The UK government has decided it will lower the Solvency II risk margin, broaden the eligibility of the matching adjustment with a wider range of assets and reduce insurers’ reporting and administrative requirements following its consultation on Solvency II reforms this year.

The Treasury has also decided to leave the design and calibration of the fundamental spread as it stands today. However, it will increase the risk sensitivity of the current fundamental spread approach to allow different notched allowances to be made within major credit ratings - for example, different allowances for assets rated AA+ or AA- compared with AA.

In its feedback to stakeholder responses to the consultation, the Treasury said: “These steps on the fundamental spread, when combined with other changes to the matching adjustment, will enable insurers to increase their investment in productive assets, fuelling the UK economy.”

The Association of British Insurers expressed strong support for the changes. ABI director general Hannah Gurga said the reforms will allow the UK insurance and long-term savings sector to support the levelling up agenda and the transition to net zero.

“Meaningful reform of the rules creates the potential for the industry to invest over £100bn in the next 10 years in productive finance, such as UK social infrastructure and green energy supply, whilst ensuring very high levels of protection for policyholders remain in place,” she said.

“More broadly, it will encourage a thriving and competitive industry which will ultimately benefit the UK economy, the environment and customers. This meets the objectives that HM Treasury set out to achieve and which the industry has supported throughout.”

 What is the fundamental spread?

The fundamental spread is used in the calculation of the discount rate for certain types of insurance liabilities, mainly annuities, where a firm has approval to apply it.

The ABI previously argued the current fundamental spread is fit for purpose and the proposals “would result in a material Brexit penalty”, meaning UK annuity firms would be worse off than they were when the UK was part of the EU.

In response to today’s decision, the ABI supported the announcement and said keeping the fundamental spread “will lead to less volatile annuity prices and ultimately provide a more stable income for UK pensioners”.

The Treasury agreed that incorporating current spreads into the calculation of the fundamental spread would have significant negative impacts. It said there was “ample evidence” from respondents that making the FS reliant on current spreads would increase capital requirements and introduce significant volatility to insurers’ balance sheets, “especially if they invest in illiquid assets”. 

“This would disincentivise long-term productive investment, clearly hindering the government’s objectives to support long-term investment and international competitiveness while missing the opportunity to boost growth.”

However, given the significance of the matching adjustment and the wider reforms to the Solvency II rules, the government has asked the Prudential Regulation Authority to keep use of the matching adjustment “under close scrutiny”. A review of whether the calibration of the fundamental spread remains appropriate will be conducted in five years’ time. 

One popular proposal was to reduce the risk margin. The Treasury has decided to lower this capital buffer by 65% for life insurers and 30% for general insurers. 

It said this decision will “free up substantial amounts of capital”, reduce the volatility of life insurers’ balance sheets and safeguard against the risk margin becoming too large and too volatile during future periods of low interest rates. 

Many UK insurers reinsure significant longevity risk, often in other jurisdictions. The regulator hoped lowering the risk margin could reduce this offshoring risk. 

According to the Treasury’s feedback report, respondents considered that a 60-70% cut to the risk margin would have “little impact” on levels of longevity reinsurance. Some respondents suggested that a larger cut of 75% or above would be required to make longevity reinsurance decisions economically neutral.

The Treasury findings chimed with comments by Harish Gohil, head of EMEA insurance at Fitch Ratings, who said in September ceding risk is part of insurers’ risk management and that this will not change because of Solvency II.

Certain assets such as real estate projects are not eligible for the matching adjustment due to the risk coming from the construction phase, but the government plans to introduce changes to broaden the MA eligibility, including the flexibility to include assets with prepayment risk or construction phases.

The ABI welcomed this decision, saying: “This would allow industry to invest in a wider array of assets and also enable relevant insurers to include morbidity liabilities in Matching Adjustment portfolios.”

Andy Briggs, CEO of Phoenix Group, said the reforms announced today “present a very significant opportunity” to ensure more private sector capital can come from insurers into the real economy.

He said: “These regulations are an important component of the changes needed to the wider UK investment landscape which will enable Phoenix to meet its ambition to invest more in the future.”

Briggs said Phoenix plans to invest £40bn-£50bn in illiquid assets and sustainable investments over the next five years to support house building, green energy, and local communities across the country. 

Tracy Blackwell, CEO of bulk annuity provider Pension Insurance Corporation, also supported the government’s decision.

 

She said: “We welcome the chancellor’s announcement on Solvency II, which  gives us the stability to support the government’s objective of investing in productive assets whilst ensuring that policyholder pensions are secured to the highest standards. We now have the certainty we need to bring more pension risk off corporate balance sheets and invest in assets that generate economic growth and benefit communities across the country.”

 

The Treasury said respondents supported proposals to reduce reporting and administrative burdens to reduce regulatory costs. These include updating approval requirements for insurers’ internal models to streamline the number of requirements and removing capital requirement for branches of foreign insurers. 

In particular, for the latter, it said: “This reform will make the UK even more attractive as a location for insurance business, spurring competition and advancing the UK’s position as a world-leading insurance market.”

Currently the minimum threshold for an insurer to be subject to Solvency II is €5m in premiums and €25m in technical provisions, but the government has decided to increase the thresholds to £15m in premiums (triple the previous threshold) and to £50m in gross technical provisions (double the previous threshold). 

“Firms below this threshold will still be able to opt into Solvency UK should they choose to. This reform will boost competition and innovation, reducing barriers to market entry and allowing smaller firms to grow more quickly.”