UK capital rule change faces delay as politicians, regulators and insurers clash

Reforms to the U.K.'s version of Solvency II insurance capital rules are likely to be delayed because of a fierce backlash against the proposed changes.

Duncan Barber, a corporate partner at law firm Linklaters, originally thought that the reforms could land in the third quarter of 2023 but now believes negative feedback is likely to push the timeline to the first quarter of 2024.

The U.K. government, keen to derive benefits from leaving the European Union in 2020, set out plans to reshape its version of Solvency II in an April 2022 consultation document. It argues that tailoring the rules to the specifics of the U.K. insurance industry would reduce life insurers' capital requirements and allow them to invest more in assets that benefit the country, such as infrastructure.

The two main proposals are to cut the risk margin, a capital buffer insurers hold above the best estimate of their liabilities, by 60% to 70% for life insurers and to incorporate more credit risk safeguards into the matching adjustment, a mechanism that allows insurers to hold less capital for certain long-term, illiquid investments if they are closely matched to liabilities. The two changes work against one another, but the government says the net effect will be a capital release for life insurers of "possibly as much as 10% or even 15%."

The Prudential Regulatory Authority says life insurers' risk margins could be reduced by around 60%, but only if accompanied by introducing a provision for credit risks equivalent to at least 35% of credit spreads, on average, into the matching adjustment's fundamental spread. The fundamental spread reduces the benefit companies get from the matching adjustment to account for investment risk. This combination, the PRA said, should deliver a capital release in line with government expectations.

'Brexit penalty'

The insurance industry sees it differently. Specialist annuity writers, among those most likely to make the investments the government wants, would need capital injections under the proposals, the Association of British Insurers said, citing a study commissioned from Willis Towers Watson PLC. The U.K. government's reform package is "significantly less favorable than the EU version of Solvency II" and the fundamental spread plan would create a "material Brexit penalty," leaving annuity companies worse off than they were under EU rules, the trade group said.

The WTW study was based on year-end 2020 data. Since then, rising interests have lowered the risk margin by almost 40%, reducing the benefit of the proposed risk margin cut while leaving the negative effects of the suggested matching adjustment revision largely unchanged, said Kenneth McIvor, director and one of the study's authors.

Some insurers will not see the full benefit of the risk margin cut until 2032 because of temporary capital relief they receive for business written before Solvency II came into force in 2016. Cutting the risk margin would reduce the relief, partly offsetting the benefit of the cut.

"On balance, we actually think that it will increase the capital within the industry rather than the other way around," Andrew James, a director of PwC in the U.K., added in an interview.

While achieving a 10% to 15% capital release may be possible with certain calibrations, it is not clear how that would work under the current proposal, Tamsin Abbey, a partner in Deloitte's consulting practice, said in an interview.

Even if there is a capital release, the reforms may not encourage the intended investment. The proposed changes would force Legal & General Group PLC, the biggest beneficiary of the matching adjustment, to look at reinsuring more of its assets and encourage it to invest in non-U.K. assets, CEO Nigel Wilson said on a recent earnings call.

The calibrations being considered for the matching adjustment's credit risk buffer will both reduce the matching adjustment benefit "substantially" and make insurer balance sheets more sensitive to changes in spreads. That would make some long-term investments less attractive, the exact opposite of what the U.K. government wants to achieve, said Brandon Choong, a senior manager in Deloitte's consulting practice.

Risk of rushing

The ABI's "hard hitting" consultation response aligns insurers with the government, which is pushing regulators into a corner, according to Barber.

"It's pretty difficult to see how this plays out," Barber said.

The market is hoping for more detail when the PRA issues a technical consultation later this year, but the entire issue will be complicated by, among other things, the selection of a new prime minister in September. Both candidates for the job want to insert powers into the Financial Services and Markets Bill on its way through Parliament that will allow lawmakers to overrule financial regulators if they consider they are holding them back from capitalizing on Brexit.

With the EU working on its own changes to Solvency II, which have an analogous aim to free up capital by reducing the risk margin, some feel speed is required to maintain the U.K.'s competitiveness.

"It would be really good if we could get on with it," Aviva PLC CEO Amanda Blanc told journalists earlier in August.

Even so, the desire to get the reforms right is likely to be stronger than the push for speed.

"I think all parties want this to be done carefully, and that includes the industry and the PRA," McIvor said. "There's been a lot of examples of things having unintended consequences through being rushed, and that is a material concern."