Accountants, consultants and lawyers have raised questions about the UK’s Solvency II reform package, as the industry has yet to see the details and the government has not given a timeline for implementation of the reforms.

Earlier this year, the Prudential Regulation Authority raised concerns over the fundamental spread, a key component of the matching adjustment, and recommended changing its design and calibration. The government ignored the PRA’s concerns and decided to keep the fundamental spread largely unchanged. However, it will allow different notched allowances to be made within major credit ratings.

The PRA will keep the use of the matching adjustment under close scrutiny, with the government planning to review the appropriateness of the calibration of the fundamental spread in five years’ time.

Additionally, the regulator might require insurers to carry out regular prescribed stress testing exercises to test their resilience to various scenarios.

Some insurers are uneasy about the new regime for one particular reason. Anthony Plotnek, a director at consultancy WTW, explained the PRA would have the ability to publish individual firm results of the stress testing.

Speaking at a webinar organised by the Network of Consulting Actuaries UK last month, he said: “We don't know exactly what that stress testing might involve. But it does indicate that the PRA would have the ability to set those stress tests and also report on them.”

Based on conversations with stakeholders, Plotnek said insurers were “quite worried” about the fact that “it pushes more power to the PRA to scrutinise these areas on a firm-by-firm basis rather than the existing regime where you look up the fundamental spread from a table”.

The Treasury decided to lower the risk margin for long-term insurance business, such as life insurers and non-life insurers subject to periodic payment orders, by 65% “under recent economic conditions”.

Although many in the industry applauded the decision, Steven McEwan, a partner in law firm Hogan Lovells, remained sceptical of the meaning of “under recent economic conditions”. 

Those four words are “quite important”, McEwan said, because it is not clear whether the government meant “the month of November, or the months of September, October, November or whether they mean in the last few years, because there's been a significant increase in the risk-free rate in November and in the last three months”.

Speaking at a webinar organised by the law firm last week, he said: “As a result, it may be that it's a 65% reduction now, at a time when the risk margin has gone down anyway because of the increase in the risk-free rate. So that remains to be seen whether the recent economic conditions mean because it's published now it's not quite as significant as it would have been had that increase not happen.”

The Treasury plans to broaden the matching adjustment eligibility criteria to include assets with “highly predictable cashflows”, subject to adjustments to the fundamental spread allowance and safeguards to be implemented by the PRA. 

Critics queried what constitutes “highly predictable” cashflows.

McEwan said: “There are going to be a lot of questions over the next few months, or years possibly, as this comes in about what ‘highly predictable’ means. Does that mean an equity release mortgage could be treated as having highly predictable cashflows because we think it's unlikely that somebody's going to go into long-term care or die? I would say no.”

He added: “What about callable bonds? If you could show statistics which say that the number of calls on callable bonds has been 1%, is that highly predictable? This isn’t clear.”

McEwan hopes there will be greater clarity on this point, “because otherwise it will just be a free for all and we’ll get inconsistency in the market”.

Chancellor Jeremy Hunt said during his Autumn Statement speech that the Solvency II reforms could free up “tens of billions of pounds” of capital to invest in the economy. However, the government has not proposed legislating to restrict commercial decisions about how the freed up capital is used. 

Critics note that extra capital may be used to reduce pricing for customers rather than be returned to shareholders. 

McEwan was sceptical about this point as other sectors have not passed their savings to their customers but acknowledged that insurers should not be forced to invest the extra capital in the economy. 

“That will mean that will be good for the economy because pension schemes and other policyholders will pay less for their insurance - that I think has to be questioned. You wonder whether the energy companies and the train companies are falling over themselves to reduce their prices because they're making big profits,” he said.

“But on the other hand, I did think it was not really the place for insurance regulation to force insurance companies to keep money purely for the purposes of investing in the economy,” he added.

Reuben Wales, head of financial services of the Institute of Chartered Accountants in England and Wales, agreed it was right that the government does not legislate the type of assets that insurers invest in but noted there is a risk that the freed-up capital is returned to shareholders. 

Wales added: “We note, however, the respondents to the government’s consultation have indicated that this is not the expected outcome. We would encourage the government to continue to work with the industry to ensure that there are appropriate investment opportunities for insurers that also promote sustainable UK growth.”