Regulatory updates
Oliver Dixon, Rothesay
A decade has passed since the UK voted to leave the European Union. Over that time, many areas of policy and regulation have changed, with a wide range of sectors impacted. As part of these changes, following HM Treasury’s (HMT’s) 2022 review of Solvency II, a new regulatory regime tailored for the UK insurance market, called Solvency UK, was born. While the Solvency UK developments have been evolutionary rather than revolutionary, there are several ways that they are impacting the regulatory landscape and behaviour of insurers today. A few of them are explored opposite.
Changes introduced to Matching Adjustment investment eligibility
The Matching Adjustment (MA) was introduced into the EU Solvency II Directive at a relatively late stage, primarily as a way to allow UK insurers to appropriately provision for annuity liabilities. However, like other elements of the long-term guarantees package, because it was brought in relatively quickly in order to hit the implementation date for Solvency II, the MA was necessarily quite limited and idealised. In particular, if any one of the strict MA eligibility requirements for assets or liabilities were not met, significantly higher capital requirements would result.
The HMT review recognised that the nature of these rules was limiting the ability of insurers to invest in UK productive assets, particularly because the requirement for entirely fixed payments on assets made it more difficult for insurers to invest in assets that supported certain types of infrastructure and energy transition projects.
The Solvency UK reforms have introduced more flexibility around the MA eligibility requirements, meaning that a small subset of insurers’ annuity related investments can be made into debt instruments with highly predictable, rather than entirely fixed, cash flows. These reforms have allowed insurers to commit to invest significantly into UK productive assets, supporting the growth of the UK economy. Also, because these changes allow insurers to better diversify their asset holdings into investment classes which are backed by underlying physical assets, they should help to further improve the security and reduce the overall risk profile of the investments that insurers hold.
Life Insurance Stress Testing (LIST)
Following the global financial crisis, stress testing was introduced for the UK’s largest systemic banks and building societies. Although there has been no similar type of stress event in the UK insurance sector, there is a general recognition that stress testing has helped improve transparency around the resilience of the UK banking
sector. Therefore, as part of HMT’s review, they have looked to extend the same kind of stress testing framework across the UK life insurance industry.
LIST 2025 was designed as a simulation of a severe market shock event. It built on previous exercises in 2022 and 2019, introducing published firm-level results for the first time. The LIST exercise underlined Rothesay’s robust capital position and balance sheet resilience, showing a poststress SCR coverage ratio for Rothesay Life Plc of 213%, the highest of any of the LIST participants, and surplus Own Funds above capital requirements remaining at almost £5bn, only a 10% reduction on pre-stress test levels.
While the LIST results provide a useful demonstration of the strength of the UK life insurance sector, forming direct comparisons between insurers proved difficult because solvency coverage ratio impacts are significantly exaggerated for firms that start with higher base solvency coverage ratios. Also, because the LIST was specifically focused on annuity business, the impacts appear to have been diluted for multi-line and composite insurers, whose businesses are sensitive to different types of stresses which weren’t explored in the LIST. Nonetheless, the LIST process marks an important step in communicating how insurers manage and respond to a wide range of external shocks, with further refinements to the exercise expected in the future.
Potential reforms to the treatment of funded reinsurance
The LIST highlighted the reliance of some insurers’ capital positions on funded reinsurance – a mechanism by which premium assets received as part of annuity transactions are transferred to reinsurers, who are typically based outside the UK and so are not subject to UK regulatory capital rules. The reinsurance contract then sits as an asset on the UK insurer’s balance sheet rather than more traditional investments, and it is the reinsurer who invests into assets which back the annuity liabilities.
Under inherited Solvency II rules, the capital requirements associated with funded reinsurance for UK insurers are typically materially lower than other assets held in MA portfolios. In recent weeks, the Prudential Regulation Authority (PRA) has launched a consultation which looks to level the playing field between funded reinsurance and other investments in the Solvency UK framework. If the proposals in the consultation become policy, this may result in less funded reinsurance being transacted, more investment being made directly by UK insurers and more capital being held in the UK insurance sector.
What next?
The 2022 HMT review identified targeted changes which could be made to the regulatory capital rules for UK insurers, and a lot of work has been undertaken by the UK government, the PRA and insurers to make these changes happen. However, HMT’s review also identified many areas where the inherited EU Solvency II rules and regulations were working as intended, and the core of this framework has remained unchanged.
So, is regulatory reform finished now? Of course not. Where market trends indicate that rules are not functioning as intended, further reforms will rightly be considered, as evidenced by the funded reinsurance consultation. However, there seems to be some consensus that it would be deeply unhelpful for long-term liabilities backed by long-term investments to be subject to completely different capital rules every few years. So, while continued evolution of regulations is a natural part of the financial services landscape, I suspect there will be more stability in the next ten years of insurance regulations than the last.
Solvency UK has introduced a number of positive changes, now it’s time to see them put to work.
About the author
Oliver Dixon
Oliver is Rothesay’s Chief Capital Officer. He joined Rothesay in 2013 and is responsible for the continuous monitoring of the firm’s solvency position as well as its economic and accounting valuation measures. Oliver’s role involves the assessment of the capital implications of new asset and liability transactions, including the impact of any changes to the regulatory capital rules. Prior to joining Rothesay, Oliver worked for Willis Towers Watson as a consultant in their life insurance practice.