Today we are pleased to launch an independent KPMG report commissioned by the ABI which analyses the potential aggregate industry impact on the Risk Margin and Matching Adjustment from the scenarios the Prudential Regulation Authority (PRA) is exploring in its quantitative impact study (QIS) in support of Solvency II reform. This report builds on the February 2021 KPMG report which highlighted that a few targeted changes to aspects of the Solvency II regime could allow up to £95bn of capital to be released or repurposed, which could be invested in long-term productive finance all while upholding high levels of protection for policyholders.
This report also highlighted that if these targeted reforms to Solvency II are implemented, UK insurers would continue to hold more than £138bn of solvency risk capital plus capital management buffers, in excess of technical provisions. In recent times however, a lot has been said about policyholder protection by different stakeholders with horses in the Solvency II reform race. These comments generally focus on how policyholder protection is considered and achieved in the current regulatory regime and Solvency II framework and how it might be impacted by Solvency II reform. In this blog, we articulate what policyholder protection means to the insurance industry, why it is profoundly important to us and why undiluted policyholder protection standards is a goal we share with our Regulators and the Government.
Policyholder protection means more than capital
Insurers recognise that high levels of policyholder protection can only be achieved by implementing Solvency II in its entirety and not through a siloed focus on Pillar 1 of the framework, which focuses on capital requirements and resources. It is therefore a concern when this topic is discussed by some solely in terms of capital. Industry is not blind to the key role capital plays in policyholder protection. But we also know that good decisions about the appropriate amount of risk-based capital required can only arise from an in-depth understanding of risks inherent in business models (including investment risk), appropriate governance structures, thorough risk management discipline and internal controls, a strong and independent third line of defence and all other aspects of Solvency II Pillar 2.
For those who consider capital levels as the primary source of policyholder protection we would like to highlight that we believe the latest KPMG report demonstrates that if implemented, QIS proposals for the Fundamental Spread (a parameter used in the calculation of the Matching Adjustment) would result in a significant hit to aggregate Own Funds or capital resources. The report shows that QIS Matching Adjustment scenarios A and B would result in an aggregate Own Funds reduction[1] of c£16-24bn (corresponding to a 5-7% increase in best-estimate liabilities) and c£2-5bn (corresponding to a 0.5-1.5% increase in best-estimate liabilities) respectively.
Therefore, if we considered policyholder protection solely in terms of capital levels the penal impact of the QIS scenarios and proposals are clear. All of this is before we consider the uncertainty, procyclicality and balance sheet volatility impacts of both proposals none of which are conducive to policyholder protection. Furthermore, consider the purpose of the Fundamental Spread as highlighted in the European Union’s (EU) Omnibus II Directive Recital (31) text which states that “Where [insurers] hold bonds or other assets with similar cash flow characteristics to maturity, they are not exposed to the risk of changing spreads on those assets. In order to avoid changes of asset spreads from impacting on the amount of own funds of those undertakings, they should be allowed to adjust the relevant risk-free interest rate term structure for the calculation of the best estimate”This key text clearly highlights that the insensitivity of the Fundamental Spread to credit spreads was a design intent and not an unintended consequence. We do not see that the Fundamental Spread needs to be reformed in any way as it has done very effectively what it was designed to do.
Industry has not called for a weakening of policyholder protection standards
To be clear industry has not called for a weakening of the levels of policyholder protection in any of our Solvency II reform asks. Industry has not called for (and would not want) a reduction in the 1 in 200 calibration of the Solvency Capital Requirement (SCR) and have kept the policyholder firmly in mind when asking for reform to regulatory reporting to ensure that when a policyholder picks up a Solvency and Financial Conditions Report (SFCR) they are able to quickly find relevant information presented clearly and concisely. It is because we care about policyholder protection and prudent financial management and good governance that we elect to hold capital buffers over SCR. It is this prudent financial management and the 1 in 200 calibration of the Solvency II SCR that has enabled us to weather 1 in 100 events such as the peak of the covid pandemic.
Furthermore, we agree with the PRA that the Risk Margin is too large, too volatile and requires reform. We also agree with the PRA’s assertion that a reduced Risk Margin would have several benefits including improved policyholder protection. In addition, an appropriate calibration of the Risk Margin would release capital that could be used to invest in productive finance, reduce prices for customers, invest in product innovation, or expand market coverage – all of which would benefit policyholders.
Policyholders are the backbone of our industry
Policyholder protection matters to Insurers because without policyholders the insurance business model does not work. We understand the faith and trust our policyholders place in us when they buy insurance products to protect their property and livelihoods or take out long-term savings products to save for their futures. It is because we acknowledge this responsibility that we run our businesses well, safely and in the interest of our policyholders. Yes, we have shareholders and their requirements and demands on us are valid, but we consider the requirements and demands of all our stakeholders including our policyholders and Regulators and this is why we do what we do how we do it.
We recognise the key role we play in society and ensure our activities have a positive impact on current and future policyholders. For example, ABI Solvency II reform proposals on the Matching Adjustment, a central mechanism to allow insurers to fulfil their natural roles as long-term investors in the UK economy, reflect our desire to further support the transition to a net zero economy, to boost infrastructure investment and support the Government’s levelling up agenda.
The short-term benefits of increased infrastructure investments boost aggregate demand in areas such as construction, materials, and engineering services, which is even more crucial in a post Covid economy, considering the economic contraction driven by the pandemic. But there are also longer-term benefits to be derived from, for example, the maintenance and delivery of public services such as schools, hospitals and rail networks which are essential parts of living and of vital importance to current and future policyholders and society at large. However, it is currently much easier to invest in a highly rated mining company than it is to invest in a wind farm for 30 years. This highlights the need to reform the Matching Adjustment to unlock the investments of the future.
A post Brexit and post pandemic UK requires a fit for purpose regulatory approach
Beyond Solvency II, the new economic and societal post-Brexit reality, driven to a material extent by the Covid 19 pandemic, requires agility, flexibility and new and innovative ways of thinking and acting, not just from businesses but from Regulators and society at large. In part, HM Treasury proposes to achieve this by transferring substantial powers and responsibilities to the Regulators. It is crucial for this transfer of powers to already independent Regulators to be balanced and subject to strong and solid democratic accountability. This would ensure that regulation not only preserves financial stability and policyholder protection but also supports economic recovery and growth. A new primary statutory objective for regulators to support economic growth is vital and is already in line with other jurisdictions commonly recognised as having a thriving global financial services industry, such as Hong Kong, the US, Singapore, Australia, and Japan. Any less than this is simply not enough because, as was recently highlighted by the Regulator, “please don’t be surprised that at the Bank and the PRA we pull the debate back to the anchors of the primary objectives. That is, after all, our job.” Without a primary objective for economic growth our Regulators simply have no incentive to implement regulation in a way that is conducive to this aim and the ongoing future regulatory framework review must appropriately and fully address this matter.
We look at the EU and how the European Commission and EIOPA (European Insurers and Occupational Pensions Authority) are explicitly supporting the recovery in Europe by actively refining elements of Solvency II to free up €90bn of capital for investment. A sub-optimal outcome for our industry post Brexit would be for UK insurers to somehow end up not being able to avail themselves of refinements to Solvency II being implemented in Europe and therefore become victims of Brexit.
In conclusion, we welcome constructive dialogue with Regulators, HM Treasury and more broadly the Government to ensure that we can play the role we are naturally designed to play in aiding the post Covid economic recovery while supporting the equally urgent and necessary transition to a much greener economy. Our analysis clearly highlights the shortcomings of current proposals. The insurance industry, the Government and Regulators care deeply about policyholder protection and perhaps there is room at the top for more than one “champion of the policyholder”. Equally, Government and industry also care about growth, but this tri-level podium currently lacks a regulatory champion.
[1] This impact is pre-tax and without a TMTP recalculation.