Convergence or Divergence? Comparing Solvency UK and EU Solvency II Reforms

Countdown to Solvency UK - Convergence or Divergence? Comparing Solvency UK and EU Solvency II Reforms

28 November 2024

Introduced on 1 January 2016, the Solvency II framework established unified solvency and supervisory standards for insurers and reinsurers across the EU, with a focus on financial stability and regulatory consistency. However, in the wake of Brexit, the UK introduced "Solvency UK" reforms aimed at better aligning the regulatory framework with its domestic market’s unique needs. The reforms are designed to allow UK insurers to allocate more capital to long-term investments such as infrastructure and green projects, thereby supporting broader economic goals while maintaining market stability.

At the same time, the EU has initiated its own review of Solvency II, following the European Commission’s 2020 legislative proposals for amendments. This review, the first significant overhaul of the framework since its implementation, builds on the final opinion of the European Insurance and Occupational Pensions Authority (EIOPA) published in December 2020.

This analysis examines the key differences between Solvency UK and the EU’s proposed Solvency II amendments, focusing on the distinct reforms that will shape the future of the insurance industry in each region.

The Strategic Shift to Solvency UK

Following Brexit, the UK's Solvency UK initiative aims to create a more competitive and efficient insurance sector through simplified regulation and smarter capital allocation. This reform aligns with broader financial regulatory changes under the Financial Services and Markets Act 2023 (FSMA 2023). FSMA 2023 grants powers to replace retained EU law with UK-specific legislation and/or Prudential Regulation Authority (PRA) rules. It also introduces a new secondary objective for the PRA - to facilitate "the international competitiveness of the UK economy, especially the financial services sector, and support its growth over the medium to long term." This mandate highlights the UK's focus on a regulatory framework that boosts domestic economic growth and strengthens its position in global financial markets.

With full implementation planned for 31 December 2024, Solvency UK began its phased rollout in December 2023, using powers under FSMA 2023, HM Treasury statutory instruments, and updates to the PRA Rulebook.

EU Solvency II Reforms: A Focus on Integration and Sustainability

The EU is also moving forward with its Solvency II reforms as part of the Capital Markets Union, focusing on financial stability and deeper integration of EU financial markets. Like the UK, these reforms aim to channel more capital into long-term investments, especially in green and digital sectors. A central aspect of the EU's approach is the principle of proportionality. By acknowledging the varying risk levels within the insurance industry, the EU aims to reduce regulatory burdens for lower-risk insurers while concentrating supervisory efforts on addressing major systemic risks. Additionally, the reforms place a strong emphasis on environmental, social, and governance (ESG) considerations, ensuring that Solvency II is aligned with the EU's broader sustainability agenda.

The EU’s updated Solvency II Directive, approved by the European Parliament on 8 October 2024, and published by the Council of the EU on 5 November 2024, taking effect 20 days later. Member States will have 24 months to integrate it into national laws, with some elements requiring additional delegated acts and technical standards and which will published at a later point. Full implementation of the EU reforms is expected by the first quarter of 2026.

Overview of key reforms

Risk Margin

The Risk Margin (RM) requires insurers to hold capital to cover non-hedgeable risks, ensuring that their technical provisions, or liabilities, align with the amount a hypothetical acquirer would demand to assume and fulfil these liabilities over time. This capital is determined by adding a fixed cost of capital rate (originally set at 6%) to a variable risk-free rate, as specified by regulators, to reflect the total return an acquirer would expect from taking on the insurer's obligations.

In response to concerns about the excessive sensitivity of the original RM calculation to interest rate fluctuations, especially for life insurers, the UK implemented revised RM calculations in December 2023. This involved reducing the cost of capital rate from 6% to 4%, which was anticipated to significantly reduce the RM for both life and general insurers. While the actual impact on insurers is expected to be less pronounced than initially projected, the reform still represents a significant step towards increased capital efficiency.

The EU's Solvency II reforms also seek to improve capital efficiency, by lowering the cost of capital to 4.75% and incorporating a time-dependent component in the RM calculation. This adjustment is designed to reflect the evolving nature of risks over time, reducing the RM’s sensitivity to fluctuations in interest rates, which can be especially impactful for long-term liabilities.

By better aligning the RM with the dynamic characteristics of long-term contracts, both the EU and UK reforms aim to create a more stable and predictable capital environment for insurers. This stability has the potential to help unlock capital for investment and innovation, allowing insurers to respond more effectively to market changes and meet customer needs, ultimately helping the growth and resilience of both the UK and EU insurance sector.

Matching Adjustment

The Matching Adjustment (MA) allows insurers holding long-term assets that align with their long-term insurance liabilities to adjust how they manage these assets and liabilities. Used in the UK to help keep annuities affordable, the MA requires firms to create a separate portfolio of eligible assets and liabilities. It adjusts the discount rate on these liabilities to reflect the illiquidity premium from matching assets, which helps insurers stabilise their balance sheets by better aligning asset and liability cash flows.

On 30 June 2024, the UK expanded MA eligibility under Solvency UK reforms to include a proportion of assets with highly predictable (rather than fixed) cash flows, aiming to simplify and lower the costs of using the MA. The reforms also introduced senior manager attestation, where senior managers must confirm that their firm’s MA portfolio meets requirements. Additionally, if a portfolio no longer qualifies, the penalty is now a 10% monthly reduction in MA benefits after two months of non-compliance, rather than a full revocation.

The EU has also revised its MA framework, although to a lesser extent than the UK. A notable change is the removal of restrictions on diversification benefits when calculating the Solvency Capital Requirement (SCR). This allows insurers to better manage their capital requirements and combine their MA assets with other investments more efficiently. While this is a positive step, the EU's approach remains more conservative compared to the UK's, prioritising stability and risk management. The EU's reforms also introduce some flexibility in matching liabilities with assets and broadening the range of MA eligible asset classes. However, the EU has not adopted the same flexibility to include highly predictable cash flows as seen in the UK reforms.

Internal Models

The Solvency II framework mandates that insurers hold sufficient capital to absorb unexpected losses (the Solvency Capital Requirement or SCR), which depend on the risks insurers face. To quantify these risks, under Solvency II firms can choose between using a standard formula or, if approved, an internal model (IM) tailored to their specific risk profiles. In the UK, recent Solvency UK reforms have simplified IM requirements by reducing both the number and complexity of approval conditions, which should help to lower compliance costs for insurers and enforcement costs for the PRA. The former binary approval system has been replaced with a permissions process where the PRA has the option to use safeguards, giving insurers greater flexibility. Furthermore, the UK has introduced "Model Limitation Adjustments" for IMs, which allow firms to make targeted modifications to specific model components rather than overhauling the entire model, easing administrative burdens and enhancing adaptability.

In response to specific industry feedback, the PRA has also noted that mergers and acquisitions often lead to short-term increases in the group SCR while waiting for the expanded group IM approval—a potential barrier for insurers considering acquisitions. To address this, the UK reforms now permit insurance groups to temporarily combine results from multiple IM calculation approaches when assessing the consolidated group SCR. Following acquisitions, groups have six months to devise an integration plan and two years for full implementation.

In contrast, the EU does not anticipate major changes in IM operations but will require firms using full or partial IMs to report an estimated SCR using the standard formula at least every two years. This reporting requirement will help supervisors compare SCR levels over time across firms.

Third Country Branch Requirements

Under Solvency II, third-country branches are required to adhere to the same capital requirements and regulatory standards as local insurers. This includes establishing and reporting branch risk margins on balance sheets and maintaining assets within the host state to cover the branch’s SCR. In contrast, the Solvency UK reforms have relaxed these obligations. Under the new framework, third-country branches no longer need to hold capital in the UK or maintain assets there. Instead, the PRA will assess whether the branch's home jurisdiction's prudential supervision is "broadly equivalent" to that of the UK before granting authorisation. Additionally, third-country branches must ensure they have sufficient global financial resources to meet ongoing supervisory requirements. This shift makes it easier for firms to establish third-country branches in the UK, bolstering the country’s appeal as a financial hub.

Notably, the EU has not proposed similar changes, underscoring that the UK's change is primarily driven by Brexit.

Reporting Requirements

Under Pillar III of Solvency II, insurance firms are subject to certain reporting and disclosure requirements. They must produce two key reports: the Solvency and Financial Condition Report (SFCR) and the Regular Supervisory Report (RSR). The SFCR is a public annual report submitted to the local National Competent Authority, while the RSR is a private report submitted to the supervisor on a regular basis appropriate to the nature and size of the insurer, and at least every three years.

The UK and EU are taking differing approaches to these Solvency II reporting requirements. The UK is removing the requirement for firms to submit the RSR and has also simplified and streamlined other regulatory forms to reduce duplication and the overall number of forms that need to be completed. In contrast, the EU is proposing to extend the annual reporting deadlines but will require insurers to provide more detailed and more frequent reports on their solvency, risk exposure, and capital adequacy. These EU measures aim to increase transparency and enable better oversight by regulators and stakeholders. Additionally, the structure of the SFCR will be revised to consist of two parts - one addressed to policyholders and beneficiaries, and one addressed to professional market players.

Application Threshold

The Solvency II regime sets thresholds that determine which insurers and reinsurers must comply with its requirements. Under this framework, insurers with an annual gross written premium (GWP) over €5 million or gross technical provisions (GTP) over €25 million, and reinsurers with GWP over €600,000 or GTP over €2.7 million, fall within its remit. Solvency UK reforms, however, will increase these thresholds, thus reducing the number of firms subject to the regime. Insurers will instead be subject to Solvency UK if their GWP surpasses £25 million or their GTP exceeds £50 million, while reinsurers fall within its scope at a GWP of £2.5 million or GTP of £5 million.

Similarly, the EU has raised its thresholds, though with a more conservative approach than the UK. The reformed EU Solvency II regime now applies to insurers with a GWP over €15 million or GTP over €50 million, with reinsurer thresholds remaining unchanged. For insurance undertakings within a group, the group’s total technical provisions must now exceed €50 million (up from €25 million) to be included. Both the UK and EU are therefore aligned in reducing the Solvency II scope of application by increasing thresholds, yet the EU has opted for smaller increases than the UK, suggesting a more cautious approach.

Mobilisation Regime under Solvency UK

The mobilisation regime is an initial phase following authorisation, during which insurers operate under a lighter set of regulatory requirements, allowing them time to establish themselves before facing the full regulatory framework. Under Solvency UK, prospective insurers can apply for this regime by submitting a plan detailing how they will exit the market if specific targets are not able to be met within the relevant period. During this period, firms must maintain a minimum capital requirement (MCR) of £1 million and comply with certain business restrictions designed to protect policyholders. The mobilisation period is intended to last 12 months, after which firms must apply for a variation of permission to move into full regulatory status.

While the EU’s Solvency II regime does not include a specific mobilisation phase, it introduces provisions for smaller, "small and non-complex" insurers to benefit from simplified regulations and proportionality measures. These simplifications are based on risk-based criteria and apply only where there are no significant regulatory concerns. Both the UK and EU frameworks aim to foster innovation and ease market entry, especially supporting the growing insurtech sector. However, the UK’s dedicated mobilisation regime provides a more structured pathway for new market entrants, setting it apart as a more comprehensive approach.

Supervision under EU Solvency II

The EU’s Solvency II reforms introduce significant changes to the supervision of insurers’ liquidity risk, cross-border activities, and macro-prudential tools aimed at safeguarding policyholders. To enhance cross-border regulatory cooperation, new guidelines will focus on significant activities within host Member States where annual gross written premiums (GWP) exceed €15 million and where these activities impact the national market. Additionally, insurers will be required to develop and maintain a liquidity risk management plan, detailing short-term liquidity assessments and projected cash flows in relation to assets and liabilities. This plan, submitted to regulators at least annually, aims to improve ongoing monitoring and provide a structured approach to managing sector-wide liquidity risks.

Furthermore, EU regulators will be equipped with enhanced macro-prudential tools to address liquidity risks more proactively. These tools will allow authorities to temporarily halt dividends, bonuses, and redemption rights on life insurance policies if necessary to protect policyholder interests collectively. By strengthening these measures, the EU seeks to bolster systemic risk management, reinforcing stability within the insurance sector and enhancing its capacity to respond to potential market-wide threats. The reforms emphasise the EU’s commitment to mitigating systemic risks and enhancing resilience in the face of financial instability.

Equity investment under EU Solvency II

In 2019, Solvency II introduced a new category of equity investments called Long-term Equity (LTE) investments within the equity risk sub-module, aiming to encourage insurers to make sustainable, long-term investments. The rationale behind LTE investments is that assets held for extended periods are less likely to be sold under pressure, making them more stable and attractive as long-term holdings. To incentivise this approach, the 2019 Solvency II review, through EU Regulation 2019/981, reduced the capital charge for both public and private LTE investments to 22%, compared to the higher capital charge and percentage applied to standard equity investments. However, insurers could only benefit from this lower capital charge if they met strict conditions: LTE investments had to be segregated, linked to specific insurance liabilities, and held for a minimum of 10 years without forced sales. These requirements, though intended to ensure stability, were seen as too restrictive and limited the broader adoption of LTE investments by insurers.

In response, the criteria for classifying LTEIs have now been simplified, with the aim of better promoting long-term investment and supporting insurers' role in financing the EU’s economic recovery. The updated requirements under the EU reforms will remove the need for insurers to allocate LTEIs to specific business lines or to manage these investments separately. Additionally, the mandatory holding period has been shortened from 10 to five years, easing the constraint on forced sales. By relaxing these criteria, the reforms aim to make LTEIs more accessible and attractive to insurers, ultimately fostering greater long-term investment in the EU’s economy.

Convergence or divergence?

The UK and EU reforms to Solvency II highlight both convergence and divergence in regulatory priorities. Both regions acknowledge the need for a more adaptable insurance framework, but their strategic aims differ. Solvency UK prioritises flexibility to address the specific needs of the UK market, reflecting a broader ambition to enhance the UK's global competitiveness. In contrast, the EU's Solvency II reforms centre on strengthening financial stability and promoting proportionality, aligning with the bloc's focus on market resilience and sustainability goals. These differing objectives is seen in regulatory divergence in some areas but also present distinct visions for the insurance sector's role in supporting each region's broader economic priorities.