Solvency UK: Moving closer to reality

At a glance

• HMT and the PRA have published draft Statutory Instruments and CP12/23, bringing the new Solvency UK regime one step closer to reality.
• HMT expects the Risk Margin (RM) rule changes to be effective from end‑2023, Matching Adjustment (MA) related changes to come into effect by mid-2024 and the remaining measures by end‑2024. This is an ambitious timeline.
• The CP gives a first look at how the PRA will exercise its new powers under section 138BA of FSMA, whereby the PRA may grant permissions to firms to disapply or modify any of its rules.
• The proposals include a range of changes, some of which are likely to reduce capital and/or operational cost. These include:
  • the RM, which is being reformed in line with expectations - the details of its calculation will enable firms to assess the impact on their capital positions; and
  • a package of reforms to the Transitional Measures on Technical Provisions (TMTP) that include removing the requirement to maintain Solvency I models or obtain PRA approval for recalculations - these are likely to reduce the operational burden of maintaining TMTPs.
• The impact of some of the proposals seems positive for industry but much of the benefit will depend on how the PRA implements the rules in practice. These include:
  • a significant reduction in the volume of tests required for Internal Model (IM) approval and more flexibility to allow permissions for a wider set of IMs, while creating a new IM ongoing review framework and requiring a new Analysis of Change exercise and related disclosures; and
  • changes to reporting and disclosures, including removing a number of templates but also amending existing templates or creating new ones – see Appendix for a summary.
• As expected, the CP includes some competitiveness-enhancing proposals by adding flexibility to the calculation of group solvency capital requirements; and the removal of third country branch capital (TCB) requirements and localisation of assets covering the branch solvency capital requirement.
• Finally, life insurers will have to wait until September 2023 to hear the details of the MA and investment flexibility reform. The draft Statutory Instruments pave the way for reform in these areas, but the all‑important detail is yet to come from the PRA.

Who this blog is for:

Board members, senior executives and actuaries of UK insurers who work on balance sheet management, pricing, reporting, capital optimisation, risk, finance, and compliance.

Introduction

The PRA and HMT are moving closer to making Solvency UK a reality. The new prudential regime for UK insurers is starting to take shape in accordance with expectations. Last week, HMT published two draft Statutory Instruments (‘regulations’) formalising key aspects of the Solvency UK reforms such as the details of the RM calculation. This week the PRA published CP 12/23 (the ‘CP’), the first of the long-awaited consultations on the new regime providing much more clarity and detail across a number of areas of the regime.

The CP includes detailed proposals on TMTPs, IMs, capital add-ons (CAOs), flexibility in calculating group solvency capital requirements, TCBs, reporting and disclosure and a few more minor areas. However, the more controversial details on the MA, including investment flexibility and safeguards such as MA attestations, will be consulted on in September 2023.

Timelines and process

HMT indicated that it is determined to implement the reforms as soon as possible, with its expectation being that reforms to the RM could be in force as soon as year-end 2023; this has been echoed by the PRA. HMT is considering options to enable reforms to the MA to follow by June 2024, with the remainder of the new regime in place by year end 2024.

HMT is clear that the regulations will need to work effectively and consistently in combination with related PRA rules and may be subject to change as the PRA finalises its rules. Final regulations will be laid before Parliament in due course.

The parts of the Solvency II regime that are not amended, or that are retained according to the regulations, will be replaced by the PRA’s new rules, which will be part of three consultation papers: CP12/23, a second consultation expected in September and a final consultation to transfer the remaining Solvency II provisions into the PRA rulebook in early 2024. CP 12/23 has a much shorter consultation period than usual; the proposed reforms are open for comments until 1 September 2023 (proposals to make minor administrative amendments to definitions in the PRA rulebook, Chapter 11, are only open for comment until end‑July).

HMT’s and PRA’s timelines could prove ambitious considering the need for both regulations and PRA rules to come together to form a coherent framework.

Exercise of the PRA’s new powers under FSMA

The CP provides a first look at how the PRA will exercise its new powers under s138BA of FSMA, as well as the PRA’s approach to transferring requirements from retained EU law. Under s138BA of FSMA, the PRA will have greater flexibility to disapply or modify the application of any of its rules, by giving firms permissions where appropriate. This marks a move away from the approvals-based approach set out in the Solvency II regime where the PRA could only grant approvals where all the specified criteria were met and was unable to apply discretion based on firm-specific circumstances.

The new permissions-based approach is also markedly distinct from waivers and modifications granted under s138A of FSMA, where firms need to demonstrate that compliance with the rules is unduly burdensome or would not achieve the purpose for which the rules were made. Under the permissions-based approach, the PRA is able to specify its approach to considering applications for permissions and the criteria it will take into consideration; these are likely to be set out in PRA statements of policy. The PRA has indicated that it may consider further aspects relating to the use of s138BA of FSMA in future. This will be particularly relevant once requirements from retained EU law are transferred to the PRA rulebook.

The PRA’s new powers will give it greater discretion and flexibility when supervising firms and enable it to exercise a markedly different supervisory approach under the new regime. The new statements of policy set out the PRA’s proposed approach to supervising firms and shed light on how the PRA will exercise its new powers in the context of the proposed reforms. It will be all the more important for firms to engage closely with their supervisors and see how the PRA’s approach to supervision evolves under the new regime. By understanding how the PRA uses its new powers and flexibility in practice, firms will be better placed to identify opportunities to seek permissions to disapply or modify rules where appropriate.

What are the key aspects of the draft regulations and CP12/23?

The CP is a very long document covering significant ground. Below we summarise some of the key aspects and focus on proposals that are likely to be material for firms.

1. Risk Margin – expected implementation 31 December 2023

The draft regulations include clarity on the RM calculation. The new RM formula will reduce the cost of capital from 6% to 4%. The regulations also confirm the value of the risk tapering factor (0.9 for long-term insurance and 1 for general insurance). A floor of 0.25 has been set, which will only bite for long-term liabilities with a duration greater than 14 years. These regulations broadly align with the Government’s original aim of reducing the RM by 65% for life insurers and 30% for general insurers. The PRA has also confirmed that implementation of changes to the RM as set out is likely to be a material change to a firm’s risk profile and therefore firms should expect to have to recalculate TMTPs when implementing the new RM.

With the new RM formula now drafted into the regulations, firms might want to consider the impact on their capital positions and carry out the necessary exercises to size the degree of capital release that may follow on implementation.

2. TMTPs: simplifications and process improvements – expected implementation 31 December 2024

The PRA is proposing to simplify the calculation of TMTPs, which will be positive news for the 24 firms in the industry that use them. The CP proposes a new method for calculating the TMTP which only uses Solvency II figures and excludes the Financial Resource Requirement (FRR) test. Firms have the option to continue to use a legacy method instead (which would also exclude the FRR test) but we expect most firms to consider using the new method, unless it would be materially financially onerous or too resource intensive. The new method would entail a final TMTP calculation using the existing methodology on the final day of the old regime, with the TMTP then being gradually run off to zero by 2032, using an amortisation adjustment where necessary, and allowing for changes in underlying Solvency II liabilities in the run-off.

In addition, the PRA expects firms to prepare actively for the end of the TMTP transitional period and to manage any risks emerging from TMTP run-off by the end of 2031.

The PRA also outlines the application of the new TMTP calculation method following a business transfer or 100% reinsurance – with firms having two months to carry out the recalculation from the transfer event. Any adjustments to TMTPs will not be allowed to create additional TMTP benefit between the transacting parties.

This package of TMTP reforms will be welcomed by firms as it removes the requirement to maintain Solvency I models or obtain PRA approval for recalculations. Although the main impact of this reform is operational ease rather than a capital release, it might lead to a day 1 release of capital for some firms, specifically those currently bound by the FRR test.

3. Internal Models: expected implementation date 31 December 2024

The PRA is proposing to amend the IM framework for the UK by:

• Reducing the number of tests and standards (T&S) required for new IMs and changes to existing IMs – the PRA plans to retain a smaller number of more principles-based requirements, alongside expectations included in the proposed new supervisory statement.
• Introducing more flexibility around when the PRA grants new permissions to use the IM – for example the PRA could still grant permission where an IM has some residual model limitations (RMLs), as long as safeguards are used to mitigate their impact (see below).
• Introducing IM approval safeguards that could be used to bring an IM that is not entirely compliant into compliance with calibration standards. These safeguards could include an RML CAO or a qualitative requirement safeguard.
• Introducing an IM ongoing review (IMOR) framework – this will rely on ongoing engagement between firms and the PRA and potentially additional data submissions.

Firms will need to consider the impact of the IM proposals on their IM change policies. The change policies are expected to set out the procedures for applying, reviewing, and removing model limitation adjustments (MLAs) before applying to the PRA for a variation of their IM permission. Firms will have up to two years from the effective date of the new rules to make changes to their IM change policies to reflect MLAs. The PRA also proposes to remove the requirement to complete a profit and loss (P&L) attribution exercise as part of the IM validation process. Instead, the PRA will replace this with a new IM requirement to carry out an Analysis of Change (AoC) exercise for changes in the solvency capital requirement (SCR) and submit the results to the PRA including a narrative explanation and evidence for the reasons behind the changes.

Firms will be expected to prepare but not submit the first AoC exercise based on 31 December 2024 numbers, with the first submission based on the December 2025 position. This will relieve firms from the requirement to complete the onerous P&L attribution exercise, although preparing the AoC will not be a trivial undertaking. Firms will likely already have a high-level version of this process and the PRA has proposed allowing firms to submit a free-form report so they can leverage the layout of their existing AoCs. The PRA would expect firms to also submit information on the governance process for completing the AoC, the definition of material used in the exercise, reasons for movement in diversification benefit, internal actions taken following the completion of the exercise and an up‑to‑date list of MLAs and CAOs that contributed to the calculation of the most recently reported SCR.

The replacement of the prescriptive rules for IM applications with principles-based requirements, along with reduced ongoing compliance requirements, will mean that firms should in theory benefit from lower compliance costs; the PRA suggests this could be up to 25% based on Quantitative Impact Study (QIS) data collected in 2021. However, the true cost underlying IM applications will depend on how onerous the changes to IM requirements, such as the new AoC exercise and engagement between firms and the PRA, turns out to be. The streamlined application process might enable quicker permissions to firms that are applying for an IM model or major model change. Furthermore, the ability to hold a CAO to become compliant could encourage firms that would otherwise be non-compliant to apply for an IM model; this is explored further below.

4. Capital Add-ons (CAOs)

Although the approach to setting CAOs will remain broadly unchanged, there are some changes proposed to support the PRA’s new flexible approach to IM. This means introducing the new CAO as a model permission safeguard noted above. This is expected to allow the PRA to grant permissions to a wider set of IMs than is currently possible.

The PRA also proposes to introduce a new approach for calculating a CAO for an IM significant risk profile deviation in exceptional circumstances. The requirement for firms to disclose CAOs set by the PRA will be maintained and the PRA will be reviewing CAOs regularly rather than annually.

5. Competitiveness enhancing proposals

5.1 Flexibility to calculate Group SCR

As expected, the PRA has set out its proposal to allow groups to use multiple group IMs temporarily following an acquisition or merger. The proposals in the CP are broader than anticipated as they also allow the temporary use of multiple calculation approaches when calculating the consolidated group SCR (e.g. IM and standard formula). Aside from affording insurance groups greater flexibility following an acquisition or merger, these proposals will also benefit IM firms that enter the scope of group supervision. The PRA’s assessment of such applications will be based on a number of factors, most notably whether there is a clear and realistic plan to develop a group IM (or group-specific parameters) to cover all group entities within a set period (normally two years).

The PRA has also introduced a proposal to allow an overseas sub-group to be included in the consolidated group SCR under method 2 (deduction and aggregation). This marks a shift from current rules where overseas insurers are brought in under method 2 individually, with no diversification benefits. The inclusion of overseas sub-groups under method 2 depends on a number of factors, including whether the sub-group is subject to equivalent group supervision. This proposal is likely to be of most interest to UK groups with EEA sub-groups, particularly those with approved group IMs, since there is increasing divergence in the tests and standards for IM approval following reforms in the UK and EEA regimes.

5.2 Third Country Branches (TCBs)

As expected, the PRA has set out its long-awaited proposal to remove the requirement for TCBs to calculate and report branch capital requirements. The CP sets out various consequential changes, including removing the requirements to report a branch RM, to hold branch own funds and to hold assets in the UK to cover the branch SCR. These proposals will be widely welcomed by the 130+ TCBs currently operating in the UK.

We note that the PRA does not propose any consequential changes to its Statement of Policy on its approach to insurance business transfers; this suggests that TCBs would still need to calculate a notional RM when determining the valuation of technical provisions being transferred. TCBs will still be required to report the branch balance sheet and hold a security deposit. The PRA proposes to amend its rulebook to specify the amount of the security deposit, denominated in sterling. TCBs should ascertain whether their security deposit complies with the revised requirements. The PRA highlights the relevance of the guidelines on TCBs and has set out a number of guidelines as provisions in the PRA rulebook or expectations in SS44/15.

Reporting and disclosure

The PRA proposes a wide range of changes to Solvency II reporting requirements, building on previous PRA consultations (here and here) to streamline the regime in this area. The CP also seeks to align reporting requirements with the overall Solvency II reform package, particularly in the context of TCBs and groups. This includes the removal of a range of templates that TCBs currently need to submit in relation to branch capital requirements and the localisation of assets.

While the PRA’s proposals aim to improve reporting efficiency and will lead to a reduction in the net volume of templates, they also introduce quite a few new reporting requirements. For example, although the PRA proposes to remove certain templates for TCBs in relation to branch capital requirements, it proposes to replace these with a new requirement to report on the TCB’s legal entity solvency and financial position. Similarly, the PRA proposes to scrap the requirements on firms to submit a Regular Supervisory Report (RSR) – but TCBs would still need to produce a standalone, resolution-focused report. This includes detailing the distribution of branch assets upon resolution, as well as a legal analysis and description of the applicable laws relating to winding-up in the relevant home jurisdiction.

For some insurers, the various changes will be onerous and costly. Firms will need to amend reporting systems and processes to align them with the new rules. In some cases, firms will also have to gather new data and information to support the enhanced reporting rules.

Importantly, we may see further changes to Solvency II reporting requirements further down the line. The PRA signals in the CP that it may review ‘other aspects of reporting and disclosure’, including the Solvency and Financial Condition Report (SFCR) in due course. A summary of proposed reporting and disclosure changes is included in the Appendix to this article.

Mobilisation

The PRA also proposes to introduce a new insurer mobilisation regime, under which a new insurer could apply to operate with business restrictions for up to 12 months while it completes the final aspects of its development. During this stage, the PRA would apply proportionate regulatory requirements, including lowering the MCR floor to £1m.

These proposals are in line with HMT’s earlier consultations, aiming to improve overall competition and remove barriers for new insurers to enter the UK market. A similar regime has been in place for new banks since 2013 that led to a significant increase in new entrants to the market.

Thresholds

The PRA proposes to increase the Solvency II thresholds, which determine whether a firm is to be regulated under Solvency II. The PRA also proposes to redenominate these thresholds from EUR to GBP. Solvency II would therefore apply to firms that have:

• A gross written premium income in excess of of GBP15m (instead of EUR5m), and
• Firm and group technical provisions in excess of of GBP50m (instead of EUR25m)

The PRA expects that this proposal would affect nine existing Solvency II insurers. It could also be of importance to new insurers that are entering the UK insurance market, as it increases the threshold before Solvency II applies.

MA and investment flexibility: what we know so far and what to expect next

The regulations describe how the Fundamental Spread (FS) and MA would be calculated and applied. Notable changes compared to the existing regulations are:

a) Investment Flexibility

The draft regulations could open the door for the use of non-fixed cash flows in the MA asset portfolios on condition that the risks to the quality of matching are immaterial and a limited proportion of the portfolio is affected. We will have to wait for the PRA consultation in September to understand how these conditions are to be assessed. Therefore, whilst it is a step in the direction of greater investment flexibility, the practical implications remain uncertain.

b) FS add-ons

The regulations are clear that firms are given the option of increasing the FS to account for all retained risks. Any add-on will have the effect of increasing liabilities. This is aligned with expectations from the industry and clarifies that the onus is on firms to lead the determination of such add-ons. What remains to be seen is whether further rules will be prescribed by the PRA in relation to the add-ons, and how this will fit in with the MA attestation requirement.

Conclusion

The insurance industry will be delighted to see progress on the new Solvency UK regime with an ambitious timeline for implementing the reform in phases, starting with RM changes, by the end of this year. The ambitious timetable also means that firms should read the proposals carefully and consider responding to the consultation in the next two months to clarify any remaining material areas of uncertainty. Firms could now start the process of quantifying the impact of the reform on their capital, investment, and commercial positions, which should provide clarity on what comes next after implementation.

Based on the proposals, most of the Solvency UK provisions will be embedded in the PRA rulebook. This means that in the future, firms might want to consider potential opportunities to apply for permissions under s138BA such that their regulatory obligations better reflect their risk profiles. Although there is still a lot to be determined, mainly around MA and investment flexibility, the current CP is an auspicious first step in the journey to the new regime.