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Regulatory outlook for 2021 - Hymans Robertson

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Regulatory outlook for 2021

28 Jan 2021

With the Brexit transition period having now ended and the UK no longer required to align its regulatory regime with EU, the future of the regulatory landscape in the UK is a hot topic of discussion in the insurance industry. Furthermore, with EIOPA proposing a raft of changes to Solvency II itself, it will be interesting to see how much of an impact these have on the future UK framework. In this article we discuss the key changes that we could see in the UK, when these could happen, and the potential impacts on insurers.

What can we expect in the UK?

In October Her Majesty’s Treasury (“HMT”) issued a Call for Evidence, seeking views on various aspects of the Solvency II regulatory regime and signalling the start of the much-anticipated review of insurance regulation following the UK’s departure from the EU.

While no views are expressed as to what changes might be expected, the key areas of consideration are the Risk Margin and the Matching Adjustment (the “MA”) which have been the most frequently debated aspects of the current regime.

It was noted that in general the Risk Margin has been higher and more volatile than was expected when Solvency II was developed. There are various ways in which this could be addressed, including reducing the 6% cost of capital currently used, adopting a tapering approach as has been proposed by EIOPA (which we discussed in more detail in a recent Newsflash), or replacing the cost of capital approach entirely.

The Call for Evidence suggested that the fundamental principles behind the MA are likely to remain. However, many insurers will be hoping to see a relaxation around the requirement for the assets to deliver fixed cash flows, to instead allow assets with highly predictable cash flows to be included. Additionally, we hope to see the MA application process become more streamlined to make it quicker and easier for insurers to bring new asset classes into their portfolios as long as the underlying risks of the assets are well understood.

On a similar note, we hope to see more efficient Internal Model application and change processes, which would benefit both existing Internal Model firms and some of the larger Standard Formula firms which may consider applying for Internal Models approval. We also hope to see the Standard Formula approach adapted to better reflect the risk profile of a typical UK insurer – for example, in relation to UK with-profits business. However, we expect changes to the Standard Formula to be further down the agenda of the PRA and HMT at this time.

How much of an impact will the proposed EIOPA changes have?

The changes proposed by EIOPA as part of the 2020 review of Solvency II will not directly impact the UK regulatory regime. Although the current Solvency II regulations have been transposed into UK law, any changes subsequently made to Solvency II will not apply within the UK unless the Government or PRA decide to make similar changes.

There has been limited discussion about the extent to which the UK will replicate any changes that are made to Solvency II in the future, with focus instead being on the extent of divergence from current Solvency II rules. It is likely that any such changes, as well as changes made to the UK’s own regime, will be taken into account by the EU when considering whether the UK regime is “equivalent” to Solvency II.

However, EIOPA’s proposal to reduce the Risk Margin (via a ‘tapering’ approach) may give the PRA a stronger argument for making its own changes to the Risk Margin, which may or may not follow a similar tapering approach.

When can we expect these changes to take effect?

While the Call for Evidence provided some suggestions on the areas of the current regime which might be changed, it offered little insight into expected timelines.

Responses to the Call for Evidence are to be submitted by mid-February and the Government will then likely take a number of months to review responses before formulating a further response, and it is possible that further consultation with the industry could be required. Certain changes will then be subject to approval by Parliament, and the PRA may need to translate the decisions made into its regulations and, again, there may well be further consultation and debate with the UK industry before anything is fully implemented.

We might expect HMT to take most of 2021 to outline changes and the PRA to take most of 2022 to implement changes. Given this, 2023 feels like the earliest that we might see any significant changes implemented.

Similarly, we do not expect to see any significant changes coming from EIOPA for a while. All recommendations must be reviewed by the European Commission before any amendments to the Delegated Acts are proposed, and any such amendments would themselves require approval from the European Parliament. This process would likely take a number of years and could see a gradual phasing of changes starting in around 2024.

What is the likely impact for insurers?

UK insurers have long argued that certain aspects of Solvency II are overly onerous and can be modified without causing a significant reduction in policyholder protection.

Top of the Government’s agenda is likely to be the ability of insurers to invest in asset classes that can benefit the UK economy and/or society – such as infrastructure or social housing. We expect to see some loosening of the restrictions around the types of assets that can be included in MA portfolios (via changes to the ‘fixed cash flows’ requirement as mentioned above), and a simplification of the application process to reduce the length of time required to add new assets into portfolios.

One criticism of the current Risk Margin framework has been that it creates an artificial incentive for insurers to use offshore reinsurance – since the cost of this reinsurance may well be lower than the size of the Risk Margin that would otherwise have to be held. Reducing the size and/or volatility of the Risk Margin would lessen this incentive.

However, we do not expect reductions in UK Risk Margins to lead to a fundamental change in longevity reinsurance strategies. Capital requirements in respect of longevity risk tend to be relatively high for Internal Model firms and reinsurance will still offer the benefit of accessing specialist longevity expertise. That said, any change in the Risk Margin methodology may prompt firms to revisit their strategy and, where they have material exposure to both mortality and longevity risk, to consider whether there are additional diversification benefits to be gained in retaining more of each risk.

It is, of course, possible that the UK regime could be altered in ways which will make it more onerous for insurers. For example, within the MA calculation the PRA could make changes to the Fundamental Spread methodology which could reduce the expected MA benefit.

Finally, for insurers with European businesses, EIOPA’s proposals are wide ranging and could have significant impacts on balance sheets – the Risk Margin and Volatility Adjustment changes generally causing a positive impact, and the risk-free rate and Standard Formula interest rate risk changes generally causing a negative impact.

Given the relatively long timelines, we expect insurers within the UK and elsewhere in Europe to be assessing the potential impacts of these changes on the balance sheet, solvency ratio and capital generation in order to identify potential actions that could be taken as the changes move from being written in pencil to pen.

We have supported numerous insurers to ensure both compliance and optimisation of their solvency balance sheets and we would be delighted to talk to you further to understand how we can help you over the coming years to achieve a successful transition to whatever the new regulation may hold.

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