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Treasury Committee have their say on PRA, Solvency II and Brexit

  • United Kingdom
  • Competition, EU and Trade - Brexit

27-10-2017

On Friday 27 October, the House of Commons Treasury Committee published a report into the “Solvency II Directive and its impact on the UK Insurance Industry”. The report will make welcome reading for the insurance industry. Perhaps less so for the Prudential Regulation Authority (PRA).

The report follows an inquiry by the committee, launched in September 2016, to assess the impact of the implementation of Solvency II on the UK insurance industry (in particular, with a focus on competitiveness), as well as to analyse the options for the industry created by the decision of the UK to leave the EU. Despite its title, the main conclusions of the report go far beyond Solvency II, and instead focus on the relationship between the PRA and the insurance industry.

Scope of the Report

In terms of the scope of the report, almost no stone has been left unturned. The topics covered, include:

  • the remit and objectives of the PRA;
  • a review of the implementation of Solvency II in the UK;
  • function of the Matching Adjustment;
  • the calibration of the Risk Margin;
  • approval of Internal Models;
  • data requirement on firms;
  • the usability of the Volatility Adjustment;
  • Transitional Measures; and
  • contract boundaries.

The report also addresses Brexit, and the potential complications and opportunities presented to the UK insurance industry.

Key findings

The overall tone of the report is clear from the very first page: ‘The Committee is concerned about the extent of disagreement between the PRA and the industry on matters that should be relatively factual’ … ’such disagreements do not foster good policymaking.

A key criticism throughout is that the PRA’s approach to supervision is overly focussed on solvency, to the detriment of its secondary competition objective, and the ability of the industry to meet the savings and protection needs of consumers. The report recommends that this secondary objective be promoted to a primary objective, at least for insurers. The report points out that the degree of market, operational and credit risks in the insurance sector are lower than in the banking sector. Whilst competition was rightly subordinated to systemic risk in banking, the report finds that the same is not true for insurance.

In addition, the report finds that the industry and the PRA need to improve their approach to working together, so that there can be more productive dialogue on issues (like Solvency II). The final criticism levelled at the PRA is that they have not adopted a proportional approach to their supervision.

The result of these failings, the committee finds, are a decrease in internal competition, as insurers exit the market, and external competitiveness, increased costs as firms strive to meet their regulatory obligations and a flight of activity to offshore locations (for example through the reinsurance of risks to non-EU territories).

The report does turn to the technical aspects of the implementation of Solvency II, in particular:

  • The report recognises the importance of the Risk Margin, but is critical of various aspects. It is described as ‘the biggest and most obvious bug’ in the Solvency II regime. The report highlights its sensitivity to risk-free interest rates, and that it can be particularly procyclical. The report also highlights that, because of the cost of the Risk Margin, firms are transferring risks to other jurisdictions with lower capital requirements. This is interesting as reinsurance to overseas reinsurers has been a real focus for the PRA in recent years in light of the perception that increasing volumes of longevity risk is being transferred offshore.
  • Solvency II has made it harder for firms to invest in illiquid assets. This is seen as a broader system problem, given the size and importance of investment firms as institutional investors in the wider market. The Matching Adjustment, whilst giving some relief, is described as a “workaround solution, bolted on to the core Solvency II rules, which is cumbersome and unnecessarily constraining”. The report recommends a fundamental review of the MA, and its eligibility criteria, to achieve a more principles-based approach.
  • The report states that the rules-based approach of Solvency II has led to an excessively rigid approach to capital models, particularly Internal Models. This has led to an excess of work and cost in preparing and seeking approval of Internal Models, as well as a lack of flexibility. This is one area where the committee particularly highlight the PRA’s lack of proportionality in its review and approval of Internal Models. The report goes on to question whether the standard formula should be enhanced, to save some firms from needing, or choosing, to upgrade to an Internal Model.

In terms of Brexit, the report proposes that the UK insurance sector should be regarded as a priority sector during Article 50 negotiations. Going further than any commentators on the topic to date, the committee also recommend that a bespoke reciprocal agreement with the EU, along the lines of the Swiss agreements or a more extensive version of the EU/US Covered Agreement, should be put in place to cover cross-border contracts post-Brexit.

Proposed next steps

The report sets out its recommendations for the steps which should be taken to address the myriad concerns raised.  The report recommends that the PRA works ‘in close collaboration’ with industry to undertake these steps, including the development of proposals to:

  1. improve calibration for the Risk Margin;
  2. develop proposals for regulatory forebearance to deal with procyclicality;
  3. design a more flexible and principles-based approach to the Matching Adjustment and Volatility Adjustment;
  4. agree an approach to the treatment of illiquid assets;
  5. reduce the amount of data required from firms in their reports;
  6. develop rules for contract boundaries which reflect economic substance over legal form;
  7. simplify the calculation and approval of Transitional Measures on Technical Provisions;
  8. better align post-Brexit regulation with IFRS17;
  9. remove limitations in the standard formula;
  10. improve the usefulness and sophistication of Internal Models;
  11. develop a solution for firms who will lose the legal validity of contracts after Brexit.

The report also states that the committee expects to receive a progress report by 31 March 2018, setting out the progress, agreement with industry, and how the PRA’s implementation of Solvency II ensures proportionality and meets the competition objective.

ES view

The findings in the report represent the culmination of 18 months’ of industry-wide experience following the implementation of Solvency II. As such, the report is a useful temperature-check on how the insurance industry has dealt with the implementation, and the areas which are still clearly causing concerns.

The criticisms of the PRA could arguably be viewed as quite heavy-handed, not least given that the report comes less than a week after the PRA sought consultation on the Matching Adjustment (CP 21/17), based on areas recommended for reform by the Association of British Insurers and following discussion with the committee.

It is clear from the overall tone of Friday’s report that the committee are putting ‘UK Plc’ into the heart of the debate, and view the PRA as hampering those efforts. Whether this will shape the future approach taken by the PRA remains to be seen. In any event, however, a greater co-operation between the PRA and industry is needed, particularly if the UK insurance industry is to be ready to deal with the challenges that Brexit may bring.