General Insurance Article - Effect on insurers as Solvency II review is coming to an end

The Solvency II reform is approaching its conclusion, after achieving significant milestones towards implementing a final set of amendments both in the European Union (EU) and the UK.

 In particular, in December 2023, the European Council and the European Parliament announced that they reached a provisional agreement on amendments to the Solvency II directive and the implementation of a new insurance recovery and resolution (IRRD) framework. Once finalised, the amendments will be presented to the EU member states’ representative and the European Parliament for approval. If approved, the Council and the Parliament will have to formally adopt the amended texts.

 The Member States are expected to adopt the amendments to the Solvency II regime by 30 June 2025 and to apply the revised regulations from 1 January 2026. In the UK, the Prudential Regulation Authority (PRA) has recently issued a second round of consultations on the subject, which closed in early January 2024 and plans to implement all the changes related to the so-called Solvency UK, the prudential regime for insurance companies in the UK, by December 2024.

 The Solvency II review started in 2020 by identifying areas of improvement in the directive. In both the EU and the UK, one of the main goals of the review was reducing regulatory capital constraints to free up capital resources and facilitate insurers’ investment in long-term assets without affecting their capital position. In doing so, insurers are expected to better contribute to economic growth and financing sustainable initiatives.

 We note that, notwithstanding the changing macroeconomic landscape, both in the EU and the UK insurance companies have maintained high solvency ratios in recent years. On top of this, the less strict capital rules are not detrimental to EU and UK insurers’ capital position and we believe that the new rules should not ultimately affect their risk appetite and asset allocation materially.

 Solvency Review: A Summary of the Main Changes
 In Europe and the UK, one of the most relevant changes to the directive is related to the risk margin. The risk margin is an additional provision insurers are required to maintain above their best estimate liabilities. Since the introduction of the Solvency II directive, the risk margin has been under scrutiny and received some criticism for being too large and too sensitive to interest rate volatility. Within the European Commission's 2021 Impact Assessment Report a recommendation was made to reduce the risk margin by introducing a time-sensitive parameter called “lambda”. In addition, the European Parliament proposed in July 2023 to reduce the cost-of-capital rate, another variable used in calculating the risk margin, to 4.5%, from the current 6%. If both changes are adopted, insurers, especially those with long-term liabilities, could benefit from a substantial release of technical provisions and regulatory capital, which could be deployed to finance European economies and long-term green investments. As in Europe, the UK regulator intended to reduce the risk margin by adopting a modified cost of capital calculation methodology. According to the new rules, the PRA indicated, in June 2023, that the risk margin is expected to decrease by around 65% for long-term life insurers and 30% for non-life insurers in the UK.

 In Europe, another significant change is related to long-term equity investments (LTEIs). The reform takes into account the fact that insurers and reinsurers are generally long-term investors in nature, and therefore, it is aimed at easing the current requirement for LTEIs, which are perceived to be too restrictive. Other changes, including the modification of the risk-free curves used to calculate best estimate liabilities and the volatility adjustment, proved to be less material than initially planned in the current higher interest rate environment. Finally, the Solvency II reform will also require insurance companies to consider climate risk and ESG factors in their risk management framework.

 In the UK, another relevant and significantly discussed measure is the adoption of less strict rules around the matching adjustment. The matching adjustment is a significant benefit for insurers that write long-term business, which can hold long-term assets that match the cash flow of similar long- term insurance liabilities. The new rules allow a broad criteria for assets that are deemed to be eligible for inclusion in a matching adjustment portfolio.Solvency II Ratios of the UK and European Insurers at Top Levels

 Most of the Solvency II amendments summarised above are expected to benefit mainly long-term insurers (typically life insurance companies). Thanks to the revised measures, insurance companies with a long-term liability profile will not only be able to deploy additional capital resources but will also be able to invest them in a wider range of long-term assets without facing much higher capital constraints. We note that the regulators will implement these significant changes to the prudential regime in a context in which European and UK insurers have maintained robust regulatory capital ratios. In recent years, insurance companies have built significant capital headroom well above the minimum regulatory requirement. As reported by the European Insurance and Occupational Pensions Authority’s (EIOPA) insurance statistics, European insurers reported an average SCR ratio of 223% at the end of Q3 2023, compared with 217% at the end of 2022. In its latest financial stability report, the EIOPA also noted that life insurance companies are, on average, better capitalised than non-life insurance companies, with a median SCR ratio of 243% at end-Q2 2023 compared with 214% for non-life insurers.

 In the UK, the average SCR ratio was slightly lower at end-Q3 2023, at 195% (190% at end-2022) but still well above the minimum requirement of 100%. In the UK, life and non-life insurers’ SCR ratios are almost equal at 194.2% and 195.5%, respectively.

 While we remain vigilant on further announcements from the regulators that outline the final version of the amendments to the Solvency regime, it remains to be seen how the asset allocation of the insurers will change in accordance with the new rules. For instance, less strict regulatory rules might attract more risky investments that yield higher returns but are less liquid. On the other hand, shifts in asset allocation, if any, will likely be implemented gradually, and we do not expect a significant change in the companies' risk appetite. We also believe that insurance companies in both the EU and the UK will maintain minimum solvency ratio targets comfortably over the regulatory requirements in the future.

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