Insights into Solvency II (UK edition) post Brexit

Earlier this year we heard a reasonable amount from Sam Woods, the CEO of the Prudential Regulation Authority (PRA), regarding his thoughts on the Solvency II regime. These came in the form of written evidence to the Treasury Select Committee (TSC) and also in a speech at the London Business School on 20 March 2017.

Those hoping that Woods has a shopping list of radical reforms that the PRA is planning to unilaterally implement in the UK post Brexit will – not surprisingly – be disappointed.

In his letter to the TSC, Woods described the fundamentals of the regime as sensible and he reinforced this view in his subsequent speech, stating that the “industry has no desire whatsoever to sit back down at the regulatory table and consume another, radically different, meal” so soon after the implementation of Solvency II.

Risk Margin “excessively volatile”

One area in which the PRA has expressed some appetite for change is the Risk Margin. In his speech to the London Business School, Woods described the concept of the Risk Margin as “a sensible one, but its current implementation in Solvency II is flawed”. His evidence to the TSC agreed with the industry that the Risk Margin is “excessively volatile due to its sensitivity to risk-free interest rates”.

If we consider the first six months of 2016, when 10 and 20 year swap rates fell by over 1%, the Risk Margin could easily have increased by as much as 40% for a block of immediate annuities with a duration of 15 years [1].  It is no surprise then that we saw a large number of firms recalculating their Transitional Measure on Technical Provisions (TMTP) mid-way through 2016, as illustrated in the chart below. The pink dots on the chart show the dates at which firms recalculated their TMTP: with 12 recalculations happening at the end of June 2016.

Hymans Robertson TMTP recalculation index

Source: FCA Register, Hymans Robertson

However, while Woods agrees that there is a problem, he disagrees with the industry on the best solution. Rather than the PRA making changes unilaterally, the regulator is seeking to influence changes at a European level, stating in his letter to the TSC that the “best course of action is to seek lasting reform of the Risk Margin at its source”.

One explanation for this could be that the PRA has an eye on maintaining Solvency II equivalence following Brexit, and does not wish to make radical changes to UK regulation that may jeopardise this. The question then becomes whether the UK has any sway at the European negotiating table now that Article 50 has been triggered.

Another explanation could be that the PRA believes that TMTP, and the ability to recalculate it, is providing some temporary relief for firms, giving the PRA breathing space to try and drive through changes at a European level.

Transitional Measure on Technical Provisions (TMTP)

In his recent speech, Woods said that the PRA’s findings are that the TMTP benefits “almost entirely offset the aggregate Risk Margin”. However this soundbite neatly glosses over a number of challenges being faced by firms:

• The TMTP does not apply to business written after 31 December 2015;

• The relief afforded by TMTP runs down over a 16 year period from 1 January 2016 – whereas the Risk Margin may take longer than this to run off;

• Woods’ particular concern about the “excessive volatility” of the Risk Margin is only addressed if the TMTP moves in line with the Risk Margin; and firms need to obtain PRA approval every time they recalculate;

• It is not clear the extent to which firms can anticipate future recalculations of TMTP when formulating their strategies for managing the Solvency II balance sheet.

Neither Woods’ speech nor his evidence to the TSC addressed these points. However, it is clear that PRA policy in this area is not settled.

A further consultation on TMTP is in the pipeline, and we expect this to focus on the 24-monthly routine recalculation. Woods’ evidence to the TSC offered adopted a collaborative tone, saying “The PRA welcomes views, particularly in the context of that consultation, on ways in which we could simplify further the TMTP recalculation process.”

The PRA has recently issued a new Policy Statement on TMTP, which we explain in this article.

Matching Adjustment: “Rumbling discontent”

In his speech to the London Business School, Woods acknowledges that there is “rumbling discontent” around the Matching Adjustment (MA) and investment in illiquid assets more generally. Woods splits this issue into two parts: distinguishing between the “clunkiness” of the design of the MA; and a lack of expertise and suitable investment opportunities for firms.

Woods agrees with industry that the MA rules are too restrictive regarding the assets that can be used to back long-dated annuity liabilities. However, he also notes that the MA itself is more generous than the illiquidity premium previously used under ICAS, largely due to the fundamental spreads prescribed by the European Insurance and Occupational Pensions Authority (EIOPA). He commented that if he had a completely free hand he would make modest changes, but the PRA is constrained by the rules.

If Woods’ hands were free, we might find that he would use both of them: giving with one and taking with the other. His inclination is to be slightly less prescriptive with the assets that can be held in MA portfolios, but the flip side is that he would also like to revise the fundamental spreads used in the calculation of the MA.

While the complications surrounding the MA are certainly not helping the situation, the PRA has found through conversations with firms that a bigger problem is a lack of expertise and opportunities for investment. In Woods’ opinion, these two factors are the main barrier to firms investing in infrastructure assets.

Reporting requirements: “there may be a case for lowering the burden”

As firms deal with their first full year of Solvency II reporting, they are feeling the strain of higher volumes of reported data with tighter timescales than before. Woods stressed in his speech to the London Business School that this was necessary to avoid situations where solvency reviews could occur as much as 18 months in arrears, as a result of the length of time it took to source the data from firms: Woods does not believe this to be acceptable.

He did temper this by saying that: “I keep an open mind about whether we have struck the right balance – there may be a case for lowering the burden”. He also mentioned that a sample of insurers will be surveyed to gather information on the impact of reporting throughout the industry and that the usefulness of the data being collected will continue to be reviewed.

So, for now at least it seems that Solvency II is set to stay pretty much ‘as good as new’

Although firms may appreciate hearing that Woods shares some of their concerns relating to the Risk Margin, it is clear that these will not be resolved any time soon: as the PRA seeks to address them “at source” in Europe. In the meantime, firms will face significant challenges in managing the interest rate sensitivity of their Solvency II balance sheets.

The Matching Adjustment is also likely to continue to pose challenges for firms. The PRA appears to have no plans to make any changes in the short term – although Woods did not explicitly discuss the regulator’s plans once it ceases to be constrained by Solvency II.

Contributing Authors:

 Stephen MakinRoss EvansAndrew Scott   Kyle West

[1] Based on Hymans Robertson’s modelling of a hypothetical annuity firm. Key assumptions are:

Firm writes only immediate annuity business with a duration of 15 years;

No reinsurance;

Standard Formula longevity stresses used to determine the size of the Risk Margin;

Longevity is the only risk included in the Risk Margin

The material and charts included herewith should not be considered a definitive analysis of the subjects covered, nor is it specific to circumstances of any person, scheme or organisation. It is not advice and should not be relied upon. Hymans Robertson LLP accepts no liability for any errors or omissions.