Following the ‘Solvency II’ reforms announced by the UK government last week, some in the insurance industry expect the changes to lead to a multi-billion-pound release of capital.
The final Solvency II reforms were announced alongside the Autumn Statement last Thursday, with the government predicting it would see “tens of billions of pounds” unlocked across a range of sectors.
What are the Solvency II reforms?
The original Solvency II rules were brought into effect for insurers in the European Union in January 2016, governing prudential regulatory requirements areas including risk assessment and governance.
This year, both the EU and UK have been looking at making changes as the rules were felt to act as a disincentive for long-term equity investment.
On Thursday HM Treasury set out its final Solvency II reforms, following a consultation launched in April this year to examine substantial changes in the calculations of ‘risk margins’ for life insurers, as well as tweaks to ‘fundamental spreads’ and ‘matching adjustment’.
The risk margin is the difference between an insurer’s technical provisions and best estimate liabilities. The matching adjustment is where insurers can hold a separate portfolio of bonds or assets with similar cash flow characteristics to their portfolio of life or annuity and reinsurance obligations. The fundamental spread is the allowance made for the risks that insurers are assumed to retain, when calculating the benefit of the matching adjustment.
Under the reforms, which the government said it will legislate as necessary, the risk margin will be reduced by 65% for life insurers for long term life insurance business and by 30% for general insurers.
No changes will be made to the way the fundamental spread is calculated and calibrated (following a warning from the Association of British Insurers as part of the consultation that changes to the fundamental spread would “penalise (not incentivise) investments in long-term productive finance”, arguing that such changes would introduce a direct link to spreads that would lead to “material pro-cyclicality and balance sheet volatility”).
As the final part of the reforms, the matching adjustment eligibility criteria will be broadened to include other assets with “highly predictable” cashflows as opposed to just fixed currently, subject to adjustments to the fundamental spread allowance and safeguards to be implemented by the Prudential Regulation Authority (PRA).
This was also welcomed by the industry, with the ABI saying it will allow investment in a wider array of assets and also enable relevant insurers to include morbidity liabilities in matching adjustment portfolios.
What’s the expected result of the reforms?
ABI director general Hannah Gurga warmly welcomed the reforms, saying the changes create “the potential for the industry to invest over £100bn in the next ten years in productive finance”.
She added that the reforms will also “encourage a thriving and competitive industry which will ultimately benefit the UK economy, the environment and customers”.
Barry O’Dwyer, chief executive of Royal London Group and ABI president, said the amendments will see an insurance sector that “maintains the highest standards of policyholder protection and also contributes significant investment into UK assets and infrastructure that will benefit our customers, the environment and wider society”.
Barclays insurance sector analysts viewed the outcome as positive for the UK life insurers for expanding illiquid portfolios although it is unlikely to impact bond investment strategies or dividends.
Loic Bellettre, a partner at EY, said the proposed legislation should provide “much-needed certainty” to the industry, while leaving the fundamental spread methodology largely unchanged will be “a relief for annuity firms particularly, which would otherwise have faced significant increases and volatility in the level of capital required”.
The PRA’s next steps would need to be seen before all the implications could be fully assessed, said Bellettre.
For a company example, Legal & General Group PLC (LSE:LGEN) said in a statement on Friday that with an estimated Solvency coverage ratio on 11 November of between 225-230%, it expects the reform to the risk margin to increase its solvency ratio by 3-4 percentage points.
“Currently, approximately half of the assets backing our annuity portfolio are bonds issued by companies that are not based in the UK. We would expect the percentage of UK-based assets backing our UK annuity portfolio to increase following the implementation of these reforms.”
What will this £100bn be used for – dividends and buybacks?
With predictions that the industry would have £100bn of “productive finance” freed up for use for investment, some investors might immediately think this will to result in a lot of dividends and share buybacks.
It suggested investment might be used in UK social infrastructure and green energy supply.
EY’s Bellettre was more restrained in his predictions, suggesting the changes to the risk margin will “release some capital”, while changes to matching adjustment eligibility criteria “could, depending on the final detail, increase insurers’ ability to invest in supporting the UK economy”.
L&G said the proposals “will allow us greater flexibility to make appropriate investments”, including in new infrastructure, in other levelling-up and climate-positive projects.
Analysts at Barclays said they saw a minimal impact on non-life insurers, but the changes may support dividends.
When will the changes come into effect?
The reforms will be introduced as part of the Financial Services & Markets Bill, which many anticipate will be during the first half of next year.