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Some closing thoughts on Solvency II reform….

Huw Evans.jpgOn his final day as the ABI’s Director General, Huw Evans shares some closing thoughts on Solvency II reform.

The first speech I read before joining the ABI in 2008 was on progress towards the establishment of Solvency II, a single capital and risk management framework for the insurance sectors of the (then) 27 member states of the EU. As I leave the ABI 13 years later, two fundamental points have changed. Firstly, the UK has left the EU just as Solvency II is being improved, meaning the PM and Chancellor have to go further than the EU if the UK is not to be at a competitive disadvantage.

Secondly, the UK has committed to reach Net Zero by 2050 requiring an estimated investment of £3 trillion and fundamental changes in the way in which long-term savings providers and insurers invest their capital. This just wasn’t on the agenda when Solvency II was agreed in 2014 at a time when politicians and regulators were overwhelmingly focused on financial security and stability in the aftermath of the financial crisis.

Because the EU has already published its Solvency II reform plans, we know what the baseline is. The EU Commission overruled its regulators to support more ambitious reforms to the Solvency II Risk Margin while proposing no material changes, for better or worse, to the Matching Adjustment. As a result, it estimates up to €90bn of investment capital will be freed up in the short term. Unless the UK Government embraces reforms of at least similar ambition, the UK will have left the EU only to have a less competitive regime than our continental neighbours. Far from a ‘Brexit dividend’ we will have a ‘Brexit penalty’ to add to the large-scale transfer of insurance hubs and contracts we have already seen since 2016.

As for investment in green finance, a useful debate about how the Solvency II Matching Adjustment can be improved has been somewhat overtaken in the UK by a series of Bank of England/PRA interventions seeking to force changes to the Fundamental Spread element of the Matching Adjustment. Not only is this an issue that wasn’t even included by HM Treasury when it set the remit for the review, any changes are almost guaranteed to increase insurer capital levels and make the UK less competitive than insurers based in the EU.  And any chance of a significant boost to green investment will almost certainly be lost.

As I clear my desk, I wanted to put on the record three key points that are in danger of being missed in the debate we are having:

Whose reform is this?

There seems to be a degree of confusion between the PRA and the UK Government about whose reform this is, particularly when it comes to the scope. HM Treasury has published two key documents on this in October 2020 and in July 2021, both of which put reform of the Risk Margin, enabling of productive finance through reform of the Matching Adjustment and simplification of processes and reporting as the key objectives. Yet in its QIS exercise launched in July and in the Andrew Bailey speech last week, the Bank of England has framed its recently discovered concerns about the Fundamental Spread mechanism of the Matching Adjustment as a key reform objective in its own right. While nobody could argue the PRA should not have its own views, it is surely an important principle of post-Brexit decision-making that the scope of a Government review and ultimately the decisions that come from it are taken by democratically elected politicians. It is regrettable that when it came to the Quantitative Impact Study the PRA commissioned in the summer, it chose only to model the Fundamental Spread reforms it wanted (both of which added capital to the UK regime) while not including the reform options put forward by the industry.

What is the problem with the Fundamental Spread?

On the issue itself, it is important to take on some of these arguments given the prominence given to them in recent months, in particular the concern that the Fundamental Spread is insensitive to credit spreads.

For this element of Solvency II to suddenly attract such attention from our regulators is baffling given it has been a central part of the design of Solvency II since it was implemented. The Omnibus II Directive Recital (31), which was viewed as a major victory for the UK in 2014, is clear that the insensitivity to credit spreads is a design intent, not an unintended consequence. This is to protect against market volatility and ensure counter-cyclical behaviour from insurers holding assets for the long term. Under the market stresses of Covid, the Fundamental Spread has behaved as it was designed to and protected Solvency II balance sheets against short-term market pressures. If it were more sensitive to those short-term pressures, it would become pro-cyclical which is not in the interests of the ultimate policyholders or the PRA which is responsible for financial stability. It is, to put it politely, surprising that an issue which is now exercising the PRA so much has barely featured in any of its output of speeches and industry dialogue since 2016 when Solvency II was implemented.

Will reform weaken policyholder protection?

The other key argument advanced in recent months is that reform to Solvency II is tantamount to ‘weakening’ the regime, which in turn will damage policyholder protection. This sounds plausible until we consider the facts. Reforms which strengthen Solvency II by making it more future-fit and better equipped to deal with a decarbonising world will enhance policyholder protection and help protect against stranded assets, a key concern of a different part of the PRA. And then look at the levels of protection. UK insurance and long-term savings providers hold an additional c£150 billion of capital above the technical provisions required to match assets to liabilities and the Risk Margin. To argue, as some senior figures have, that any reforms to the Solvency II regime put policyholder protection at risk is simply not plausible when you look at the level of prudence already built into the capital regime, never mind the wider governance and risk management reforms that are central to Solvency II and which have made it a much safer regime than its predecessors.  It is not axiomatic that any reduction of capital levels, however modest, results in any material impact on policyholder protection and regulators insult all our intelligence when they assert the opposite.

Let me end on a more constructive note. There is more common ground between insurers, regulators and the UK Government than might appear on the surface. We all want to retain the core elements of Solvency II, maintain a strong and effective system to protect policyholders and to improve some of the cumbersome processes and reporting that have bedevilled the system. We all agree – as does the EU – that the Risk Margin mechanism can be improved in line with emerging international standards. Despite some political encouragement to do so, nobody in the sector is arguing for deregulation, a point that could perhaps be better appreciated.  

What we have instead are two fundamental choices. Having seen the UK’s role as the insurance capital of Europe diminished by Brexit, do we at least take the opportunity to reform Solvency II that is presented? Or, to use a rugby metaphor, do we fumble the ball on the try line in the 80th minute, gifting our competitors (who had the sense to score earlier) the win?

Secondly, are we serious about funding Net Zero? If so, not to use the immense investment power of the UK’s world-leading long-term savings and insurance sector would be a massive mistake. At the moment it is easier to invest in a mining company than a wind farm. A fundamental test for Solvency II reform is whether this changes.  

The technical details can be complex but the realities are really very simple. The UK’s version of Solvency II will either be fit for the decarbonising future we will inhabit or it will remain trapped in the psychological architecture of the post-2008 period, leaving us at a competitive disadvantage to the EU. I hope our political leaders are determined enough to choose for the future and that 2022 sees a renewed determination by regulators, insurers and the Treasury to agree an ambitious way to achieve this.

Last updated 09/12/2021