News analysis: Solvency II - should brokers be worried about the impact the reforms will have?

The average person had probably never even heard of Solvency II, let alone considered it, when deciding to vote in 2016 on whether to remain or leave the European Union. However, Brexiteer politicians believe that the UK, free from Europe’s powers, can shake up this important piece of regulation, thereby boosting the country’s prosperity.

“Solvency II puts the UK market at a competitive disadvantage, and it is ripe for reform,” said Jacob Rees-Mogg, following his appointment as Brexit Minister for Opportunities in February 2022. However, fast forward a year, and the government has published its final proposals for Solvency II.

All attention is now on the Financial Services and Markets Bill, which is likely to be passed in spring this year, and which would allow for European Union-derived legislation to be revoked, kick-starting the changes to Solvency II. For brokers, there are two questions: what are big changes and how does it impact business?

The broad political idea of reforming Solvency II is to relax capital held by insurers, making them more competitive on the international and domestic stage. 

Furthermore, some politicians believe that reforming Solvency II will unleash a wave of investment from insurance and pension companies into infrastructure and energy projects, thereby boosting economic growth.

The major changes

When you get down to the nuts and bolts of the Solvency II reforms, the major changes are in three areas: risk margin, matching adjustments and fundamental spreads.

The biggest impact is likely to come from a change in risk margin. The risk margin is an additional capital buffer held over the best estimate of their liabilities. It is stress-tested to withstand a ‘once in a 200-year’ bad outcome event. 

The other purpose of the risk margin is to cover the cost of transferring a book of liabilities from a failed insurer to another company. If it passes the legislation, risk margin reductions will come in at 30% for general insurers and 65% for life insurers.

Risk and reward?

Some politicians and insurers have lobbied for this change, believing that the current risk margin is too strict.

Hugh Savill, former director of regulation at the Association of British Insurers, and now senior adviser at Sicsic Advisory, said: “The risk margin is a big issue for life insurers, which have to hold capital for decades. But it is not a big issue for general insurance: Prudential Regulation Authority figures set the risk margin at £7bn for general insurers against £32bn for life insurers.

“The government’s consultation on Solvency II reform states there is a general agreement that a reduction of 30% would have limited impact on business decisions.”

Next up is matching adjustment. This is where the insurers’ liabilities are discounted by the risk-free interest rate to calculate their present value. It reduces the value of liabilities and, therefore, the assets needed to cover them.

“Why do regulators allow this? The assumption is that these insurers are buy to-hold investors, so they are not subject to fluctuation in the value of the bonds they hold,” Savill continued.

Insurers believe that the matching adjustment is too restrictive, meaning that there should be a more expansive approach on which assets can be held against liabilities.

Finally, there is the fundamental spread is the difference between the face value and market value of a bond. This caters for expected losses from a downgrade or default.

Impact of shake-up on brokers

With the shake-up in Solvency II set to get the green light, one area of focus will be impact on rates. If insurers hold less capital, it may result in a more competitive landscape with lower prices.

Although the reforms are predominantly aimed at life and pension providers rather than the general insurance sector, the one area that could benefit is motor insurance. This is because motor insurers hold longer duration assets to match up liabilities from catastrophic injuries in the form of periodic payment orders.

Longer duration asset holders are the ones primed to receive the most benefit from relaxation in capital rules and requirements coming from the Solvency II shake-up.

Toby Clegg, CEO at Clegg Gifford, said: “The relaxation on capital requirements is aimed at the big institutions – very large public companies like Aviva. It’s not for smaller and more, dare I say, agile insurers because they simply won’t have the surplus to invest anyway.”

The relaxation on capital requirements is aimed at the big institutions – very large public companies like Aviva. It’s not for smaller and more agile insurers because they simply won’t have the surplus to invest anyway.

Toby Clegg

Consultant Ian Clark, who runs Mighty Quin Consultancy, added: “Could it lead to lower rates – cutting capital costs and competition. Well, it could do. But the motor insurance sector is an awful state. None of them are publishing good results.

“They are all putting rates up – or they, should be putting rates up – but aren’t. So the prospect of a rate cut is some way off. It really is because the market is losing hand over fist; in most cases anyway.”

Clegg believes brokers will have to explain to clients ‘in an inadvertent way’ the changes on Solvency II, and explained: “When they sit there and say ‘I haven’t made a claim in X years, or I’ve got a very good account with you and it runs very well’. You have to turn around and say ‘but the rules have changed fundamentally, in that these insurers have to show that everything is priced that year’. 

“You can’t take into account good behaviour from previous years so much, because it is based upon the chances of you having an accident that year.”

Insurer failure threat

Solvency II reforms will matter most on the impact on insurers’ financial strength and the brokers understanding the risk of an insurer failing. Insurer failure is the biggest potential downside to the reforms.

Prudential Regulation Authority head Sam Woods told a House of Commons Treasury select committee this month of the threat.“The reform package as a whole increases risk. That is the trade-off that the government has made,” Woods said.

The reform package as a whole increases risk. That is the trade-off that the government has made.

Sam Woods

Bank of England governor Andrew Bailey mentioned Equitable Life in relation to the Solvency II reforms, stressing ‘it can happen’. Equitable Life, established in 1762, closed to new customers in the year 2000 and almost collapsed after making unsustainable guarantees to policyholders.

The threat of failure should not be overlooked by brokers, according to Savill, who said: “At a high level – the solvency of an insurer is important for brokers, as solvency avoids failures and ensures the carriers’ capacity to pay claims. Those who have cleared up the mess after the failure of a carrier will know this.

“Customers have to be helped with their claims – which falls on the Financial Services Compensation Scheme. And in the case of small markets, with a limited amount of capacity, it can be difficult to find alternative capacity at the same price.

“The reason is that failed insurers were often under-pricing and that can drive other carriers out of the market [because they cannot compete profitably]. This has all happened recently, for example with the failures of Gibraltar-based insurers five years ago.”

PFK Littlejohn Partner Neil Coulson believes the risk of failure does increase slightly with the reforms.

“If you hold less money, then obviously you are increasing your chances [of failure]. I don’t think it is that significant. You have this buffer that is normally in the Solvency II rules, but they are always looking for something above and beyond”, Coulson added.

Rating agency checks

In terms of what should brokers should actually be doing, Clark comments it will vary from broker to broker.

Insurers are unlikely to give brokers any specific communication on their Solvency II capital changes, unless it impacts business. This means the rating agencies will be very important in helping brokers understand an insurer’s risk post-Solvency II reforms.

Clark added: “It’s very dependent on the size and scale of the broker as to whether they are doing the job properly. The first thing they’ll do is look at the insurer rating with one of the established agencies. That’s the first port of call.

“If it’s a commercial business, you’re looking for an A-minus minimum solvency requirement. None of that is going to change at the top end.

“As for the high street broker, they’re turning to their network if they are a member.

In the case of Broker Network, it has 700 members. The network is looking at the solvency and publishing solvency lists regularly to all of their members, and putting up approved risks.”

For the ‘unsophisticated’ broker, Clark adds that they will end up dependent on the strategy of the individual insurer, and what decisions they make with the additional surplus likely coming from the Solvency II reforms.

Solvency II watered down

The overall conclusion being broadly drawn by the market is that the Solvency II reforms will have some impact on general insurance, but it will not be significant. Even if the government wants Solvency II to be a big and bold, the regulator is lurking in the background with its primary concern of financial stability.

Even if the government wants Solvency II to be a big and bold, the regulator is lurking in the background with its primary concern of financial stability.

“They are faced by a regulator that does expect the capital buffer to go above and beyond. They don’t just say we want 100% capital as calculated. They usually are looking for up to 25%,” Coulson commented.

The regulator has already succeeded in having safeguards built into the important technical elements of the Solvency II reform.

Savill continued: “The PRA believed that the current matching adjustment formula understated credit risk. So, their suggestion was that there should be an additional credit risk premium.

“The PRA over-played their hand, and their proposed credit-risk premium would have wiped out all the benefit of reducing the risk margin. It also took a pasting in the consultation responses on theoretical grounds.

“The Treasury decided not to change the fundamental spread. We don’t know why. On the face of it a victory for the insurers, but in practice the other safeguards negotiated by the PRA as they climbed down the ladder should give them all they need.”

Often in the past, the regulators talk a good story, but when they actually come to adjusting things, perhaps they unlock things rather less than you think they might do.

Neil Coulson

Even the much-vaunted unleashing of investment into the British economy is in question. In a joint letter in August 2021, the then Prime Minister Boris Johnson and Chancellor Rishi Sunak called for an ‘investment big bang’ to unlock hundreds of billions of pounds sitting with UK institutional investors. 

Solvency II was a critical part of their ‘investment big bang’ ambitions.

Chancellor Jeremy Hunt has joined the bandwagon, saying in November the reforms will ‘unlock tens of billions of pounds of investment for our growth-enhancing industries’.

Coulson said: “I think it will be very interesting to see exactly what they do about the rules of making it more attractive for these infrastructure in long-term investments. Often in the past, the regulators talk a good story, but when they actually come to adjusting things, perhaps they unlock things rather less than you think they might do.”

The road towards reforming Solvency II has been a long-time coming. The end is in sight. The only thing is, those politicians expecting a new dawn in financial services blazed by the Solvency II reforms, will likely face a damp squib. Brokers needn’t lose too much sleep.