiary operation in the EU.

“If you’re a French insurance company and you’re buying reinsurance from a UK reinsurer, with equivalence, then the benefit (in assessing solvency) is the same as if you had bought it from a German reinsurer,” he says.

Much remains to be resolved. But Haken and others are optimistic that a solution can be found. Given how recently Solvency II was introduced, it would appear to be one of the more straightforward issues for the Commission to resolve.

“If we’re not equivalent for Solvency II purposes, what could we ever be equivalent for?” says Haken. “It should be an easy one for the Commission.”

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