What does the future hold for insurance supervision in the UK?
06 Jul 2018 - Estimated reading time: 5 minutes
Last year, the Prudential Regulation Authority (‘PRA’) withstood several shots to its bow in the Treasury Select Committee’s (‘TSC’s’) report into the Solvency II Directive and its impact on the UK Insurance Industry. The report made sweeping recommendations and criticised the PRA’s implementation of Solvency II, as we reported in our newsflash.
But since the report was published, the PRA has been quick to respond. Sam Woods penned an interim response, and this was followed by a substantial response from the PRA in February 2018. In addition to these responses, the PRA has published a series of consultation papers and announcements, including:
- Consultation on changes to the Matching Adjustment (see our newsflash);
- Consultation on a Dynamic Volatility Adjustment (see our newsflash);
- Changes in insurance reporting requirements;
- External audit of the Solvency and Financial Condition Report; and;
- PRA review of model change related processes, policies and reporting.
But, one glaring area left to address, and that is ripe for reform, is the Risk Margin, which Sam Woods recently put on the backburner when he stated that the PRA could see no way to “implement a change” given the current uncertainty of Brexit. Below we consider the Risk Margin and the Matching Adjustment calculation and how the PRA’s approach to these may evolve.
The Risk Margin
Plan A: A helping hand from EIOPA
The Risk Margin has long been highlighted by both industry and regulators as an element of Solvency II that doesn’t work as intended. Two common criticisms of the risk margin are – as articulated by the regulators themselves – that:
- “[it] is too sensitive to the level of interest rates and therefore too high currently”; and
- “firms have responded to the level of risk margin by reinsuring a substantial proportion of the longevity risk offshore”.
The PRA has highlighted the difficulty of improving the Risk Margin while delivering its statutory objectives and remaining within the constraints of European law. As Sam Woods stated in March last year in his evidence to the TSC, the PRA’s ‘Plan A’ was “to seek lasting reform of the Risk Margin at its source, in the Solvency II regime itself”.
However, EIOPA reviewed the calibration of the Risk Margin and, as we reported at the end of last year, recommended no change. In his interim response to the TSC, Sam Woods admitted that he was “disappointed with the outcome of EIOPA’s review”.
Roll on Plan B.
Plan B: No Risk Margin bargain?
Shackled by European Law, there are still aspects of the Risk Margin that some believe the PRA could change.
One proposal came from Legal & General and the Association of British Insurers who shared legal advice with the TSC that had been obtained by Legal & General concerning a potential way in which insurers could mitigate the Risk Margin. This advice considered the impact of the Board passing a resolution that it will reinsure longevity risk under specific circumstances. In the calculation of the Risk Margin, the insurer would assume that the theoretical reference undertaking would also adopt the management action on, or immediately following, the transfer of insurance liabilities. Therefore, in the calculation of the Risk Margin, firms would replace the longevity risk element of the Risk Margin with the cost of hedging longevity risk.
It was rumoured that the PRA was considering this proposal, however, this rumour was scuppered by Sam Woods in his letter of 4 June 2018. In this letter he stated that, in light of the uncertainty caused by Brexit, the PRA did not see a “durable way to implement a change” to the calculation of the Risk Margin.
So, what is Plan C?
Plan C: Desperate for Brexit
Depending on the detail of any transitional deal, the UK’s relationship with the European Union (‘EU’) after March 2019 is as yet unclear. Sam Woods, in his letter, said that the PRA has been considering some changes to the Risk Margin but is constrained by the uncertainties surrounding Brexit. It will therefore keep the issue “under review”, and update the TSC once it sees a “clear way forward”.
The letter implied that the PRA is supportive of an approach that allows some scope for the use of future risk mitigation to dampen the sensitivity of the Risk Margin to interest rates. It is therefore likely that, if and when it is freed from EU legislative constraints, this option will once again be put on the table.
In that situation, it is unclear what other areas the PRA may feel it appropriate to modify. However, it will need to balance its own view of alternative approaches appropriate to a UK-specific regime with the desire to remain “equivalent” to Solvency II.
The Fundamental Spread: Fundamentally Flawed?
While the PRA regaining control of the insurance regulations may lead to a positive outcome for insurers on the Risk Margin, there may be areas where the outcome is less positive. A particular example where the PRA seems to have concerns is the calculation of the Matching Adjustment.
The Fundamental Spread is an amount deducted from the yield on assets within the Matching Adjustment Portfolio to arrive at a discount rate, which, under Solvency II regulation, can be used to discount the liability cash flows on certain lines of business. The deduction represents the cost of expected defaults and downgrades of assets in the insurers Matching Adjustment Portfolio, which is calibrated by EIOPA using data about past defaults and downgrades on corporate bonds.
In a Speech to the Westminster & City 16th Conference on Bulk Annuities, David Rule, Head of Insurance Supervision at the PRA, expressed some concern that the Matching Adjustments currently being calculated could include compensation for additional risks associated with assets other than corporate bonds.
Take for example, Equity Release Mortgages (‘ERMs’). ERMs are included in many Matching Adjustment Portfolios as they typically result in high Matching Adjustments (see below). In order to meet the Product Standards of the Statement of Principles of the Equity Release Council, an ERM must include a no negative equity guarantee. As a result, the no negative equity guarantee has become a common feature of UK ERM products.
Average Matching Adjustment By Matching Adjustment Eligible Asset Class as at 31 December 2016:
Source: David Rule speech 26 April 2018 – Westminster and City – 16th Conference on Bulk Annuities
The PRA may be concerned that, because the calculation of the Matching Adjustment is calibrated on default and downgrade experience of corporate bonds, it could fail to properly allow for the non-standard risks associated with some illiquid asset classes – in the case of ERMs, this would include the risk that the no negative equity guarantee bites.
Indeed, the PRA confirmed this with the release of CP 13/18. CP 13/18 specifies an approach and calibration for valuation of the no negative equity guarantee that firms can undertake to meet the PRA’s minimum requirement for compliance.
However, after Brexit, one further avenue that may be available to the PRA would be to require firms to calculate their own Fundamental Spreads. This may remind some of the Individual Capital Assessment regime that pre-dated Solvency II. Under this regime, the Fundamental Spread wouldn’t capture the risks of a portfolio of corporate bonds, but would instead be calibrated to the specific asset classes that the insurer holds within its Matching Adjustment Portfolio. This could result in a Matching Adjustment that more accurately captures the illiquidity premium of these asset classes.
In the meantime, the PRA is likely to keep a close eye on whether insurers’ internal ratings processes remain appropriate (as we've highlighted before) and to confirm firms' compliance with CP 13/18 to ensure that the Fundamental Spread is not underestimated. Furthermore, a poor internal ratings process could lead to a breach of the Prudent Person Principle.
The industry’s wait for a solution to the Risk Margin continues and, with so much uncertainty, it is impossible to know what will happen in the coming months. Brexit may bring opportunity for the PRA to change the Solvency II regime and crucially the Risk Margin. However, as we’ve laid out, Brexit could also bring change elsewhere – and this may not all be for the better.
Hymans Robertson has a wealth of relevant Solvency II experience, from risk and capital optimisation under Solvency II, through to broader areas such as model calibration and validation in the areas of longevity risk, credit risk, and dependency & aggregation. Our consultants would be delighted to support you. If you would like more information or advice, please get in touch.