The multi-year reviews of Solvency II in the EU and the UK are approaching completion, despite the very different macroeconomic environment since these reviews began in 2020 and 2021. The reforms fundamentally aim to boost investments in long-duration assets or businesses.
The proposed reforms are expected to alleviate capital strain and enhance Solvency II ratios for these insurers, Fitch Ratings says. The timeline for implementation is notably short, with new rules for a lower Risk Margin potentially in place by the end of 2023 and further updates, including a more flexible Matching Adjustment, anticipated by the end of 2024.
Higher market interest rates mean that insurers’ sensitivity to duration-related reforms have substantially reduced but we still expect both reviews to conclude in 2024.
Insurers to deploy some of the capital freed up by the reforms into these long-term investments, attracted by the prospect of higher returns, we believe they would stay within their existing risk appetites and avoid depleting their capital enough to jeopardise ratings.
The EU & UK Solvency II Review
The UK SII review aims to reduce the risk margin – a part of the value of technical insurance provisions. The reform will introduce changes to broaden assets eligibility to the matching adjustment, an increase in an insurer’s liability discount rates (see How the New Solvency II Reforms Boost the UK Insurance Market?).
The EU review also proposes changes to the risk margin. The proposal would ease the SII capital burden associated with long-duration liabilities, with proposed reforms that could release significant amounts of regulatory capital for investment.
Although an initial proposal to alter the calculation of the matching adjustment was rejected, the reform will broaden eligibility for matching adjustment assets.
These reforms primarily aim to encourage investments in long-duration assets without jeopardising insurers’ capital positions or ratings. With solvency ratios at record highs and lower interest rate risk, most insurers have strong capital headroom.
For the UK, the reduction in the risk margin is expected to enable insurers to take on more risk and potentially increase their allocation to illiquid credit assets. However, significant decreases in credit quality or asset concentration risk could have a negative impact.
The EU’s revision of the risk margin formula, a key quantitative item in the review, aims to reduce its size for long-duration insurance business and lower sensitivity to interest rate movements. Changes in interest rates have mitigated the impact of these reforms.
While the EU also proposed increasing the volatility adjuster, this change is expected to have limited impact, as it has generally improved insurers’ solvency ratios in the past.
Another notable proposal is to widen eligibility criteria for long-term equity assets, potentially reducing capital requirements for equity risk for insurers using the standard formula. However, this is not expected to lead to a significant increase in risky asset allocation.
Solvency II reform addresses the extrapolation of interest rates
The proposed reform addresses the extrapolation of interest rates, ensuring that provisions accurately reflect future obligations. The gradual implementation of this reform is expected to safeguard insurers’ capital positions.
The inclusion of recovery and resolution proposals reinforces the framework’s ability to protect policyholders and ensure financial stability in the event of insurer default.
In a nod to environmental considerations, European insurers will be required to prepare mandatory transition plans toward reaching net-zero emissions by 2050.
Insurers investing in green projects will benefit from capital relief, marking a significant step towards sustainable finance in the insurance sector.
The ongoing Solvency II reviews are expected to shape the future of insurance regulation in the EU and UK, promoting stability, resilience, and sustainability in the industry.
Further afield, the Bermuda Monetary Authority announced the review of its S2-equivalent regime. The consultation aims to ensure a degree of alignment with regulatory reviews in Europe with the view of maintaining equivalence.
However, it also aims to ensure the regime remains sufficiently transparent and fit for purpose.
How the New Solvency II Reforms Boost the UK Insurance Market?
The Bank of England proposed further reforms to capital rules for UK insurers in a step it said would cut red tape without lowering solvency standards. The Solvency II rules were inherited from the European Union and their reform is seen by the insurance industry and by lawmakers who supported Britain’s exit from the bloc as a key “Brexit dividend” to unlock billions of pounds to invest in infrastructure.
The introduction of a tapering mechanism is expected to lessen interest rate sensitivity, a significant concern for life insurers.
The Risk Margin reduction is particularly significant for capital-intensive long-term business like annuities.
The reforms will expand the range of assets that UK life insurers can prudently invest in, as the proposed Matching Adjustment rules are set to allow a broader scope of illiquid assets to back annuity liabilities.
S&P Global Ratings suggest that the government’s announcement of its proposed change to Solvency II is likely to be neutral for the creditworthiness of rated insurers in the UK as it expects them to broadly maintain their capital positions.
What is Solvency II?
Solvency II is the prudential regime for insurance and reinsurance undertakings in the EU. It has entered into force in January 2016.
Solvency II sets out requirements applicable to insurance and reinsurance companies in the EU with the aim to ensure the adequate protection of policyholders and beneficiaries.
Solvency II has a risk-based approach that enables to assess the “overall solvency” of insurance and reinsurance undertakings through quantitative and qualitative measures.
How is the Solvency II regulatory framework structured?
The Solvency II regulatory framework is built on a three-pillar structure:
- Pillar I sets the quantitative requirements i.e. the assets and liabilities valuation and capital requirements.
- Pillar II sets the qualitative requirements, including governance and risk management of the undertakings and the Own Risk and solvency Assessment (ORSA).
- Pillar III sets the supervisory reporting and public disclosure.
The three pillars form a coherent approach that allow to understand and to manage risks across the sector.
What are its main features?
The key features of the Solvency II regulatory framework are:
- Market consistent: assets and liabilities shall be valued at the amount for which they can be exchanged, transferred or settled in the market
- Risk-based: Higher risks will lead to a higher capital requirement to cover for unexpected losses
- Proportionate: regulatory requirements shall be applied in a manner that is proportionate to the nature, scale and complexity of the risks inherent to the business of the insurance and reinsurance undertakings.
- Group supervision: supervisors shall increase coordination and exchange of information in colleges of supervisors to improve cross-border supervision of insurance and reinsurance groups
How and why Solvency II came to life?
Three generations of EU Directives applicable since the 1970s paved the way for an insurance market to operate on the basis of freedom of establishment and freedom to provide services within the European Union. Over time, the regulatory framework seemed increasingly ill-suited to supervise the industry.
Due to its simplicity, lack of an economic risk-based approach and differences in implementation across the European Union, the existing regulation needed revision.
In 1999, the European Commission presented its paper on “The Review of the Overall Financial Position of an Insurance Undertaking”. This initiated the discussion among the European institutions, regulators and supervisors on the modernisation of the prudential framework for the supervision of insurance and reinsurance undertakings.
The discussions took particular importance in the wake of the 2008 financial crisis. Although the majority of troubled institutions were banks, several insurers were also affected by the crisis, attributable to inappropriate investment decisions by insurers which led to significant losses, the interconnectedness with banks or, in general, evidence of poor governance, a report issued by EIOPA in July 2018 stated.
The crisis showed the importance of a harmonised understanding of the risks by all involved actors, and the need for considering wider implications for financial stability.
It crystallised the need for bringing the regulatory framework at the forefront of modern risk management, reflecting the reality of large groups operating on a cross-border basis. The crisis also showed that the EU was not sufficiently equipped to ensure effective cooperation and coordination between national financial supervisory bodies as well as a consistent application of the legal framework across all Member States.
In 2009, a report was issued by the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, echoeing the weaknesses in the supervisory and regulatory regime that contributed to the financial crisis.
The Solvency II Directive (Directive 2009/138/EC [recast]) was adopted in November 2009, and amended by Directive 2014/51/EU of the European Parliament and of the Council of 16 April 2014 (the so-called “Omnibus II Directive”).
On 10 October 2014, the European Commission (EC) adopted the Delegated Regulation (Delegated Regulation (EU) 2015/35) containing implementing rules for Solvency II. The Delegated Regulation was published in the Official Journal on 17 January 2015.
On 20 September 2015, the EC adopted the Delegated Regulation 2016/467 amending Commission Delegated Regulation (EU) 2015/35 concerning the calculation of regulatory capital requirements for several categories of assets held by insurance and reinsurance undertakings.
The first set of Solvency II Implementing Regulations laying down implementing technical standards with regard to the supervisory approval procedures for undertaking-specific parameters, ancillary own funds, matching adjustment, special purpose vehicles, internal models, and joint decision on group internal models was adopted in March 2015. The second set of Implementing Regulations was adopted later in 2015.
Edited by Oleg Parashchak