Reforms to Solvency II Must Meet the Needs of the U.K. Insurance Sector.

A few months ago, I wrote a paper for the Centre of Built Britain that focused on the impact that finance can have on the built environment, as well as the benefits of using a digital twin. Since writing that article, I have been asked by friends and colleagues why I decided to write a paper so different from what I usually write about.?

One of the reasons was the influx of funding coming from institutional investors.?

Some people may be surprised to learn that the murky, behind-the-scenes world of insurance regulation is also part of the campaign for the next prime minister of the United Kingdom.?

As the debate centres on tax cuts versus public investment to address Britain's rising cost of living, the next leader of the governing Conservative party may find the idea of freeing tens of billions of pounds from the perceived shackles of Brussels red tape intriguing.?

It is commonly believed that the former chancellor and chief advocate of the European Union’s (EU’s) Solvency II insurance regulations will become the next prime minister. One of Rishi Sunak's rivals, Tom Tugendhat, has lately pointed to Solvency II reform as a positive aspect of Brexit.

What is Solvency II??

Solvency II sets out regulatory requirements for insurance firms and groups, covering financial resources, governance and accountability, risk assessment and management, supervision, reporting, and public disclosure.

Solvency II was implemented when the United Kingdom was still a member of the EU, and it sets forth rules for the minimum quantity and makeup of capital reserves held by firms.?

An examination of the Solvency II regulatory framework is underway. This review’s aim is to look at increasing the availability of long-term capital from insurance companies, which might free up a substantial amount of funds for investment.?

Competition is expected to be fierce for this area of regulation after Brexit.?

The sector has been well organised, and its efforts to reverse what it sees as unnecessary restrictive EU legislation have allowed it to deploy more money as needed. Insurers’ promises to put money toward measures—such as income inequality reduction, infrastructure development, and green assets—caught the attention of Boris Johnson’s administration, which swiftly began a reform consultation due to run until the end of July.?

Supervisors at the Bank of England are leery of compromising policyholder rights to benefit shareholders.?

Even the European Commission in Brussels?agrees that Solvency II must be revised, as the EU moves to achieve the ambitious objectives set out in its Green Deal and Next Generation EU plans for recovery after COVID-19. Insurers can portray this scenario as a race, thanks to EU reform measures, but doing so runs the danger of burdening the U.K. with regulations that the EU eventually scraps—an economic hit due to Brexit instead of a dividend.?

Since annuity-focused life insurers would dominate the domestic market in Britain after Brexit, the country will be able to draught its own legislation to regulate the sector. Some provisions of Solvency II unfairly target this sector. What assets insurers may use to fulfil long-term commitments is at issue right now, and this fight is part of the “matching adjustment: regime.?

The Prudential Regulation Authority of the Bank of England, which oversees insurers, has indicated that it is ready to drastically decrease bureaucracy and some Solvency II capital requirements, releasing up to GBP 90 billion for investment, but only provided that the matching adjustment is also lowered.?

Some have hypothesised that the proposed changes to the so-called matching adjustment, which is used in the calculation of insurers’ long-term obligations, might nullify much of the advantage from a planned decrease of the crucial capital buffer.?

On Friday, July 8th, Prudential Regulation Authority (PRA) CEO Sam Woods made the following observation:?

“In our view, our proposed package of reforms to insurance regulation will support all of the government’s objectives for the [Solvency II] review. But it is essential that we take forward all three elements: a major loosening of one important part of the regime (the risk margin); changes to cut bureaucracy, and to enable insurers to invest in a wider range of assets; and changes to put another part of the regime (the matching adjustment) on to a more sustainable footing.

“Industry views at this stage seem broadly to support the first two elements of the package, but not the third. In our view, a package which did not tackle the issues we have identified with the matching adjustment would be seriously unbalanced. It would simply remove bits of regulation that insurers don’t like without taking proper account of risks to policyholders and would not provide a solid basis for investment.

“I worry that some might consider such a thing to be a free lunch,”?he continued,?“but in fact, less capital, fewer checks, and fewer restrictions on assets, with no steps to strengthen the part of the regime where that is needed, means more risk for pensioners and other policyholders.”

The matching adjustment enables insurers to recognise upfront capital as a component of future cashflows that have not yet been generated. By using matching adjustment benefits, life insurers have a considerable influence on business choices and are advantageous to the greater U.K. economy. The matching adjustment increased insurer balance sheets by GBP 81 billion by the end of 2020.?

Credit, illiquidity, and other lingering concerns are present when insurers engage in long-term assets. Insurance companies may store assets until maturity and should be less susceptible to illiquidity risk when asset and obligation cashflows closely match. Credit and other lingering hazards are still there, however. The basic spread, a provision for these retained risks, is taken out of the matching adjustment to represent them. The fact that there is still disagreement on how the basic spread should be altered shows how crucial and difficult it is to do correctly. The matching adjustment advantage decreases as the basic spread increases, it was added.

This could not fully communicate the risks associated with more modern, diverse portfolios, such as those in which infrastructure plays a bigger role. Now, insurers worry that a strict PRA approach to another Solvency II requirement may negate any benefits from relaxing the first rule.?

The larger risk arises when policymakers put their own interests ahead of those of the technical community. In addition to its present statutory obligations of protecting policyholders and ensuring corporate soundness, the PRA is also under danger from government initiatives to preserve U.K. competitiveness. Promoting the United Kingdom is the responsibility of governments and lobbying groups, not watchdogs.?

If pension and policyholder funds are mishandled, future governments may have to decide between giving policyholders haircuts or providing public bailouts, regardless of who is in charge.

The Why?

The Treasury wants to include economic infrastructure including renewable energy, transportation, digital, water, and waste in assets that may be used for the matching adjustment, in addition to making changes to the basic spread. Ministers have made it clear that they want the U.K. insurance sector to make investments to help the move to net zero, whether via the distribution of funds to encourage the creation of new green technology or the adoption of green practises.

So, the reforms are intended to unlock tens of billions of pounds for long term productive investments, including infrastructure, by lowering the capital requirement thresholds and giving insurers more freedom over where they can invest their assets. According to the ministers, this will “materially release [...] possibly as much as 10% or even 15% of the capital currently held by life insurers.”?

The U.K. branches of international insurers will no longer be required to calculate local capital requirements but rather will be able to depend on group capital, which the Treasury believes will lessen the administrative burden of Solvency II.?

It also intends to streamline the directive's reporting obligations and raise the thresholds before Solvency II takes effect.

If done correctly, the U.K. insurance sector could see improved cost-effectiveness and higher competitiveness, while the U.K. economy gains from a substantial infusion of funding for crucial infrastructure projects.

Therefore, helping?to secure funding from Investors in the built environment