Clifford Chance

On 9 December, the Chancellor of the Exchequer Jeremy Hunt unveiled the “Edinburgh Reforms” for UK financial services, which constitutes a plan to drive growth and competitiveness in the sector. Among the plans of the UK government is a commitment to implementing the Solvency II reforms over the course of 2023. These include reforms to rules governing insurers' balance sheets, which the government hopes will unlock over £100 billion for insurers to invest in long-term productive assets to support growth and fuel the UK economy.

While the reforms are unlikely to free up significant amounts of capital for reinvestment in the UK's current high inflation and interest rate environment, nevertheless the Association of British Insurers (ABI) "strongly welcomed" the changes to the Solvency II regime, saying the reforms support the levelling-up and net zero transition agendas.

The industry will also react positively to HM Treasury not shying away from disagreement with the PRA over policy and legal matters and should be impressed that HM Treasury has shown its commitment to the UK insurance sector by undertaking a significant reform project in a relatively short time frame. InsurTech businesses ("InsurTechs") and UK branches of foreign insurers will also benefit from the final reforms to the Solvency II regime.

Final Reforms

Nearly two weeks before the announcement of the Edinburgh reforms, in the Autumn Statement 2022, the Chancellor unveiled the final reforms to the Solvency II regime in HM Treasury's "Review of Solvency II: Consultation – Response" (the "Response"):

Risk Margin

The Risk Margin (which is an additional reserve required to be held by insurers on top of their Best Estimates Liabilities ("BEL")) is to be calculated, using a modified cost of capital approach, which in the current economic conditions is set to reduce the Risk Margin by:

• 65% for long-term life insurance business (including Periodic Payment Orders); and
• 30% for general insurance business.
  

This reduction (a significant one for life insurers) should 'free-up' capital which will then be available to be deployed for other purposes.

Matching Adjustment

The Response confirmed several Matching Adjustment ("MA") reforms:

• the broadening of MA eligibility criteria to include assets with highly predictable (rather than "fixed") cashflows;
• the broadening of liabilities eligible for inclusion in MA portfolios which will include removing the severe treatment of assets rated below investment grade (BBB);
• the introduction of a more proportionate approach to MA breaches to prevent insurers automatically losing the full MA benefit on a portfolio if a breach of the rules lasts for over 2 months and then being unable to (re-)apply for MA approval for a two-year period; and
• increased flexibility in MA applications with the government supporting a new streamlined eligibility application process for less complex assets and the provision of greater flexibility for how innovative assets are treated as well as the setting up of a mechanism for the PRA to better report on MA application timelines and approval rates.

Since the MA is a risk mitigation technique benefitting insurers who hold long-term assets to "match" the cash flows of their similarly long-term insurance liabilities, the MA reforms will make it easier for insurers to apply for MA and make use of a wider range of assets in their MA portfolios. Such "matching" of assets and liabilities significantly reduces an insurer's liquidity risk allowing insurers to discount the valuation of their long-term insurance liabilities at a more favourable rate, which enables the insurer to hold fewer assets against those liabilities within an MA portfolio. In particular, the reforms will be of most benefit to insurers writing annuities, who will be evermore encouraged by the MA reforms to invest in long-term, illiquid and fixed-interest assets.

Fundamental spread

Given the lack of consensus on the best approach on reform of the fundamental spread, as noted by HM Treasury in the Response, the existing methodology and calibration of the fundamental spread will be maintained but the sensitivity of the current approach will be increased to allow for the use of different notched allowances for assets' credit ratings, e.g. differing allowances for AA+, AA- as well as AA. This approach will be welcomed by insurers for continuity purposes at least. However, HM Treasury also announced that the UK government would support the PRA by ensuring it has the powers necessary to take forward additional measures including:

• requiring insurers to participate in regular stress testing exercises prescribed by the PRA and to allow the PRA to publish individual firm results; and
• requiring nominated senior managers under the SMR to attest formally to the PRA whether or not the level of fundamental spread on their firm's assets is sufficient to reflect all retained risks, and that the resulting MA only reflects liquidity premium; and
• allowing insurers to apply a higher fundamental spread through an add-on where they conclude that the standard allowance is insufficient taking account of these attestations.

The UK government will also review whether the calibration of the fundamental spread remains appropriate in 5 years' time and has asked the PRA to keep the use of the MA under close scrutiny.

Internal Models

Approval requirements for firms' internal models will be updated to streamline the number of requirements and allow the PRA to exercise more supervisory judgment in assessing the adequacy of firms' models. This should help insurers seeking internal model and/or model change approvals.

Reporting and Administration

The UK government will ease burdens by reducing reporting and administrative requirements including measures accommodating InsurTech's and UK branches.

For InsurTechs and other new and innovative market entrants to the insurance industry:

• a new mobilisation regime will be introduced for insurers with lower entry requirements in respect of key personnel, governance structures, capital floors and reporting; and
• the premium and reserve thresholds before the Solvency UK regime applies will be increased up to £15million in annual GWP and to £50 million in gross technical provisions.

For UK branches of foreign insurers, the Response confirmed that branch capital requirements are to be removed where the branch can demonstrate that its parent is "appropriately capitalised".

Next Steps

The Response provided no timeline for the implementation of the final reforms. However, HM Treasury issued as part of the Edinburgh reforms its policy statement 'Building a smarter financial services framework for the UK' announcing that the work to repeal, and where appropriate replace, retained EU Solvency II law will be divided into two initial tranches. The government expects to make significant progress on Tranches 1 and 2 by the end of 2023.

In signalling the start of the Edinburgh reforms, the Chancellor also issued new remit letters to the FCA and PRA emphasising their new secondary competitiveness objectives and encouraging them to facilitate the global competitiveness of the UK economy and its growth in the medium to long term (subject to alignment with relevant international standards). The government also made clear to both UK regulators the need to deliver reform to areas which will provide the most significant boost to UK growth and competitiveness. Since Solvency II was highlighted as one of the key areas of reform, we should expect to see further details on future tranches in Q1 2023.